When I look out of an aeroplane window and see the Rolls-Royce (LSE: RR) logo on the engine cowling, I view it as a symbol of quality and expertise. Many airlines are also fans of the firm, using its engines in their fleet. So it may come as a surprise to learn that this famous aeronautical engineer is a penny stock at the moment. Does the Rolls-Royce share price make it a bargain for my portfolio?
The Rolls-Royce share price
It has been a roller-coaster few years for the Rolls-Royce share price. The shares tumbled in expectation of the damage to the business a rapid decline in global air travel during the pandemic would cause. A rights issue massively diluted existing shareholders to raise extra funds. The share price fell below 40p in October 2020.
Sentiment towards the shares later improved with the expectation of a recovery in aviation demand, as well as a new business plan reflecting the changed realities of Rolls-Royce’s market landscape. Last year the share price reached £1.60 at one point. But it has since fallen back, driven in part by ongoing concerns about the size and scale of aviation demand recovery and also the planned departure of Rolls-Royce’s chief executive later this year. They are 23% down so far this year and have spent most of the past month trading just inside penny share territory.
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Why I think Rolls-Royce is an attractive business
Before getting onto valuation, I think it is worth considering whether Rolls-Royce has the characteristics of a business that can be successful over the long term. I feel it does, but am aware that there are also some notable risks involved.
The aircraft engine manufacturing industry is dominated by just a few large players. I expect that to remain the case, because the technology, expertise, and capital expenditure required to succeed act as high barriers to entry. Rolls-Royce’s own position in this industry is strong, thanks to experience and customer relationships built up over decades.
A key question is demand. The share price tumble during the pandemic largely reflected concerns that passengers would fly less. Investors feared that would lead to lower demand from airlines for aircraft engine sales and servicing. But even before the pandemic, some investors were concerned that demand for flying would fall in future, due to reasons such as environmental concerns. While I do think that could stop some individual passengers from flying, in the long term I expect demand for flights to keep growing. Huge developing markets such as India and Brazil will likely mean that demand for aircraft and the engines to power them grows over time.
Although selling an engine can be lucrative, companies such as Rolls-Royce make a sizeable chunk of their profits from servicing them. Rolls-Royce has an installed base of nearly 13,000 engines worldwide. The obvious supplier for servicing is the company that made the engine in the first place and understands exactly how it works. That means that the company could still be profiting decades from now on engines rolling off the production line today.
Risks
But as the pandemic shows, even if air travel does continue to grow in popularity, it may not do so evenly. That means that revenues and profits can suddenly fall, as they did a couple of years ago.
Another risk I see in the business model is its capital intensity. The cost to develop, build, and sell even one new model of aircraft engine can be massive. So any downturn in cash flows can strain liquidity. Indeed, concern about maintaining enough liquidity explains why Rolls-Royce had the rights issue a couple of years ago.
Are Rolls-Royce shares attractive to me?
But just because a business has attractive economic characteristics, that does not mean its shares are equally appealing. That depends on their valuation.
At the moment, despite its penny stock status, Rolls-Royce has a chunky market capitalisation of £8.4bn. Last year its underlying operating profit was £414m. But that metric does not fully represent a company’s cost base — the underlying profit once other costs were added in was only £10m. Still, at least the company was in the black and it also moved back into free cash flow generation. That could help ease lingering liquidity concerns.
Even before the pandemic, though, the business had been heavily loss-making for a couple of years. So while it is easy to compare the current market cap to 2017 post-tax profits of £3.4bn and see the valuation as a bargain, the reality is that this is a complex and costly business with projects that span decades. That has implications on its financial reporting. Rolls-Royce has made some very big profits in the past decade — but it has also recorded some very large losses.
After cutting costs in the past several years, I reckon Rolls-Royce’s attractive business model, free cash flow generation, and proven ability to generate substantial profits, albeit inconsistently, mean that at their current price, the shares could be an attractive purchase for my portfolio.
My next move on this UK penny share
Based on that analysis, I bought Rolls-Royce for my portfolio last month.
A key consideration for me was the company’s return to free cash flow generation. I saw that as positive for Rolls-Royce’s liquidity position. The planned departure of the chief executive does not bother me. I do not think the future success of the company is reliant on the current management team. What I like about Rolls-Royce is the company’s business model.
I plan to hold my shares in hopes of further business recovery. I think that could push the shares higher from the penny share territory in which they are currently trading.
