It seems investors remain concerned that nearly half of the engine maker’s revenue comes from supplying the civil airline sector, which is yet to fully recover from the pandemic. The firm needs more aircraft with Rolls-Royce engines back in the skies as soon as possible.

Yet the company also has a very large defence division, where business is much healthier. So, could rising geopolitical tensions eventually feed through to a much higher Rolls-Royce share price?

A ‘New Cold War’ has probably already started

Addressing the United Nations last year, President Joe Biden said that the US does “not seek another Cold War or a world divided into rigid blocs”, and was not “asking any nation to choose between the United States or any other partner.”

However, Russia’s invasion of Ukraine has raised tensions between Moscow and the West to levels not seen since the days of the original Cold War. This has left most foreign policy analysts believing that a ‘New Cold War’ has already started, with the US and western nations on one side, and Russia and China on the other.

In response, lots of countries around the world have been bolstering their defence systems and securing contracts with military equipment providers, such as Rolls-Royce.

The UK government had committed to significantly increase its own military spending, with its defence budget having been due to rise to £100bn by 2030. Yet this is now in doubt, as the new British government plots spending cuts to get public finances in order.

Even so, many nations are still rearming in the face of increased military threats.

How could all this benefit Rolls-Royce?

Rolls-Royce has more than 16,000 military engines in service, with 160 customers in 103 countries, so the company is certainly a powerful player in the defence aerospace market.

The firm is also the world’s leading supplier of marine propulsion equipment, with its products found on more than 95% of the US Navy’s Surface Warfare fleet. The US Navy is the company’s largest naval customer, to which it provides propulsion equipment for frigates, destroyers, submarines, aircraft carriers, and many other vessels.

The company actually equips more than 70 navies worldwide, as well as military air forces. The hardware it builds for these customers accounts for around 30% of its underlying revenues today, but that could easily increase with rising defence budgets.

Should I buy the stock?

Rolls-Royce has been struggling with soaring inflation and supply chain issues. In the first six months of 2022, the company reported a loss of £1.6bn. And it also had net debt of £5.1bn on its balance sheet, as of June, which is far from ideal.

I think rising military budgets could provide a massive tailwind for the company’s defence division, and this may increase the share price. However, I don’t like to see established companies so debt-laden and still posting losses after decades in business. So I’d rather invest in other UK shares right now.

Travel tailwinds

Given that the Derby-based manufacturer earns the bulk of its revenue from its Civil Aerospace segment, it’s only natural for me to pay attention to how well the travel sector has been doing. Major airlines reported rosy numbers last month, which sparked a rally in the Rolls-Royce share price. This is because more flying hours mean the FTSE 100 firm will be servicing more engines.

With no signs of travel demand cooling down, analysts are expecting the engine maker to show gradual signs of recovery post-pandemic. Therefore, the company is expected to hit the guidance it set out for itself by the end of the year.

Nonetheless, it’s worth noting that although travel demand continues growing, the industry is still lagging behind its pre-pandemic numbers. This means a ceiling for the Rolls-Royce top line, thus limiting the recovery of its shares. On top of that, it’s also been facing a number of supply chain issues, which have impacted its ability to service and manufacture engines at a steady pace.

Energetic prospects

Aside from Civil Aerospace, the group is expected to build on the strong growth in its Power Systems segment as well. Since Rolls-Royce released its half-year results, it’s been working hard to implement its MTU engines and technologies for its naval clients. Moreover, it’s been developing a line of sustainable fuels for aircraft and yachts, which could help boost growth in the firm’s energy segment over the long term.

And with the Russia-Ukraine war unfortunately ongoing, higher military spending should see the firm retain a significant level of income. Most recently, it’s been able to secure a number of military contracts that further adds to its order backlog of over £50bn.

Stalling behind consensus

With all that in mind, can the Rolls-Royce share price recover? Well, there’s certainly potential given the ongoing travel rebound and tailwinds from its Defence and Power Systems segments. However, I think the initial excitement has already been priced in given the recent rally over the past week.

