Why is Rolls-Royce a penny stock?

With the iconic engine maker now a penny stock, Christopher Ruane considers the outlook for the Rolls-Royce share price and explains his next move.

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A Rolls-Royce employee works on an engine

Image: Rolls-Royce

With Rolls-Royce (LSE: RR) trading below a pound, the famous engine maker is now a penny stock. But the Rolls-Royce share price traded higher just a couple of months ago – and I think it could go up again.

Turbulence for the Rolls-Royce share price

Concerns about demand for air travel meant that companies heavily exposed to it, such as Rolls-Royce, were hard hit after the pandemic started.

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The shares were climbing earlier this year, but have shed a quarter of their value since their mid-March highs. They are now up just 4% over the past year. There are a number of reasons for that.

One reason is the inconsistent pace at which air travel demand is coming back. With each setback, such as delays in lifting restrictions, investors fret about the prospects for Rolls-Royce. That has hit the Rolls-Royce share price. A second reason is the company’s liquidity. It massively boosted liquidity last year. But it did so at the expense of existing shareholders, through a heavily dilutive rights issue. While I think the company currently has ample liquidity, the proven risk of dilution could be dampening enthusiasm for the shares.

Quality on the cheap

Often, penny stock status suggests concerns about a company’s future business prospects.

Undoubtedly a decline in demand for aircraft engine servicing has hit Rolls-Royce hard. Last year it booked a £3.1bn loss. With demand for air travel still significantly below pre-pandemic levels, there is a risk that weakened revenues in the company’s core engines business will weigh on profits again this year – and perhaps beyond.

But there are signs of longer-term resilience in the air travel market, including large aircraft order from major airlines. Only a few global aircraft engine makers of scale exist, and Rolls-Royce is one of them. That alone ought to help it return to financial health in future. Add to that the fact that the company isn’t just reliant on civil aviation – and its other business divisions have held up fairly well during the pandemic.

So while the Rolls-Royce share price may languish beneath the pound mark for a while yet, I don’t expect it to stay there forever.

Where next for the Rolls-Royce share price

While I see potential for a higher Rolls-Royce share price, a key question is: what will be the driver to move it?

One possible factor could be the release of the company’s interim results, due next month. Rolls-Royce has repeatedly said it expects to become free cash flow positive in the second half of this year. An update on that target at the time of the interim results could lead to a rerating of the shares, either positively or negatively. The effects of the company’s cost savings programme ought also to show up more clearly now than it did before. If it looks like it has cut out costs without damaging Rolls-Royce’s reputation with customers, that could also provide a boost to the Rolls-Royce share price.

For now, however, I continue to watch from the sidelines. I do not plan to buy Rolls-Royce shares in the absence of clear evidence of strong, sustained business recovery.

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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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