An aircraft engine made by Rolls-Royce (LSE: RR) can easily sell for millions of pounds. The company’s stock price though, is nowhere near as expensive. In fact, right now I could add Rolls-Royce shares to my portfolio for just pennies apiece. But should I?
Why do Rolls-Royce shares sell for pennies?
A few years ago, the engine maker’s shares were flying high. In 2014, the Rolls-Royce share price was over £4. So what has happened since then?
The obvious explanation is that demand for civil aviation has been markedly lower over the past several years. But in many regions it is now showing strong signs of recovery. However, we are still a long way from seeing 2019 flying hours across the board. That continues to pose a risk to the servicing revenues Rolls-Royce generates on its large installed base of engines.
But the price fall also reflects what may be permanent scars inflicted in the past couple of years. In the face of plummeting demand, it made wide-ranging cost cuts, sold off some businesses and boosted liquidity by heavily diluting existing shareholders.
Those may have been smart strategic decisions. But as a consequence, there are now far more Rolls-Royce shares in circulation while the business continues to perform worse than it did before the pandemic. That alone helps to explain why the Rolls-Royce share price has crashed.
Recovery prospects
However, has the share price fall now gone too far? After losing 29% in the past year, the shares now look like they may be priced for a company that could struggle to recover. But I think the business evidence points the other way.
Rolls-Royce has tightened its cost base and started to generate free cash flow again, although the first half once again saw a net outflow of cash. Returning to positive free cash flow could help to ease liquidity concerns.
Revenues also grew in the first half and the company expects an improved performance in its civil aerospace segment in the second half of the year.
Clearly there is still work to be done at the firm. A lot of things are outside its control, critically passenger demand for civil aviation. Despite that, I think the business is showing signs of health again and could be set to continue recovering in the coming years.
Are the shares a bargain?
So does that mean Rolls-Royce shares are a bargain? Ultimately, the answer to that question depends on whether a sustained business recovery comes to pass. If the company grows profits to the level I think its expertise and competitive advantage merit, today’s price looks like a bargain to me. That is why I am holding the shares in my portfolio at the moment.
On the other hand, Rolls-Royce shares have already lost a lot of ground and that might continue. There are clearly risks here. The pace and scale of demand recovery in civil aviation is outside the firm’s control but important for its business performance in coming years.
Weighing up the pros and cons though, I would happily buy more Rolls-Royce shares for my portfolio while they continue to trade for pennies.