Penny stocks are — as the name suggests — shares that trade for pennies. Typically at the lower end, they’re smaller companies and are thinly traded. As a result, they can be swayed by larger trades. But even though at the higher end, they’re much bigger businesses, it’s probably not the territory you’d expect to include an engineering giant like Rolls-Royce (LSE:RR). The firm, best known for its aviation business, fell back into penny territory earlier this year having previously done so during the pandemic.
But with the aviation industry heading back towards pre-pandemic levels, here’s why I’m backing the Rolls-Royce share price to kick upwards.
What’s behind the fall?
Firstly, its worth looking at why Rolls-Royce has found itself in penny territory. The London-headquartered firm is now trading at 80p a share, that’s down 75% over the past three years.
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2020 was a very bad year for Rolls-Royce. Civil aviation is the company’s largest business and it was hit hard by the pandemic. One reason for this is that Rolls-Royce earns money through flying hours and maintenance, not just the sale of engines. Flying hours fell by around 50% during the first half of 2020 and have remained at reduced levels for around two years. Rolls-Royce ended up taking on more debt — £5.2bn by the end of 2021. Servicing this debt may impact future profitability.
Prospects
It appears to be through the worst of the pandemic-induced disruption. Flying hours could return to pre-pandemic levels during the summer, while higher fuel prices don’t appear to be having a huge impact on the aviation industry so far. This is largely because most airlines hedge fuel. There’s also a lot of pent-up demand for travel.
Rolls-Royce management is pretty optimistic too. The company recently forecast “positive momentum in… financial performance in 2022, despite the challenges and risks around the pace of market recovery, global supply chain disruption and rising inflation”.
But more generally, I don’t see demand drying up for air travel and air freight. The group is the market leader when it comes to engines for wide-body aircraft. In 2020, Rolls-Royce had a 35% market share of engines installed in such passenger aircraft.
Risks
Rolls-Royce’s order book has been impacted by the cancellation of 63 Airbus A330-900 aircraft. Engines for the wide-body jet represented the bulk of its order book. However, I’m hopeful that the company will be able to report new orders in the coming months. In a recent report, it said it had a “strong order book covering near-term activity” in all its departments.
A pandemic-induced efficiency drive may also hurt the group in the long run. The business went ahead with proposals to trim staff numbers and reduce capex. This, along with debt servicing costs, may negatively impact long-term growth.
Should I buy?
With Rolls-Royce trading in pennies, I think now is a good opportunity to buy this engineering giant. There certainly are challenges ahead for the firm, but I’m optimistic on the core aviation business, which is historically very profitable. I own Rolls-Royce shares and recently bought more.
