It has been a simply phenomenal few years for investors in Rolls-Royce (LSE: RR). Over the past five years, the Rolls-Royce share price has soared 979%. Yes, 979%.
Compare that to the 47% growth in the wider FTSE 100 index over that period and it is clear that Rolls has done brilliantly.
Five years ago, of course, it was on its knees.
The pandemic and associated travel restrictions had seen demand for civil aviation plummet. Rolls-Royce raised capital by issuing new shares for just pennies each, diluting existing shareholders. At the time, that looked like it might be throwing good money after bad.
How different things now look with the benefit of hindsight!
Strong business fundamentals
I think the rise in the Rolls-Royce share price is understandable in many ways. After all, the barriers to entry in its chosen business areas are substantial. Rolls is one of a small number of firms globally that can do what it does, giving it pricing power.
It also has a large installed base of engines. That helps it generate sizeable revenues in the lucrative after-sales service market. With aircraft engines often lasting for decades, that can be a big money spinner.
Still, with the share price last week hitting an all-time high and tantalisingly close to the £10 mark, I am not willing to buy Rolls-Royce shares for my portfolio. This is because of what I think is an unattractive risk-to-reward proposition at the current valuation.
Specifically, here are three risks that concern me.
1. Demand is high, but could fall suddenly
Rolls is riding a tide of high demand in all three of its businesses. Civil aviation has bounced back with a vengeance in recent years. But both defence and power generation are also seeing strong customer demand right now.
I expect the latter two areas to see steady demand growth in years to come. However, I feel far less confident when it comes to the civil aviation division.
As shown by the pandemic, passengers can abandon flying in droves overnight for reasons totally outside airlines’ control, let alone engine makers. That could be a volcanic eruption, war, terrorist campaign, or hard recession.
I do not think that risk is accurately reflected in the current Rolls-Royce share price.
2. Focussing too much on financials
A second risk I see may seem more surprising.
Management’s tough medium-term financial targets for the company have been key to the surging Rolls-Royce share price. After decades of inconsistent performance, they have been widely welcomed.
I understand that – and see the appeal myself, too.
But as we have learnt elsewhere, including at Boeing, short- and medium-term financial focus at the cost of things like product quality, customer satisfaction, or competitive pricing can ultimately damage a business.
I have no reason to believe that Rolls has compromised those areas. But a very strong focus on financial performance has a mixed record when it comes to aeronautical engineering.
3. What if the music stops?
The soaring Rolls-Royce share price has incredible momentum.
Momentum can work both ways, however. If investors start dumping the share to take profits, it could crash even if the business is doing fine.
I see that as a risk if I invest in Rolls-Royce now – but it could present me with a welcome buying opportunity in future!
