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Despite the rally, I wouldn’t buy Rolls-Royce shares anytime soon

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There aren’t many stocks in the FTSE 100 as popular for debate as Rolls Royce (LSE: RR). The balance between diehard supporters of the company, and those who think its days are numbered, seems to change as quickly as the share price. This is especially the case in the month when the price has risen by an astonishing 35%.

However, this rally needs to be considered in the context of the last few years, with the stock still down over 27% in the previous year.

It’s fair to say that the stock has had a difficult time over the last few years. The price fell 52.5% in 2020 during the pandemic. It then had a slight recovery in 2021, rising just over 10%. This was short-lived, however, given the fall that occurred this year. It is now down around 63% from pre-pandemic levels, which has raised questions about whether it is a bargain or worth avoiding.

Looking at the company

To determine the likely cause for this fall in stock price, I have to better understand the business model. The name ‘Rolls-Royce’ is most commonly associated with a range of luxury cars, however, BMW wholly owns the car production business. This stock represents the civil aerospace, power systems, and defence business elements.

When looking at the underlying fundamentals, I’m not massively enticed. The company has high debt levels and very low profit margins. Also, the return on capital employed (ROCE) is very low, indicating that the company is not particularly efficient at generating profit from invested funds. Furthermore, the company had to cut the dividend due to the pandemic and is yet to reinstate this payment.

Director outlook

Recently Rolls-Royce released its trading statement, which provided a great opportunity to get an insight into the outlook from the executive team. The report outlined a continued recovery in many underlying business sectors and that full-year guidance will remain unchanged. The board also outlined a plan to be disciplined due to the inflationary headwinds impacting the wider economy. This is certainly encouraging and helps to explain the recent share price rally.

The announcement also highlighted that the disposal of ITP Aero, one of the company’s underlying holdings, allowed it to repay a £2bn loan due in 2025. It also has £5.5bn of undrawn borrowing facilities, which can be used to aid cash flow if needed. This is undoubtedly a step in the right direction. However, it’s important to note that the company still has £4bn in debt.

Past performance

In addition, it is essential to look at these improvements in the context of the previous year’s performance. The company has produced a substantial loss consistently since 2018. This rose dramatically in 2020, hitting a full financial year loss of £3.2bn. This did improve significantly in 2021, with a full-year profit of £120m, although this is by no means back to previous levels.

There is a long way to go before Roll-Royce is back to its previous levels. There have certainly been steps in the right direction. However, the business is still in a challenging position, and this starts to justify the poor share price performance. Therefore I would not be keen to add the company to my portfolio at this stage.

The post Despite the rally, I wouldn’t buy Rolls-Royce shares anytime soon appeared first on The Motley Fool UK.

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Gabriel McKeown has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.