A recovery rally could be on the cards, but I believe that investors will still have to see significant improvement to Rolls’ current financial state before pushing its stock back up to £1. This is especially so given the current macroeconomic environment. After all, its balance sheet remains far from ideal, with negative shareholder equity and a staggering debt pile of £6.24bn.

Either way, analysts’ consensus for Rolls’ full year remains modest. So far this year, it’s earned £5.31bn in revenue, which means that the next two quarters will have to show stronger revenue growth in order to meet analysts’ consensus. Along with that, Rolls-Royce has lost 2.24p per share in its first six months. As such, investors will be hoping for its bottom line to improve drastically.

Either way, its shares currently have an average price target of 83p, which doesn’t present much of an upside from current levels. And with the likes of JP Morgan and Berenberg advocating a ‘hold’ rating, I won’t be investing in Rolls-Royce.

Demand for Rolls-Royce shares hasn’t risen on the back of any company- or industry-specific news. They’ve been carried higher by an improvement of broader investor confidence in recent days.

Should I join the stampede and buy the troubled blue-chip share?

Danger here

Rolls-Royce has exposure to many different engineering markets and industries. However, its fortunes are closely tied to those of the airline industry. Its civil aerospace division generates more than 40% of underlying revenues.

So a bet on Rolls-Royce shares can be seen as a bet on the travel sector. And an uncertain outlook here worries me as a potential investor. Jet sales and aircraft servicing revenues depend on strong airline profits and flight activity.

Recovery to slow?

The precariousness facing the airline sector is highlighted in a fresh report from Bain & Company. For 2022, analysts at the management consultancy have upgraded their revenues estimates for the industry. They now expect turnover to hit $525bn this year, or 84% of pre-pandemic levels.

However, Bain said that it expects a lower rate of growth over the next 18 months as discretionary spending begins to decline.

The firm said that its current growth estimates could be downgraded too, “amid mounting recession concerns in many key economies” and “turbulence with OPEC+ resulting in recent cuts to oil supplies”. It added that business travel isn’t tipped to recover fully until 2025.

Defence demand

The problem for Rolls-Royce is that it also supplies product to other cyclical industries. So as the chances of an economic downturn increase, its broader profits outlook worsens.

On the plus side, the business also generates considerable revenues from defence customers. This provides it with some welcome earnings visibility as defence budgets remains broadly unaffected by economic conditions.

In fact, its defence division enjoys huge long-term opportunities as global arms spending soars. Statista thinks defence expenditure in the US — a major user of Rolls-Royce aircraft engines — will grow strongly every year over the next decade.

The verdict

However, this isn’t enough to encourage me to invest. Even the bright long-term outlook for the airline industry will not tempt me to buy Rolls-Royce shares.

This is because of the company’s gigantic debt pile. It stood at $5.1bn as of June, and a slump in the global economy will hamper its ability to pay this down.

Consequently, Rolls could struggle to fund its growth programmes. It might also have trouble restarting its dividend programme (the engineer hasn’t paid a dividend since 2019).

Today, Rolls-Royce’s share price trades on a whopping price-to-earnings (P/E) ratio north of 270 times. This is far, far too high, in my opinion, given its high-risk profile. So I’d rather buy other UK shares right now.

I am hoping they may recover in the fullness of time. But, meanwhile, I think there is a lesson to be learned from the declining Rolls-Royce share price that could help me in future investing decisions.

The difficulties of market timing

That lesson, in short, is that market timing is a difficult investment strategy to employ successfully.

Market timing broadly means trying to guess the point at which a share hits a bottom, or indeed reaches a high point. That could be a lucrative approach in theory, if it enabled an investor to buy low and sell high.

But the problem as I see it is that timing markets is essentially impossible. If there was certainty about the direction in which a share would move next, people would pile in on that basis. Instead, what happens is that investors are making a judgement about what they think will happen next. That may turn out to be true – but we can often be surprised and disappointed by the way in which a share moves.

