Image source: Rolls-Royce plc
I like a lot about Rolls-Royce (LSE: RR) and have owned the shares until now. But while I would be happy to become a shareholder again if the right opportunity arose, I have no immediate plans. Instead, I'm waiting for a lower Rolls-Royce share price before buying it; in fact, much lower.
To begin with, I must acknowledge that the last two years have been nothing short of remarkable for shareholders of blue-chip companies. FTSE 100 company.
In 2023, it was the best performer of all the FTSE 100 shares. Last year it came close to achieving that title again (although IAG beat it).
In the last five years, participation has increased 144%. However, five years ago it had not yet been shaken by pandemic-era travel restrictions and their effect on civil aviation demand.
Since October 2020, by contrast, Rolls-Royce's share price has soared by 1.322%.
However, past performance is not necessarily an indication of what to expect in the future. That's where my concern comes in about adding the stock to my portfolio at the current price.
Strong fundamentals but a challenging business space
Part of investor optimism about Rolls is due to the company's strengths.
It operates in an area of business that benefits from high barriers to entry – few companies have Rolls' technical know-how.
Its large installed customer base is another commercial advantage. Buying an engine that can run for decades is just the beginning of an airplane owner's expense. It will also need to be serviced repeatedly, and in many cases, owners prefer to have the maintenance performed by the company that manufactured the engine in the first place.
So far, so good. On top of that, Rolls is benefiting from booming demand in the defense sector and could also see growth in its energy business in the coming years.
But I see a big challenge in the core civil aviation space and it's one that is largely outside the company's control.
Let's consider the reason for that share price drop in 2020, and for previous ones, such as the one that followed the 2001 terrorist attacks in the United States. Civil aviation demand can drop overnight for reasons largely or entirely outside the control of an airline, let alone an engine manufacturer.
Why I don't like the price
So while in principle I would be happy to buy back Rolls-Royce shares, I want to buy at a price that gives me a margin of safety that I consider large enough to reflect the risk of a sudden drop in civil aviation demand.
After the rise of the last few years, Rolls-Royce stock's current P/E ratio of 21 doesn't give me what I think is a large enough margin of safety to feel comfortable with.
I think the price could rise even further from here, especially if management meets its ambitious financial performance targets.
However, if not, participation could plummet, and I fear that could also happen if civil aviation demand suffers another big external shock.
