Name an aircraft engine maker. For many people, one of the first ones that springs to mind is Rolls-Royce (LSE: RR). Not only does the aeronautical engineer have an iconic brand, it operates in an industry with high barriers to entry, where price tags can easily be in the millions of pounds. Despite that, Rolls-Royce shares trade for pennies.
What has gone wrong here — and does it offer a buying opportunity for my portfolio?
Heavy turbulence
The weak performance at Rolls-Royce in recent years is largely due to the pandemic. As well as selling engines, a key part of the business is servicing them.
Demand for civil aviation plummeted in 2020. That led to servicing revenues tumbling, as well as many airlines putting plans to buy new planes on ice.
Manufacturing aircraft engines can be a capital intensive industry. In the midst of the downturn, Rolls-Royce shored up its liquidity. While that was a smart move, it involved diluting shareholders. There is a risk the same thing could happen the next time the aviation industry enters a sudden prolonged downturn.
Beyond the pandemic, Rolls-Royce has faced other challenges too. For example, there is growing demand for engines that do not use fossil fuels. While that could be a massive opportunity for the firm in coming decades, in the short term it will likely involve large research and development costs.
Fundamentally attractive business
But while Rolls-Royce has been flying through some heavy weather, I think it is helpful to remember that the business does have some very attractive characteristics.
Demand for flying is likely to grow over time, I think, as it has already been doing for decades. Rolls-Royce ought to benefit both from selling new engines and servicing its large installed base. The limited amount of competition and mission-critical nature of its products gives Rolls-Royce pricing power. Indeed, some planes are designed exclusively to be fitted with Rolls-Royce engines.
Despite challenges in the here and now, I take a long-term investing approach and think Rolls-Royce has a promising future as a business.
Valuing Rolls-Royce shares
Over the past year, Rolls-Royce shares have lost 29% of their value.
The company now has a market capitalisation of under £7bn. But I think it is worth more than that. It has a competitive business I reckon has a long-term future. The business has proven before that it can make large profits and I expect that to be the case in the future too. Its installed base of engines already gives it a major commercial advantage. On top of that, parts of the business such as its defence unit could benefit from increased customer spending in coming years.
So I see Rolls-Royce shares as a bargain for my portfolio, not a value trap. Indeed, that is why I have bought some this year.
