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Rolls-Royce (LSE: RR) shares fell last week after the company’s half-year results disappointed investors. It’s true that market conditions are still difficult. But I think the real story here for investors is the company’s ongoing recovery.
Air travel is returning to normal, and Rolls-Royce’s other businesses are also performing well. I think now should be a good time to buy the shares for a long-term investment.
Ready for take-off?
Rolls-Royce says that the flying hours on its engines reached about 60% of 2019 levels during the first half of the year. The company expects flying hours to return to 2019 levels by 2024.
One of the big headwinds so far this year has been the impact of Covid lockdowns in China, which have prevented a lot of travel.
However, demand is bouncing back well elsewhere according to the company, including elsewhere in Asia. This recovery was reflected in an improved half-year financial performance.
Rolls-Royce’s revenue rose from £5.2bn to £5.6bn during the first half of this year. The company’s operating profit for the period rose to £223m during the half year, compared to just £38m during the same period in 2021.
Perhaps most importantly, Rolls-Royce has stopped leaking cash. The free cash outflow from the group was just £68m during the six months to 30 June, compared to £1,174m during the same period last year.
Improved cash generation meant that net debt was unchanged, at £5.1bn. This figure should fall by around £1.5bn over the coming weeks, when the company receives the proceeds from the €1.8bn sale of its ITP Aero engine parts business.
What should I be worried about?
Investing in turnaround situations always carries some risk. With smaller companies, the business might fail altogether.
With Rolls-Royce, I think the big risk is that the company could end up repeatedly disappointing investors. That could cause the shares to lag behind the FTSE 100 for an extended period, damaging shareholder returns.
Even if Rolls-Royce’s recovery is successful, the company could end up having to reinvest much of its profit in energy transition projects.
UK government policy is for Britain to hit net zero by 2050. It may not be easy to find cleaner sources of energy to replace fossil fuels for long haul flights.
Are Rolls-Royce shares cheap?
Broker forecasts suggest that Rolls-Royce shares trade on a whopping 45 times 2022 forecast earnings. However, the stock’s P/E ratio falls to 20 times forecast earnings in 2023, and just 12 times earnings in 2024.
City analysts also expect that Rolls will be in a position to restart dividend payments in 2023 or possibly 2024, as cash generation gets stronger.
At this stage, these are only estimates. But if Rolls-Royce can deliver on its guidance for a recovery over the next couple of years, I think the stock will probably attract a higher valuation.
With the stock trading close to 80p, I’d be happy to buy Rolls-Royce shares today and tuck them away for three-to-five years. I think the company’s big market share and strong technology are likely to deliver a solid recovery over this period.