Since its low in October 2020, Rolls-Royce (OTCPK:RYCEY) has performed spectacularly, rising 15x as its price to sales ratio has rebounded from record lows of just 0.15%. The entirety of these gains has been the result of multiple expansion, primarily arising from declining default risk. The stock now trades at 29x, 2024 expected full-year earnings, which seems too high for a company that still has negative net assets and little room for default risk to fall. The company’s potential in Small Modular Reactor technology provides upside risks, but valuations now require an unprecedented earnings boom.
Decline In Default Risk Is Nearing An End
At the October 2020 lows, Bloomberg’s default risk model put the odds of a Rolls-Royce bond default within 12 months at 25%, forcing the required rate of return on the stock through the roof. As the global economy recovered from the Covid lockdowns and flight travel returned, default risk collapsed and this allowed for an explosion higher in sales and earnings multiples. The chart below shows how the price to sales ratio has moved in lockstep with the price of 5-year credit default swaps, which show the price in basis points per year for protecting against a bond default.
Rolls Royce PS Ratio Vs 5-Year CDS (Bloomberg)
The 5 year CDS is now just 88bps, down from a peak of 666, with decisions this year by rating agencies Fitch and S&P Global to raise the credit rating back to investment grade further helping lower debt costs. However, there is little further that perceived default risk can fall from here when we consider that the UK government’s 5-year CDS trades at 21bps. Rolls-Royce is also one of the few multi-billion dollar companies with negative net assets, owing to the decline in long-term assets and rise in non-current liabilities since Covid.
Rolls Royce Net Asset Value, GBP (Bloomberg)
Record Price To Sales Ratio Suggests Investing In New Era Of Profit Growth
The company’s market cap currently sits at GBP40.75bn while expected 2024 full year net income is GBP1.39bn, resulting in a PE ratio of 29x, putting it in the top 10 most expensive stocks in the FTSE 100. As Rolls-Royce’s profit margins have been highly volatile over the company’s history, the price to sales ratio is perhaps the best gauge of the company’s valuation relative to its own history. The current figure of 2.2x is consistent with annual total returns of -10% for a full decade based on the historical correlation between the ratio and subsequent returns. This should be a concern to bulls, as the R-squared between the two variables over the past 26 has been as high as 0.76.
Bloomberg
To justify this PS ratio, I believe the company will have to sustain profit margins of at least 13% assuming continued long term sales growth of 4%. At the current share price and sales, this translates to an earnings yield of 6% with earnings growing at 4%, to result in a total return of around 10%. Considering that the company’s net margin has averaged just of 3% over the long term, and its EBITDA margin has averaged just over 9%, investors must be anticipating a significant rise in margins or huge revenue growth in the future. However, according to analysts surveyed by Bloomberg, the consensus estimate for sales for the full-year ending December 2025 is just USD18.7bn, which represents just over 3% annualised revenue growth.
Highly Exposed To A Recession
Rolls-Royce is an extremely cyclical stock as civil aerospace revenues which, are directly tied to miles flown, continue to make up the largest share of the company’s revenues. This leaves the company highly exposed to a US or global recession, which rate markets show is looking increasingly likely.
Rolls Royce Earnings By Segment, GBP (Bloomberg)
As shown below, when the spread of 2-year bond yields over the Fed funds rate has fallen to current levels in the past, a recession has always ensued.
Spread of 2-Year Yield Over Fed Funds Rate Vs US Recessions (Bloomberg, NBER)
Why I’m Not Shorting
While I believe Rolls-Royce to be overvalued, I am not short the stock. The first reason is I tend to avoid shorting stocks with market capitalisation of less than at least a few hundred dollars as they are more susceptible to sharp price increases. The second is that Rolls-Royce has potential in power demand amid the data centre capex boom, particularly in its Small Modular Reactor technology, which this article details. That said, investors should be aware that the stock’s valuation now necessitates an earnings boom that is unprecedented in the company’s public history, while remaining as exposed to an economic downturn as ever.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
