The aerospace engineer Rolls-Royce (LSE: RR) is famous for making powerful engines that gain altitude at great speed. Sadly the same cannot be said for the Rolls-Royce share price lately. It has lost 9% over the past year – and over a third of its value since November alone. It now trades as a penny share.
Is that a buying opportunity for my portfolio? I think the answer is yes – here I explain why.
Attractive long-term economics
Usually lots of people want to fly and cargo demand is also substantial. Then from time to time, something happens to disrupt that. The 2001 terrorist attacks in the US were one example. The pandemic was another.
These upsets in demand can set the economics of the aviation industry on its head for a while. But typically, flights come back sooner or later. Accepting occasional demand shocks on a big scale is part of investing in aviation, in my view. That is not just true for airlines but also engine makers like Rolls-Royce. Less flying can lead to fewer engine sales. But it also leads to a reduction in the demand for servicing the installed base of engines. That has hurt Rolls-Royce’s civil aviation business badly in the past couple of years.
But the economics of the aircraft engine remain attractive in my view. Engines are very costly to design and build. Only a few companies globally have the right capabilities. Reliability is critical, so customers are willing to pay a price premium. The servicing model means a manufacturer can still be making a profit from an engine it sold decades before.
Rolls-Royce strengths and weaknesses
All of that puts a company like Rolls-Royce in a strong position, in my view. The company is also helped by having a sizeable defence unit. Even when civil aviation demand falls, defence spending tends to be more resilient. Last year, Rolls-Royce saw its revenues from defence customers grow 5%. Given the current geopolitical climate, I expect defence revenues to increase further in coming years.
The company has worked hard to manage its cost base and has returned to generating free cash flow. I see that as positive, because it reduces risks that a liquidity crunch forces the firm to dilute existing shareholders by issuing new shares.
That remains a risk if there is another demand downturn, though. Rolls-Royce had a dilutive rights issue in 2020. Another risk is the company’s attempts to develop engines that are less reliant on fossil fuels. Aircraft engine development programmes tend to be capital intensive and can eat into profits over the course of decades.
My move on the Rolls-Royce share price
Although I recognise the risks, I have been buying Roll-Royce shares and would consider adding more to my portfolio.
I like the industry economics and Rolls-Royce’s well-respected position within it, which helps it attract and retain customers. I see the potential for long-term profit growth. That could boost the flagging share price.