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Name an aircraft engine manufacturer. For many people, it’s one of the first things that comes to mind. Rolls Royce (LSE: RR) The aeronautical engineer not only has a brand name, but also operates in an industry with high barriers to entry, where price tags can easily run into the millions of pounds. Still, the Rolls-Royce trades for pennies.
What went wrong here – and does it provide a buying opportunity for my portfolio?
Rolls-Royce’s poor performance in recent years is largely due to the pandemic. As well as selling engines, a major part of the business is servicing them.
Demand for civil aviation declines in 2020. This has caused service revenues to decline, and many airlines have put plans to buy new aircraft on ice.
Manufacturing aircraft engines can be a capital intensive industry. Amidst the recession, Rolls-Royce increased its liquidity. While that’s a smart move, it involves diluting shareholders. There are fears that the same thing could happen when the aviation industry goes into a sudden, long-term recession.
In addition to the pandemic, Rolls-Royce faced other challenges. For example, demand for engines that do not use fossil fuels is increasing. While this could be a huge opportunity for the company over the next decade, it could involve huge research and development costs in the short term.
Basically attractive business
But while Rolls-Royce is flying in some serious weather, I think it’s worth remembering that the business has some very attractive features.
The desire to fly may be increasing over time, I think, as it has been doing for decades. Rolls-Royce should benefit both by selling new engines and serving a larger installed base. The limited volume of competition and the mission-critical nature of its products give Rolls-Royce pricing power. In fact, some aircraft were only designed to be fitted with Rolls-Royce engines.
Despite the challenges in the here and now, I take a long-term investment approach and think Rolls-Royce has a promising future as a business.
Valuing Rolls Royce shares
Rolls-Royce shares have lost 29 percent of their value in the past year.
The company now has a market capitalization of just under £7bn. But I think it’s worth more than that. I think it has a long-term future, it has a competitive business. The business has proven to be hugely profitable in the past and I expect it to continue to be so in the future. The engine base installed in it already gives it a big commercial advantage. On top of that, segments of the business such as the defense segment are likely to benefit from increased customer spending in the coming years.
So I see Rolls-Royce shares as a bargain for my portfolio, not a price trap. Of course that’s why I bought some this year.