Why I’d shun the Rolls-Royce share price and buy this FTSE 250 stock instead

Roland Head explains why he expects this FTSE 250 (INDEXFTSE:MCX) stock to beat Rolls-Royce Holding plc (LON:RR).

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I must be missing something. Rolls-Royce Holding (LSE: RR) reported an operating loss of £775m this morning and announced a £554m charge to reflect ongoing service issues with its Trent 1000 jet engines. So why are its shares up by 3% at the time of writing?

The good news is that the remainder of this FTSE 100 engineering business is doing quite well. Better than expected, in fact. Chief executive Warren East now expects underlying profit and cash flow for the full year to be “in the upper half of our guidance range”.

This means that shareholders can expect Rolls to report a full-year underlying operating profit of between £400m and £500m this year, compared to previous guidance of £300m-£500m. Free cash flow is also expected to be better than expected, at £450m-£550m.

What’s changed?

Today’s results show that the group’s revenue rose by 12% to £7,487m during the first half of the year. Underlying operating profit rose by £205m to £141m, erasing last year’s H1 loss of £84m.

The biggest contributor to this impressive revenue growth was the Civil Aerospace division. This business produces jet engines for wide-body passenger and cargo aircraft. A 19% increase in engine deliveries and higher spare-part sales helped to lift revenue by 26% to £3,600m during the half year.

Power Systems — which makes large diesel engines for marine and industrial use — also performed well, with sales up 13% to £1,471m. This resulted in a 193% increase in underlying operating profit, which rose to £80m.

I’m still not going to buy

Today’s reported loss of £775m includes one-off costs related to acquisitions, Trent 1000 engine problems and major restructuring. I’m willing to ignore these costs and accept the group’s underlying profit guidance for the full year.

My problem is that this still leaves the shares looking expensive, on around 70 times 2018 forecast earnings. Even if earnings double as expected in 2019, the stock will still have a P/E of 35 and a dividend yield of just 1.4%.

In my view, Rolls-Rocye is already priced for a full recovery. I may be wrong, but I still can’t see enough value here to tempt me to part with my cash.

One engineer I would buy

On the other hand, I am tempted to put some of my investment cash into FTSE 250 engineer QinetiQ Group (LSE: QQ). This business is mainly focused on the defence sector. It provides technical services and research in areas such as battlefield communications and weapons systems.

One of the firm’s historic weaknesses was that it was heavily dependent on UK government contracts. But QinetiQ is building a broader mix of customers and generated 27% of its revenue overseas last year.

Buy, hold or sell?

The company said that first-quarter trading was in line with expectations. Analysts expect the group’s underlying earnings to fall by around 12% to 17p per share this year. Although I wouldn’t normally suggest investing in a business with falling profits, I think the overall picture remains strong for long-term investors.

The company generated an operating margin of 17% last year and ended the period with net cash of £266m — equivalent to about two years’ profits.

Factoring-in this cash gives the stock a cash-adjusted forecast P/E ratio of about 13 and a prospective dividend yield of 2.5%. For investors buying at this level, I think QinetiQ should perform well as part of a long-term portfolio.

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.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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