A small-cap stock I’d buy alongside Rolls-Royce Holding plc for 2018

With manufacturing output rising, Rolls-Royce Holding plc (LON: RR) and the whole engineering sector could be in for a healthy 2018.

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There’s no denying the last few years have been tough on the UK’s engineering industry, which resulted in a three-year slide for Rolls-Royce Holding (LSE: RR). Earnings per share more than halved, and the dividend was slashed by almost the same amount.

But after a big slump in 2008/09, UK manufacturing output has been steadily recovering, and the latest figures show the Manufacturing Index at its highest level in 10 years. Global economic growth has helped, and the weakening of the pound since the Brexit referendum has given Britain’s exports a significant boost.

Both of these trends tie in nicely with Rolls-Royce’s restructuring and cash-savings progressing ahead of plan, as reported at the halfway stage this year. At the time, underlying revenue was up 6% with underlying pre-tax profit up 148%.

On target

November’s update confirmed the company is on track to achieve its expectations for the year, telling us that its Civil Aerospace, Defence Aerospace and Power Systems were all performing well. The Marine division was still weak due to depressed demand from the oil and gas business, but with the black stuff getting ever closer to $70 per barrel, I can see a recovery there in 2018.

I confess I’m a little twitchy about the Rolls-Royce share price, after a one-year climb of 27% to today’s 846p. That gives us a forward P/E multiple of 24 based on forecasts for 2018, which looks a bit high. But if we really are past the bottom of the cyclical engineering downturn, the new slimmer company could be set for a return to its decades-long trend of steadily rising earnings.

The dividend is on the way back too, and though the predicted rise for this year would take it to a yield of only 1.6%, it’s a definite turn in the right direction.

Better bargain?

A smaller engineering company that impresses me is Castings (LSE: CSG) which, as its name suggests, is in the iron casting and machining business.

Thursday’s trading update confirmed that things are going as expected and spoke of “steady demand from our commercial vehicle customer base.” The firm was also able to draw a line under the costs of a couple of changes. Its new management team decided to pull out of a few projects it deemed unsuitable, which has cost £1.3m, and the reorganisation of its machining business has impacted the bottom line to the tune of £3.4m.

Full-year profit is expected to come in between £12.5m and £13.5m, with “positive” cash flows.

Current forecasts suggest P/E ratios for this year and next of 16 and 14 respectively, which is a good bit lower than Rolls-Royce’s current valuation. And I think that makes the shares a bargain at this stage in the manufacturing cycle.

Cash too

What’s more, Castings has been paying steady dividends, even while its earnings have been a bit erratic over the past few years. This year there’s a 3.2% yield on offer, with 3.3% pencilled in for the next year. It’s progressive too — around twice covered by forecast earnings, and just about keeping up with inflation.

If this is how the company has been rewarding shareholders during a downturn, I can see scope for significantly enhanced dividends in the future if the export-led manufacturing growth phase really does continue.

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.

Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has recommended Castings. 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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