The falling share price

I would say that lesson has been brought home again in the case of the recent performance of the Rolls-Royce share price.

A lot of things that ought to be positive for the company’s investment case have happened in the past year. Demand for civil aviation has recovered strongly in many markets, helping to boost the firm’s revenues. The company proved it can return to profitability and free cash flow generation. While that has not yet been shown consistently, the economics of the business certainly look stronger than they did a couple of years ago.

Despite that, the shares have been falling.

My move as a long-term investor

So what does that mean for my move as a Rolls-Royce shareholder? Being reminded of the difficulty of market timing is often a hard but useful lesson. It can push me to focus on the fundamentals of a share. Instead of trying to time the market, I ask myself whether a company has strong long-term economic characteristics and trades at an attractive price.

The Rolls-Royce share price has fallen party because of the challenges the company faces. Its debt makes for a weighty balance sheet that could hurt profitability in future. Cost inflation is another risk to profits.

But I think the business has an attractive position in an industry I expect to see long-term demand and that has high barriers to entry. Its installed base means the engine maker should benefit from servicing revenues for years, or decades, to come.

So I am not worried by the share price fall, nor am I trying to time the market. Instead, I see the current Rolls-Royce share price as a good opportunity for a buy-and-hold investor like myself to increase my stake in Rolls-Royce. If I had spare cash to invest right now, that is what I would do.

The collapse of Rolls-Royce shares

Back in August 2018 — long before Covid-19 reared its ugly head — Rolls-Royce shares were flying high. On 3 August 2018, they closed a smidgen above 375p. As I write on Thursday afternoon, they stand at 75.53p. Thus, they have collapsed almost four-fifths (-79.9%) from August 2018’s high-water mark. Crikey.

Thanks to the damage wreaked by coronavirus, this popular stock has crashed hard. Here’s how it has performed over six different timescales:

Over the past half-decade, the stock of this great British engineering firm has crashed by more than three-quarters. Also, Rolls-Royce shares have lost almost two-fifths of their value in the past 12 months. Yet some analysts warn that things might get worse for the group before they get better.

Is Rolls-Royce heading for stormy weather?

Along with defence, a large slice of Rolls-Royce’s income comes from its Civil Aerospace arm. This has benefited from surging passenger miles flown as demand for foreign travel recovers. But European consumers are struggling with soaring inflation, sky-high energy and fuel bills, and rising interest rates. As consumer confidence plummets, I suspect that many millions of foreign holidays will be ditched due to the ongoing cost-of-living crisis.

Then again, innovative developments in other Rolls-Royce divisions might energise future revenues. For example, the company’s plans to build nuclear-powered small modular reactors (SMR) are gaining momentum. The group is also entering the market for hydrogen-fuelled engines, but these blue-sky projects will be years in the making.

I might have missed the boat to buy

At their 52-week low, Rolls-Royce shares plunged to an intra-day low of 64.44p on 28 September. They have since rebounded by more than 11p to their current level. This leaves me thinking that I may have missed my chance to get on board at a bargain-bin price. Then again, as a veteran value investor, I find it very difficult to put a firm price on Rolls-Royce stock.

Without any tangible profits, positive earnings, or dividends to work from, it’s very tricky to justify the company’s current market value of £6.3bn. What’s more, the firm carries over £5bn of net debt on its balance sheet — and global interest rates are taking off. Also, the company lost £1.6bn in the first half of 2022, with positive profits unlikely to arrive until well into 2023.

In short, in this increasingly turbulent global economy, Rolls-Royce shares are too risky for me, although I think they are by no means a dead duck. Hence, I’ll stick to what I know best — buying shares in quality businesses at modest prices for the long term!

Tailwinds not dissipating

Rolls-Royce earns the bulk of its income from its Civil Aerospace division. Therefore, it’s expected to continue benefiting from the rebound in travel demand. Longer flying hours for airlines and private jets should greatly benefit the company’s top line.

