As a previous shareholder in engineering giant Rolls-Royce (LSE: RR), ought I to buy back in? Here are three reasons I see to be bullish about Rolls-Royce shares — along with why I have no plans to buy back in just yet.
1. Long-term demand trends
When buying shares, many people simply focus on numbers. What is the share price today and what was it yesterday?
Famous, investor Warren Buffett sees things differently. For him, buying a share means owning a stake (albeit a small one) in a business. So rather than seeing a share just as a piece of paper, Buffett asks whether it is a business in which he would like to be a part owner.
When assessing a business, one thing I consider is whether it has a large potential or existing target market. When it comes to aircraft engine sales and servicing, I think the answer is yes.
Airlines operate tens of thousands of planes. In the long term, I expect demand for air travel to be robust. That should be good for aeronautical engineers, including Rolls-Royce.
2. Unique position
But being in a market with strong customer demand does not necessarily translate to profits.After all, a potentially lucrative market often attracts many businesses. That can lead to price competition, hurting industry profitability.
That is where it helps a firm to have some competitive advantage.
Rolls-Royce has such an advantage, in my view. The technical expertise needed to make aircraft engines is substantial. Capital expenditure is high and lead times for new engine development typically stretch across decades. That means that engine manufacturing has high barriers to entry.
Rolls-Royce benefits from already having a large installed base of engines. The servicing requirements for those engines can be a strong source of revenues for the firm. In the long run, I see that as positive for Rolls-Royce shares.
3. Evolving business model
During the pandemic, Rolls-Royce cut its costs extensively.
A new chief executive joined the business this year and he has introduced further cost-cutting measures. Reducing expenditure can help profit margins. I think the prospect of this is one reason why Rolls-Royce shares have performed strongly in 2023.
But when it comes to aircraft engines, precision and quality are paramount. One risk I see with cutting costs is that if doing so threatens product quality in any way, in the long run that could be bad news for Rolls-Royce shares.
If that risk is managed, though, I think the sharper focus on optimising the company’s business model we have seen in the past several years is a reason for investors to be bullish about the company’s long-term prospects.
4. Valuation
Despite my bullishness, I do not plan to add Rolls-Royce shares to my portfolio.
That is because I think the current valuation already factors these points in.
Indeed, an improved business outlook for the aviation industry helps explain why the shares have done so well this year. Now I think Rolls-Royce shares need to grow into their existing valuation. Meanwhile, I do not see them as a bargain and plan to sit on the sidelines.
