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A company that has been around for many decades, is a key player in a large global industry, and has a big installed customer base. That describes aeronautical engineer Rolls-Royce (LSE: RR).
Those characteristics are also similar to what I often look for when finding businesses in which to invest. So should I buy Rolls-Royce shares today for my portfolio and tuck them away for the coming decade?
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I do think the company has many characteristics of an attractive business.
Aircraft engines are complex, large and costly to make. That means that barriers to entry for the industry are high, and gives pricing power to firms such as Rolls-Royce and rival GE.
The large installed customer base is an asset as engines need to be serviced. Indeed, servicing revenues over the long lifetime of an engine are often much larger than the initial purchase cost. As a manufacturer, Rolls-Royce has an inbuilt advantage in persuading customers to provide servicing for its own product.
Over the long term, I expect demand for aviation to grow. One risk is some passengers flying less for environmental reasons. But a rising global population means demand should keep increasing, in my view.
But the long-term price performance of Rolls-Royce shares has been underwhelming.
Why is that, if the business has the positive attributes I described above?
One reason is that making aircraft engines is a business that requires high levels of capital expenditure. That can lead to an unattractive balance sheet. Rolls-Royce has been cutting its debt but remains heavily indebted. That is a risk to future profitability.
Another thing I do not particularly like about Rolls-Royce is its customer base.
Selling expensive engines and services to airlines means the company’s own fortunes are largely tied to those of the aviation industry. But aviation can suffer from unforeseen and sizeable sudden drops in customer demand, whether due to a pandemic, terrorist attack, volcanic eruption, or a number of other reasons. That can lead airlines to cut back spending for years.
Some of those factors help explain Rolls-Royce’s uneven performance in recent years, which has included some enormous losses.
As a long-term investor, I am looking for shares that I can buy for my portfolio today and hold for years to come.
Do Rolls-Royce shares match this description at their current price?
While the underlying business is attractive to me, I also recognise that there are significant risks. Rolls-Royce has had a tough few years, leading it to dilute existing shareholders during the pandemic to boost liquidity. Although it has seen improving demand and is cutting costs, the engineer is not out of the woods yet.
However, Rolls-Royce shares have soared 86% in the past year.
Until there is further evidence of a sustained business turnaround, I do not think that valuation gives me an attractive entry point to buy. For now, I have no plans to add Rolls-Royce to my portfolio and will instead wait to see whether its business recovery gathers momentum.