The likes of Delta, United Airlines, and American Airlines have reported no slowdown in long-haul international travel thus far, and IAG is expected to report the same when it unveils its Q3 results later this week.

As such, it’s a bit of a head-scratcher to see the Rolls-Royce share price drop down to 70p from £1. This is especially the case when considering passenger seat numbers. These have increased by approximately 15% since the end of February. Thus, I’m expecting Rolls-Royce’s top line to continue recovering when it reports its Q3 results next month.

Energised for innovation

Nevertheless, it’s the firm’s Power Systems division that excites me. In its half-year results, the branch saw an impressive 20% growth year on year. Building on this, I believe that there are a number of key breakthroughs that could spark a fundamental improvement to Rolls-Royce’s earnings potential.

The biggest would be its ambitious plans to build Small Modular Reactors (SMR). Given the importance surrounding energy independence in light of the Russia-Ukraine conflict, these nuclear SMRs could be groundbreaking and bag massive profits, if successful.

Additionally, Rolls-Royce recently shared a number of interesting developments. The British firm has been successfully implementing its MTU engines and technologies for its naval clients. Moreover, it’s developing a line of sustainable fuels for aircraft and yachts. Consequently, Rolls-Royce signed an agreement with easyJet to pioneer the development of hydrogen combustion engine technology.

Sky’s not the limit for now

With all that in mind, will I be buying Rolls-Royce shares for its potential? Well, the conglomerate is leading the charge in the clean energy space with its radical innovations. Admittedly, these do excite me as I believe the upside potential for the stock could be incalculable, if successful.

But even so, I still can’t turn a blind eye to the state of its balance sheet. With negative shareholders’ equity and a staggering pile of debt, Rolls-Royce is going to struggle to fund all of its promising ventures if its financials don’t improve drastically.

The recent sale of ITP Aero worth €1.8bn should help shore up its finances slightly. However, management will still have to hope that free cash flow continues to improve at a steady pace, or risks missing its debt repayments in the near future.

Having said all that, as much as I’m a big fan of the manufacturer’s visions, I won’t be investing in Rolls-Royce shares today due to the state of its finances. Not to mention, brokers from JP Morgan and Deutsche have an average price target of 75p for the stock, which doesn’t present much upside from the stock’s current price.

Here are four reasons I’m avoiding the FTSE 100 share today.

1. UK defence spending

Defence revenues are a big deal for Rolls-Royce. The hardware it builds for military customers account for around 30% of underlying revenues.

It’s a critical supplier of power systems to the Ministry of Defence. But political turmoil in the UK — and the mounting pressure of dealing with spiralling public debt — casts a growing shadow. Demand for its plane, boat, and submarine engines could potentially disappoint over the next decade.

Previous Prime Minister Liz Truss’s pledge to spend 3% of GDP on defence by 2030 remains in play. But her touted replacements have so far refused to commit to such spending.

2. Supply and cost pressures

Cost inflation is soaring and supply issues are a significant headache at Rolls-Royce. It’s why the business swung to a thumping £1.6bn loss in the first half of 2022.

Worryingly, Rolls-Royce says that it expects “these issues will persist into 2023”, too. A long war in Ukraine and fresh Covid-19 lockdowns in China could hit the company’s profits hard next year and potentially beyond, too.

3. Sinking civil aviation sales

Rolls-Royce depends on a strong airline industry to fuel earnings. Sales of its civil aeroplane engines and its servicing packages account for 44% of underlying turnover.

Encouragingly the commercial aviation industry is tipped to explode over the medium to long term. Passenger numbers (and especially in emerging regions) are expected to grow strongly and by extension so are aeroplane sales.

Boeing, for example, expects 41,170 aeroplane deliveries over the next 20 years. This is a good omen for Rolls-Royce’s longer-term profits.

But the outlook for the airline sector is plagued with danger in the nearer future. Soaring inflation across the globe is putting increased pressure on consumer spending. Rising turbulence in the global economy also threatens to derail ticket demand from business travellers.

