The world only has a few large aircraft engine makers and one of them is Rolls-Royce (LSE: RR). Given the likely long-term growth of aviation demand and a need for reliable engines, it would seem to have the formula for a successful business. Bur the Rolls-Royce share price has been falling lately and the company now trades in penny share territory.
Does that offer me a cheap entry point for a potential long-term success story? Or is the low share price a warning signal that there could be further turbulence ahead?
The economics of aircraft engines
Walking on board a large plane, there are often murmurs of wonder from passengers at its size and ability simply to get off the ground. That reflects the complex science of flight. Building the sorts of engines that can power large aircraft is a highly skilled feat of engineering. It can take years or decades of research and testing before even one engine is sold. The manufacturing process can also be complex and costly. After all, nobody wants to be up in the sky and discover that their aircraft engine has a fault.
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Those economics can be seen as both bad and good for aeronautical engineers such as Rolls-Royce. They are bad in the sense that the industry requires substantial capital expenditure, often long before any associated revenue arrives. But they are good because they create a high barrier to entry. With only a few companies able to make such engines, pricing competition can be reduced. That should be good for profits. The economics of aircraft engine manufacturing are what attract me to it as an investment idea.
Why is the Rolls-Royce share price falling?
Given those apparently attractive economics, why has the Rolls-Royce share price been falling?
One reason is an uncertain demand outlook. The pandemic and government restrictions led to a steep decline in civil aviation. While demand has been recovering, it remains fragile and unpredictable. That is bad for Rolls-Royce in several ways. Fewer flying hours mean aircraft engines need to be serviced less frequently, hurting revenues. An uncertain civil aviation market has also stretched airline finances. That could make them more hesitant to order new planes, leading to falling engine sales.
But it is not just the present that is weighing on the Rolls-Royce share price, it is also the future. The company has plans to make its engine range less environmentally damaging. That will likely involve extensive research and development over many years. That could eat into profits for a long time to come.
Why I’m buying
Those concerns are all holding down the Rolls-Royce share price. But I think the short-term outlook may be clouding a more positive long-term investment case.
Rolls-Royce benefits from the attractive economics of aircraft engines. Whatever the current demand shocks, in years to come I expect demand for civil aviation to keep growing. On top of that, the company’s defence business has been resilient over the past couple of years. Surging defence budgets could help it grow in the next several years.
Given that, the fall in the Rolls-Royce share price looks overdone to me. I have been buying the shares. I see Rolls-Royce’s penny share status as a buying opportunity for my portfolio.
