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Why this FTSE 250 engineer could be a better buy than BAE Systems plc

Image: Rotork. Fair use.

Shares of FTSE 250 component manufacturer Rotork (LSE: ROR) rose by as much as 4% when markets opened on Monday morning, despite the company admitting that pre-tax profit fell by 10.6% to £91.1m last year.

In this piece I’ll explain why I think Rotork shares could have further to rise, and why this stock could be a better buy than FTSE 100 peer, BAE Systems (LSE: BA).

A solid set of figures

The oil and gas industry accounted for 52.4% of Rotork’s revenue last year. A subdued performance was always likely, given the scale of the downturn in this sector.

However, last year’s performance was far from bad. Including acquisitions and currency effects, Rotork’s sales rose by 8% to £590.1m. The group’s order intake was 9.6% higher. To help protect profit margins, Rotork’s management made cost savings worth £6.6m, offsetting the impact of weaker pricing in some areas.

The overall result was that adjusted earnings fell by 3.8% to 10p per share in 2016, slightly ahead of consensus forecasts of 9.65p per share. The full-year dividend was increased by 1% to 5.1p per share, giving the stock a trailing yield of 2.1%

A superior business?

It’s worth pointing out that Rotork’s adjusted operating margin of 20.4% is significantly higher than the equivalent figure for BAE Systems, which is about 10%. Sales growth at the smaller firm has also been much stronger in recent years.

Rotork’s revenue has risen by an average of 7.5% per year since 2010, when the firm reported sales of just £380.6m. In contrast, BAE’s 2016 revenue of £17,790m was broadly unchanged on the group’s 2011 figure of £17,770m.

Rotork has achieved this growth without sacrificing the strength of its balance sheet. Strong cash generation enabled the group to reduce its net debt by £16.2m to £55m last year, despite spending £16.3m on the acquisition of Mastergear. The group’s net debt equates to less than one year’s net profit, so is very modest and definitely not a concern for investors.

BAE’s debt levels aren’t a concern either, but the defence group’s £6.1bn pension deficit might be. It represents 6.5 times last year’s net profit of £938m and currently requires deficit reduction payments of more than £400m per year.

My choice to buy

In general, I rate BAE Systems as an attractive long-term income buy. I hold it in my own portfolio for this reason. But the defence group’s shares are currently trading at all-time highs. I’m not convinced now is the right time to buy.

Although BAE’s forecast P/E of 14 and prospective yield of 3.6% seem fairly affordable, the firm’s growth rate seems likely to remain fairly pedestrian. I suspect that investors buying at this level will be unlikely to beat the wider market.

Rotork shares also look fully priced, on 22.8 times 2017 forecast earnings. The firm’s yield of 2.2% is below the FTSE 250 average of 2.7% and may not attract many income investors.

However, Rotork has a track record of growth and should benefit from the continuing recovery in the oil market. I believe this FTSE 250 stock is more likely than BAE to beat expectations over the next couple of years, despite its strong valuation.

This FTSE 250 stock might be a better choice

If you're looking for profitable and established business with real growth potential, then you may want to consider this FTSE 250 alternative before making a decision about Rotork and BAE.

Our experts believe that the value of this business could rise by 200% over the coming years. The firm is benefiting from a strong reputation in its field and an ambitious expansion programme.

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Roland Head owns shares of BAE Systems. The Motley Fool UK has recommended Rotork. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.