4. Debt danger

For certain stocks I might be tempted to overlook some short-term risks. But in the case of Rolls-Royce, I’m not. This is because of the company’s huge debt pile.

Net debt stood at an eye-watering £5.1bn as of June. A slump in civil aerospace revenues could cause Rolls’ debt mountain to grow again. This would be particularly problematic as interest rates rise and the cost of debt servicing increases.

Massive debts like the business currently has could significantly hamper its growth strategy. R&D at Rolls doesn’t come cheap after all. It also means investors need to consider the possibility of further share placings later down the line.

Rolls-Royce shares are pricey

I think the company could be a great way to capitalise on growing long-term travel demand. But on balance I think the risks facing the business outweigh the potential rewards.

And what’s more, I don’t think the dangers are reflected in the engineer’s enormous forward P/E ratio of 260+ times. I’d much rather buy other cheaper UK shares right now.

Rolls-Royce (LSE: RR) shares have been on a downtrend since November last year. With the stock near 73p, its plunged by around 47% over the past 12 months.

That wasn’t supposed to happen! The reasons for the company’s troubles during the pandemic have been well reported. But the partial recovery in airline flying hours should have propelled the business well along the runway to recovery. 

And the way the company has been selling non-core operations to shore up it’s debt-laden balance sheet should have provided added impetus for the shares.

The business isn’t the stock

The problem for shareholders is that the business isn’t the stock. Rolls-Royce the business has been on a fast-recovering trajectory. City analysts forecast chunky triple-digit-percentage increases in earnings this year and next. Revenue is on the rise too. And operating cash flow has recently dragged itself out of negative territory.

However, the background to those positive figures is that Rolls-Royce has proved it relies on the health of the airline industry. And that’s a vulnerable and cyclical sector. But on top of that, the company carries a lot of debt. The business was making a loss in the two years before the pandemic even started. And I think that speaks volumes about the complexities — and costs — of the engineering industry.

If I was starting a business from scratch, or buying one outright, it wouldn’t be an engineering enterprise. There are easier ways to make money. And if I’d never heard of Rolls-Royce before, I wouldn’t consider buying the shares today, based on the current trading and valuation figures.

For example, the company currently pays no shareholder dividend. City analysts are forecasting a big recovery in earnings, true. But even after the recent slide in the share price, the advance is more than priced-in. The forward-looking earnings multiple for 2023 is just over 19. And I think that valuation looks full and well up with events. 

Potential for higher earnings ahead

But the firm’s quality indicators don’t look so good either. The profit margin is running below 3% and the return against invested capital below 5%. If I’d happened to find this company on my screens by chance, I’d have likely moved on to examine the next opportunity.

However, flying hours in the airline industry are still at just around 60% of their pre-pandemic levels. So, theoretically, there’s potential for an increase of just under 67% to get back to the 100% capacity from 2019. And if the industry does fully recover, Roll-Royce could see its revenue and cash flows increase. Potentially, net profits could receive a significant boost.

Nevertheless, Rolls-Royce shares are not for me today. And that’s because I see stock opportunities that look better to me right now. For example, in the same industrials sector, I like the look of IMI. The business engineers and manufactures products that control the precise movement of fluids.

There are no guarantees of a positive performance from an investment in IMI shares. But the company delivered an upbeat trading statement at the end of July. It also has some impressive quality metrics. And the balance sheet features far less debt than Rolls-Royce’s. I’m thinking about buying it.

What do I mean? Well, apart from a few minor wobbles, the Rolls-Royce share price has resisted further falls in the couple of weeks following that ill-fated mini-budget.

It’s times like this that I remember my favourite quote from ace fund manager Sir John Templeton, who said “The time of maximum pessimism is the best time to buy“.

We’ve certainly been through some pessimistic times over the past few years. But it’s hard to think of a time when more financial weeping was done, or more teeth were gnashed, than October 2022.

Downside?

To me, this all makes the potential downside of an investment in Rolls-Royce look more palatable. For most of the past couple of years, I’ve felt sentiment towards the aero engine maker was shaky at best. And several times, it’s only taken a bit of bad news for investors to sell and flee.

