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He rolls royce (LSE:RR) stock price is rising strongly in early 2023. In fact, it is leading the FTSE 100 higher in Friday trading and was last 3.8% higher on the day.
At 108 pence, Rolls shares are now up 14% in early-year trading. Can the engineering giant continue to make up ground? And should long-term investors like me buy the business for their investment portfolios?
the case for
A bright outlook for the defense and civil aviation markets provides a good reason to buy Rolls-Royce shares today. Together, these industries account for around three-quarters of the group’s revenue.
The number of commercial passengers from emerging markets is projected to skyrocket over the next decade. As a consequence, the number of planes in the air should also grow considerably, as the following graph from the Oliver Wyman consultancy shows.
Rolls can also expect demand for its engines to grow as military budgets increase.
Tension in the West over Chinese and Russian expansionism boosted global arms spending over 2 trillion dollars for the first time in 2021. Governments around the world have also pledged to further increase arms spending after Russia’s invasion of Ukraine.
Exposure to growth markets alone does not make a stock worth investing in. Massive competitive pressures can still greatly affect a company’s profits and hurt shareholder returns.
The beauty of Rolls-Royce is its formidable barriers to entry. It has decades of experience building aircraft engines and maintaining them, making it a go-to hardware provider for aircraft manufacturers and the military. It also operates in a highly capital-intensive industry. New rivals are not going to appear overnight to steal your customers.
the case against
Having said all that, I still have major reservations about buying Rolls-Royce shares. My main concern is its huge financial liabilities (net unused debt was £4bn in September).
The cost of maintaining this is huge and will rise even more as interest rates rise. These huge debts also cast a shadow on the company’s R&D spending in areas like green technology. And I am particularly concerned given the uncertain near-term outlook for the aviation industry.
Airline profits have rebounded strongly following the end of the Covid-19 lockdowns. But they could cool off sharply as the global economy falters. Travel spending by tourists and business passengers could hit the cap in 2023, hurting the revenue Rolls earns from its service activities and affecting its ability to pay these debts.
The verdict
As a value investor, I think Rolls-Royce shares look very attractive right now. City analysts believe the engine maker will increase earnings 292% by 2023. This results in a minimum forward price-to-earnings (PEG) growth ratio of 0.1. Any reading below 1 indicates that a stock is undervalued.
However, there are plenty of other FTSE 100 value stocks for me to choose from today. And I am discouraged by Rolls’ high debt levels, as well as the prospect of strong and sustained cost inflation. High costs led to a £1.6bn loss in the first half of 2022.
On balance, I’d rather invest in other cheap UK stocks right now.
