Two risks to the Rolls-Royce share price

Our writer assesses a couple of key risks to the Rolls-Royce share price — and explains while he would still consider buying the company for his portfolio.

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A Rolls-Royce employee works on an engine

Image: Rolls-Royce

Aircraft engineer Rolls-Royce (LSE: RR) has faced another challenging year. There has been some very cheering news too, such as a recent return to positive free cash flow. But here I want to zoom in on a couple of risks I see to the Rolls-Royce share price in 2022. I then explain why I would consider buying the shares for my portfolio even with those risks.

Risk 1: weakening aviation demand

A key risk to the business continues to be weakened demand for commercial aviation. Heading into 2022, I believe there is a chance that this could get worse.

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This isn’t just about whether or not pandemic developments lead to new travel restrictions. Crucially, it is also about consumer confidence. Even if there are not new restrictions, many people will decide that the uncertainty involved in booking air travel is not worth it. So, in the next few years, it is possible that aviation demand will stay weak or perhaps even get weaker. I expect this to vary by market. In the US, for example, aviation has seen a strong rebound. But in Europe the picture is more mixed, while passenger aviation demand in Asia continues to be very low.

That matters to Rolls-Royce not only because of what it might mean for engine sales. Crucially, fewer flying hours also translates to less servicing needs for the company’s installed base of engines. That could hurt both revenues and earnings.

Risk 2: negative cash flows

One of the reasons for improved investor sentiment on the Rolls-Royce share price in the past year has been the company’s anticipated return to positive cash flow. It reckoned it would achieve this in its second half and indeed has now reported that it is again free cash flow positive. That is good news because it reduces liquidity concerns. If the engine maker has cash coming in the door rather than going out of it, it will hopefully not need to raise more money by diluting existing shareholders, as happened last year.

But a downturn in expected demand for aviation could tip Rolls-Royce back into negative free cash flows. That could hurt the company’s liquidity, increasing the risk of another dilutive rights issue in the future.

Why I remain bullish on the Rolls-Royce share price

I see both these risks as substantial. They could certainly weigh on the Rolls-Royce share price next year.

However, I think that they are largely factored into the price already. There are a number of reasons to be bullish about Rolls-Royce’s prospects, in my view. For example, it has a sizeable defence business, which has proven to be resilient. Other divisions, such as the company’s power business, could also see growing demand in coming years regardless of the outlook for aviation demand.

The company’s return to positive free cash flow lately suggests its financial discipline over the past 18 months is paying rewards. That could also mean that the outlook for profit margins in future could be stronger than it was historically.

There are definitely risks to the Rolls-Royce share price. But they wouldn’t stop me considering adding the company to my portfolio.

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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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