Buying a Rolls-Royce (LSE: RR) jet engine is a very expensive business. By contrast, investing in the engineering firm can be a much, much cheaper affair. With Rolls-Royce shares currently trading in penny territory, are they an attractive choice for my portfolio?
The Rolls-Royce investment case
Whatever the share price, I think the long-term prospects for revenues at Rolls-Royce are promising. I expect strong future demand for civil aviation, even though there may be some sudden falls along the way.
If that demand comes to pass, it could be good for Rolls-Royce revenues in a couple of ways. Customers may order new engines. But the firm’s large installed base of engines will also need to be serviced. As the original manufacturer, Rolls-Royce will be the service provider of choice in many cases.
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I also see positive drivers for revenue outside of civil aviation. The company’s defence business saw underlying revenues increase 4.6% last year. A worsening security environment could lead governments to boost defence spending. That should also increase revenues at Rolls-Royce.
But what about profits? One of the historical challenges at Rolls-Royce has been converting revenues into earnings. In 2018, for example, revenues of £15.7bn produced a loss of £2.4bn. The company has taken steps in recent years to prune its cost base. That could help its profitability model. Last year, the company produced a small profit, its first in four years. It also returned to generating free cash flow. That helps liquidity.
Why are Rolls-Royce shares selling for pennies?
Despite an increasingly positive commercial outlook, there are still risks for Rolls-Royce shares.
While aviation demand is returning, airlines have been badly hurt by the lower passenger numbers of the past couple of years. That means they are likely to postpone engine orders, or drive a hard bargain. That could hurt Rolls-Royce’s profit margins.
In some cases, airlines have been cancelling orders for new planes, which could have a knock-on effect on engine orders. Meanwhile, aircraft engines are receiving increasing criticism for their environmental footprint.
A fair amount of that criticism comes from people who still fly for work and leisure so, for now at least, I see limited risks of serious action to change aircraft engines radically. But Rolls-Royce is proactively working on new engine technology that is less dependent on traditional jet fuel. That could help business down the line. In the next few years though, it is likely to add extra costs.
My move on the Rolls-Royce share price
Definitely there are ongoing risks to the Rolls-Royce share price. The company also badly burned shareholders with a heavily dilutive rights issue a couple of years ago. The risk of that happening again if aviation demand falls sharply may have put some investors off the company.
But are those risks so grave that they justify the 17% fall in the Rolls-Royce share price seen over the past year? I do not think so. The company’s business results have been improving and its long-term economics look attractive to me. I have a long-term perspective when investing, so that suits me fine.
So I have been happily buying Rolls-Royce shares for my portfolio.
