Aerospace engineer Rolls-Royce (LSE: RR) has a prestigious name and reputation. So it may come as a surprise to learn that Rolls-Royce shares are trading in penny stock territory.
This is why – and what it means for my portfolio.
A reeling Rolls-Royce share price
Over the past year, the Rolls-Royce share price has lost 23% of its value. That comes on top of large falls in 2020. Over the past five years, these shares are down 73%.
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Why has this blue-chip company fallen so out of regard with investors?
Partly it is due to the nature of the aviation engine business. Rolls-Royce not only manufactures engines, it also services them. With an installed base of thousands of engines, this line of business is an important source of revenue for the firm. When flying demand falls, as it did during the past couple of years, airlines need to service their aircraft engines less frequently. That has hurt revenues and profits at Rolls-Royce.
But the slide in the Rolls-Royce share price reflects other concerns too. The company is looking at expanding its footprint in businesses such as small nuclear reactors and aircraft engines that run on energy sources other than traditional aviation fuel. While such ventures could work well in the long term, they bring costs in coming years that could eat into profits. On top of that, they may turn out to be less successful than hoped. The nuclear industry has a long history of spiralling cost estimates and long-tail liabilities.
Could Rolls-Royce shares recover?
Despite such concerns, the decline in the Rolls-Royce share price looks overdone to me.
The company has taken steps to reduce its cost base. It has also started to generate free cash flows again, which helps lift concerns about liquidity. After it previously diluted shareholders to raise new cash, that had been a particular concern of mine. I still see it as a risk, but I think the likelihood of more dilution is reduced, for now at least, by Rolls-Royce’s free cash flow generation and liquidity.
Meanwhile, there is a lot to like about the business. Its iconic name and strong reputation help it attract customers. A large installed customer base should help revenues for many years to come. The industry has high barriers to entry, helping to support profit margins. Rolls-Royce’s defence business is also set to continue performing well, as the demand is robust and set to grow in the current geopolitical environment.
My next move
I have bought Rolls-Royce shares for my portfolio this year. I would consider buying more while they are still trading as penny shares.
There clearly are short-term challenges, even as aviation demand returns closer to pre-pandemic levels. But as a long-term investor, I think the picture looks promising. If business continues to improve, that will hopefully be reflected in the share price. I would be surprised if Rolls-Royce shares continue to trade for pennies years from now, although it is possible. So I am seeing the current price weakness as a buying opportunity for my portfolio.
