Why I’d avoid Rolls-Royce Holding plc and buy this growth stock instead

Bilaal Mohamed thinks this engineering business could be a better investment than Rolls-Royce Holding plc (LON:RR).

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In its most recent trading update, pre-eminent engineering group Rolls-Royce (LSE: RR) confirmed that it was making good progress in its bid to ramp up production, bring new large civil engines to market, and enhance aftermarket capabilities across all its businesses. All the while, management has been pressing ahead with restructuring and cost-cutting programmes, leaving the group in a much stronger position than it has been for quite some time.

Bribery and corruption

It’s all a far cry from just a few years ago when a string of profit warnings, not to mention corruption and bribery allegations, caused the company’s reputation, profits, and inevitably its share price to nosedive. All this negativity culminating in a record-breaking pre-tax loss of £4.6bn for 2016 – one of the biggest in corporate history.

But with a new CEO at the helm, there has been a concerted effort to restructure the business, reduce costs and stamp out corruption. Things have certainly improved, with the group reporting a swing to pre-tax profits of £1.9bn for the first half of this year, compared to a £2.2bn loss for the same period in 2016, with revenue up by £1.1bn to £7.6bn.

Clearer skies ahead

Not only has management been striving to turn Rolls-Royce into a much leaner business, it’s also been running with the times by developing cleaner, safer, and more efficient engines. All-in-all the turnaround plan seems to be moving along nicely, and so too has the share price, almost doubling in less than two years.

I think there are clearer skies ahead for Rolls-Royce, and the business certainly looks to have a much brighter future, but the valuation still troubles me. With the soaring share price now within touching distance of £10, the forward earnings multiple of 25 is well above the company’s most recent five-year range of 10-22. At current levels I feel the market has already priced-in a good deal of future growth.

Buy, improve, sell

But there is an alternative. FTSE 250-listed Melrose Industries (LSE: MRO) can’t claim to have anything even resembling Rolls-Royce’s brand or heritage, but it can certainly boast an excellent track record when it comes to creating value for its shareholders. Since 2003, the specialist manufacturing investor has grown from a tiny £13m AIM-listed minnow to a £4.5bn engineering group with a premium listing on London’s Main Market.

So is Melrose an engineering group or an investment business? Well, both actually. The group’s highly successful model involves acquiring underperforming manufacturing businesses (usually engineering), then providing investment in order to improve performance, with a view to selling them on at a future date, and returning the proceeds to shareholders.

This strategy of buy, improve, sell, has been very successful over the years, and the company’s shares have commanded a premium rating as a result. However, a sharp pull-back in the share price since this summer’s all-time highs has presented a rare buying opportunity for those looking for long-term capital growth, with the earnings multiple down to a more modest 21 for 2017.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Bilaal Mohamed has no position in any shares mentioned. The Motley Fool UK owns shares of Melrose. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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