Seeing the name Rolls-Royce (LSE: RR) on the side of a plane engine cowling reassures me. The company is an expert in making engines, for which it can charge large sums. But large sums are not something now associated with the Rolls-Royce share price. The shares change hands for pennies and have lost more than half of their value over the past year.
Why is that – and might it be a buying opportunity for my portfolio?
Turbulence behind and maybe more ahead
The main reason I see for the fall in the share price is the change we have seen in the aviation market since the start of the pandemic.
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Civil aviation demand slumped. It has been coming back but remains well below where it stood in 2019. As well as selling engines, Rolls-Royce makes money by servicing them. So the fall in civil aviation flying hours has hit its revenues and profitability hard.
However, passenger demand is growing again. On top of that, the company’s defence business looks set to benefit from increased spending on national security by European governments. So why has the share price been falling?
I think that reflects the changed economics of engines now compared to before the pandemic. Not only has demand fallen, but airline customers are constrained in their spending. Input costs from labour to parts have been hit by inflation. That changes the outlook for long-term profitability at Rolls-Royce for the worse.
Valuing the shares
Not only that, but the company issued lots of new shares in 2020 to boost liquidity. That was a useful way to raise funds for the business at a time of uncertainty. But it had the effect of diluting existing shareholders.
So even if the company can get back to its old levels of profit, the earnings per share will be much lower than before.
I see a risk that the same thing could happen the next time aviation sees a sudden, unexpected demand slump.
The Rolls-Royce share price attracts me
Despite those risks, I have been buying the shares for my portfolio. The tumbling Rolls-Royce share price offers me the opportunity to buy more shares. I would be happy to do that if I had spare money to invest at the moment.
Despite the challenges, as a long-term investor I am considering what the picture may be like for Rolls-Royce years not just months from now. It is one of the key players in an industry with few competitors and high barriers to entry.
I expect demand for air travel to keep rising. Safety is paramount, so airlines are willing to pay for quality. That gives Rolls-Royce pricing power and could help its future profitability.
With a market capitalisation of under £6bn, the firm looks attractively valued to me. That is why I would be happy to buy more of its shares now for pennies and hold them for the long term.
