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Name an aircraft engine manufacturer. For many people, one of the first that comes to mind is Rolls Royce (LSE: RR). Not only does the aeronautical engineer have an iconic brand, but he operates in an industry with high barriers to entry, where prices can easily run into the millions of pounds. Despite this, Rolls-Royce shares the trade for pennies.
What’s 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. Besides selling engines, a key part of the business is servicing them.
Demand for civil aviation has plummeted in 2020. This has led to a drop in maintenance revenue, as well as many airlines considering buying new planes on the ice.
Aircraft engine manufacturing can be a capital-intensive industry. Amid the recession, Rolls-Royce has bolstered its liquidity. Although it was a smart move, it involved diluting shareholders. There is a risk that the same will happen the next time the aviation industry enters a sudden and prolonged downturn.
Beyond the pandemic, Rolls-Royce has also had to deal with other challenges. For example, there is a growing demand for engines that do not use fossil fuels. Although this could be a huge opportunity for the company in the coming decades, in the short term it will likely involve significant research and development costs.
Fundamentally attractive company
But although Rolls-Royce has been through rough times, I think it’s worth remembering that the company has some very attractive features.
Flight demand should increase over time, I think, as it has for decades already. Rolls-Royce should benefit from both the sale of new engines and the servicing of its large installed base. Limited competition and the critical nature of its products give Rolls-Royce pricing power. Indeed, some aircraft are designed exclusively to be equipped with Rolls-Royce engines.
Despite the challenges here and now, I take a long-term investment approach and believe Rolls-Royce has a bright future as a business.
Valuation of Rolls-Royce shares
Over the past year, Rolls-Royce shares have lost 29% of their value.
The company now has a market capitalization of less than £7 billion. But I think it’s worth more than that. He has a competitive business which I think has a long term future. The company has already proven that it can make big profits and I expect it to do so in the future as well. Its installed base of engines already gives it a major commercial advantage. On top of that, parts of the business such as its defense unit could benefit from increased customer spending in coming years.
So I see Rolls-Royce shares as a boon to my portfolio, not a value trap. That’s why I bought it this year.