Aircraft engine maker Rolls-Royce (LSE: RR) has not been a great investment for shareholders lately. Over the past 12 months, the Rolls-Royce share price has fallen 21%. It now trades for just pennies. Does that make the shares a bargain for my portfolio?
Business versus investment
A good business does not always make a good investment.
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Is Rolls-Royce a good business? Broadly speaking, I think it is. There are only a few aircraft engine makers and that is unlikely to change as the industry has high barriers to entry. With a large installed base of engines, Rolls-Royce can benefit not only from selling new ones but also from servicing existing units. Aviation safety is critical, so customers are willing to pay a premium price for quality in this marketplace.
But a couple of things about the business are risks that never seem to go away. It is capital intensive, so a company needs a lot of financial liquidity. On top of that, aviation demand is outside the company’s control. So sometimes its customers suddenly decide to cut back on engine expenditure — and there is little that Rolls-Royce can do about it.
As an investment, those risks can sometimes make Rolls-Royce unattractive. The need to boost liquidity could lead to shareholders being diluted, for example. That happened just a couple of years ago. Then again, I do find the underlying business attractive — so at the right Rolls-Royce share price, I would happily buy the company for my portfolio.
The Rolls-Royce share price makes it a penny stock
Rolls-Royce shares look quite cheap at the moment. After all, they trade in penny stock territory.
But are they really cheap? Last year’s earnings per share came in at 1.5p. This means that even the current Rolls-Royce share price implies a costly sounding price-to-earnings ratio of 55. Maybe that reflects the ongoing business recovery – if earnings are higher in future, the current share price may indeed be cheap. But the engineer has a patchy track record of profitability. Although its huge losses in 2020 could be pinned to the pandemic, it had recorded large losses for the previous couple of years too.
Not a bargain, but I’m buying
So I would not say Rolls-Royce shares look like a ‘bargain’ at the moment. The valuation does not look especially cheap based on the business recovery to date. While hopefully the business recovery will continue, that is uncertain at this point. Time will tell.
But although I do not see them as a bargain, I feel Rolls-Royce shares still offer good value – and have been buying them for my portfolio because of that.
The industry has attractive economics and Rolls-Royce is once again both profitable and generating free cash flow. If its recovery continues, the finances could look a lot healthier a couple of years from now. In fact, it could become very profitable due to rising demand and stringent cost controls. So although I do not see the shares as a bargain today, I reckon Rolls-Royce is a company with strong prospects trading at an attractive valuation. That is enough to make me want to own it in my portfolio.