Saying that, there is still significant risk, and I’m not sure if Rolls fits in with my personal appetite for it. I still see debt as the biggest threat. At the end of the first half, at 30 June, Rolls-Royce was still shouldering £5.1bn in net debt. And it still reported net cash outflow — though greatly reduced, at just £77m.

Since then, though, the company has completed the sale of ITP Aero, which raised €1.6bn (£1.4bn at current exchange rates). The cash was earmarked for paying off loans. So I expect to see a significant improvement in the debt situation by the end of the year.

Outlook

On the upside, valuations based on forecasts are starting to look reasonable. This year’s price-to-earnings (P/E) multiple won’t be great, not when profit is only just returning.

But analysts expect decent earnings growth in the next couple of years, which would bring the P/E down around 10.5 by 2024. Adjusting for debt gives an enterprise value P/E of around 17-18, which doesn’t look as attractive. But that’s using an estimated net debt figure for today. And the balance sheet will presumably look better by 2024.

Of course, analysts’ forecasts are uncertain, and plenty could still go wrong in the next two years. But I can’t help wondering how 2023 and 2024 could possibly be anywhere near as bad as the years Rolls-Royce has just suffered. Hmm, I do hope those words don’t come back to bite me.

Verdict

So what’s my verdict? I still see a fair bit of risk with Rolls-Royce shares even at today’s possible ‘maximum pessimism’ valuation. But I can’t help feeling the tide might be turning.

I won’t invest, myself. But that’s because I see more attractive FTSE 100 buys out there with less risk.

But with the business showing signs of recovery, could this be the time to add to my existing holding?

Long-term investing

My answer to this is driven by my philosophy of long-term investing. While the Rolls-Royce share price has moved around a lot in the short-term, my focus is on what I think the company will be worth five or even 10 years from now – and whether today’s share price offers me a bargain on that basis.

To do that, I could use a number of valuation techniques. For example, I might look at the company’s discounted future cash flows  Alternatively, I could use its prospective price-to-earnings ratio, based on what I think the firm’s future earnings might be.

Turbulent times

The challenge that faces me as an investor, no matter what valuation technique I adopt, is that there are a lot of unknown elements about the future financial prospects for the aeronautical engineer.

Dramatic demand swings for passenger flights over the past several years were a sudden, unexpected event. That hurt not only engine sales but also servicing revenues from the company’s large installed base. There is a risk the same thing could happen again, whether due to a pandemic, terrorist event, or unexpected weather phenomenon as seen with an Icelandic volcano in 2010.

High fuel prices and mounting regulations concerning fossil fuel use are another unknown. On one hand they present an opportunity. Rolls-Royce is developing a line of engines designed for alternative energy sources. But such new product development tends to be costly. The end result is not guaranteed to find favour with purchasers.

Solid business foundation

Despite such variables, we do know quite a few things I think will likely impact the company’s future prospects.

For example, that large installed base should keep generating servicing revenues for years to come. Growing anxiety about national security across Europe also looks set to help bolster the long-term growth outlook for Rolls-Royce’s defence business.

On top of that, I find the basic business model highly attractive. Designing, making and servicing engines is highly specialised. So the industry has high barriers to entry. Rolls-Royce only has a few big competitors, which can help it sustain pricing power. Engines are mission-critical, further enhancing its pricing power.

It has also been recovering from the challenging business environment of the past several years. The firm now forecasts “good” revenue growth and improved profitability for this year compared to last.

My move on Rolls-Royce

Set against that, the company’s current market capitalisation of £6.3bn looks cheap to me, given the long-term prospects of the business. Admittedly, it has a sizeable debt pile, but the recent sale of ITP Aero could help to reduce that.

As a long-term investor, if I did not already have a sizeable holding, I would see the current Rolls-Royce share price as a buying opportunity for my portfolio. Mindful of the need to keep my portfolio diversified, I do not plan to buy more right now — but will keep my stake.