Warren Buffett‘s Berkshire Hathaway does not own Rolls-Royce (LSE:RR) shares. But that doesn’t mean it’s not a stock that meets his investment criteria.
Buffett has repeatedly said that investors should only own companies with a competitive edge. He buys when stocks are meaningfully undervalued, but avoids distressed assets.
So let’s take a closer look at Rolls-Royce, and explore why I think this stock would meet the legendary investor’s criteria.
A distressed asset?
Let’s start by assessing one reason why Rolls-Royce might not meet Buffett’s criteria. It’s not what you’d describe as a distressed asset, but it certainly faces challenges.
Rolls has been working hard to pay off its debts, and completed a £2bn sell-off of business units in September. These funds were used to pay down near-term debt. However, Rolls still has £4bn in debt obligations — all on fixed-interest rate terms — between 2024-2028.
Revenue dropped substantially during the pandemic, and it’s still not back at pre-pandemic levels. The company, which gets paid when its engines are airborne, said hours flown by its customers were now at 65% of 2019 pre-Covid levels.
It’s worth noting though, that other firms do use debt to leverage greater revenue. And despite continued pandemic-induced disruption, cash flow is once again positive.
Meaningfully undervalued?
In the summer, Morgan Stanley analysts said shares in the engineering giant were “woefully mispriced” — at the time Rolls was trading for 88p.
The stock then tanked during the short, but disastrous, premiership of Liz Truss. With Rishi Sunak at the helm, a more predictable macroeconomic environment, and a recent positive earnings update, the share price has jumped 30% in a month — back to 90p.
There are metrics to support the notion that Rolls is still undervalued. It trades with an enterprise value-to-sales ratio of 1.11 versus a sector average of 1.72. Meanwhile, the enterprise value-to-EBITDA ratio is in line with the sector median. Other metrics also suggest the firm is trading at a discount to its peers in the industrials sector.
Competitive edge
Rolls-Royce is synonymous with quality. And that’s important as the sectors the company operates in — aviation, defence, and power systems — put a premium on quality.
The firm is a market leader in aviation, particularly in the provision of engines used on long-haul flights. It’s not the type of market where customers are willing to skimp on quality to get a better price. Rolls is also at the cutting edge of efficiency — its UltraFan demonstrator aero engine is 25% more fuel efficient than the first Trent engine models.
The firm is also responsible for maintaining and developing the UK’s nuclear submarine fleet — there aren’t too many competitors here and nuclear tech is closely guarded. In many respects, this provides Rolls with defensive characteristics.
So while Buffett might not own Rolls stock, I think it could meet the billionaire investor’s criteria. It’s also worth noting that Rolls-Royce is down 63% over three years (-33% over one year). But despite the £2bn in business unit sales, the company isn’t substantially smaller. In fact, remaining business units are demonstrating strong growth.
I already own Rolls-Royce stock, and I’m looking to buy more this year.
The post Would Rolls-Royce shares meet Buffett’s famed investment criteria? appeared first on The Motley Fool UK.
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James Fox has positions in Rolls-Royce. 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.