Looking out for bargain shares to buy, Rolls-Royce (LSE: RR) might not be an obvious place to start.
The company has a market capitalisation of £110bn following a 1,200% rally in the share price over the past five years. It now sells for 42 times earnings.
Still, plenty of stock market analysts remain positive about the outlook for the FTSE 100 aeronautical engineer. What do they see that others may not?
Designing a brilliant business from scratch…
Rolls-Royce is a long-established business that has evolved over time. It has had plenty of ups and downs including the drop in civil aviation demand during the pandemic that sent its share price down to pennies.
But, if you wanted to design a dream business model from scratch, you could do worse than to end up with something like Rolls today.
It has core expertise that, thanks to a combination of proprietary technology and deep engineering knowledge, gives it a strong competitive advantage. On top of that, it operates in business areas that have a high barrier to entry for would-be rivals, helping give the firm pricing power.
By operating in three distinct but interconnected areas – aviation, defence and power systems — the company is able to benefit from commonalities such as that engineering expertise while diversifying. That diversification is limited given how central civil aviation is to the firm’s fortunes, but it is still diversification.
A well-established installed customer base is another strength, while the focus on cost efficiencies in recent years has helped improve the cost basis of the company.
Things could get even better from here
But while Rolls’ business has the makings of brilliance, there could be better results yet to come.
The cost-cutting drive of late should prove its worth more fully over time. Defence sales are booming and look set to stay that way.
Meanwhile, the power business also has the wind in its sails. As interest in non-fossil fuel power continues to grow, this could potentially be a strong opportunity for Rolls-Royce.
Here’s why I’m hesitant
I do think there is a lot to like about it. If all three business divisions keep doing well and earnings grow significantly as they are forecast to do, the current valuation could end up looking like a bargain a few years down the line.
But, as the company’s history demonstrates, things do not always go smoothly. Aerospace engineering can involve long timelines and costly delays.
More pressingly, there is also the question of civil aviation demand. Jet fuel has soared in cost lately and some airlines are already cutting back their schedules.
As the pandemic showed, fewer flying hours equates to less demand for engine servicing. If airlines feel the pinch, new engine orders could fall sharply.
So although I like the positive elements of the investment case, there are risks that I think the share price today does not accurately reflect.
At the current price, I have no plans to add any Rolls-Royce shares to my portfolio.
