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Why I’d buy this dividend stock over Rolls-Royce Holding plc

FTSE 100 engineering group Rolls-Royce Holding (LSE: RR) has been a standout performer this year, rising by almost 40% since January.

But the business’s financial progress hasn’t been as rapid as its stock market gains. And while I wouldn’t rush to sell shares in this British champion, I’m not sure I’d want to buy them.

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Future uncertainty

Last week’s trading statement confirmed that Rolls’ 2017 results should be in line with expectations. According to the latest broker consensus forecasts, that means a net profit of £570m and adjusted earnings of 34.5p per share.

This puts the stock on a forecast P/E of 27, with a prospective dividend yield of just 1.3%. Clearly this valuation is pricing in a better future, with higher profits and a more generous dividend.

I suspect that the group’s highly-regarded chief executive, ex-ARM boss Warren East, will deliver on this promise. But I don’t know quite how long it will take.

The risk for investors — in my opinion — is that the firm’s near-term performance is uncertain and could be disappointing. In addition to the complexities of the group’s changing business model, investors also have to cope with a change in accounting rules.

This shift — to IFRS 15 rules — will mean that the way the company reports revenue from multi-year customer contracts will change. In turn, this will mean that Rolls doesn’t plan to issue any guidance for 2018 until its 2017 results are published in March. By then, we’ll already be a quarter of the way through the year.

Long-term only

I believe Rolls-Royce has a great long-term future. But that doesn’t necessarily mean that the shares offer good value to investors at current levels. I plan to wait for a better buying opportunity before considering this stock again.

A dividend stock I’d consider

If I was looking for a dividend stock to buy today, I’d be more interested in FTSE 250 mining group Vedanta Resources (LSE: VED). This £2.4bn Indian firm is a little quirky as it’s controlled by chairman and majority shareholder Anil Agarwal.

But Vedanta owns a lot of low-cost mines, which are powering strong profit growth this year. Today’s half-year results flagged up some impressive figures. Revenue rose by 39% to $6.8bn during the six months to 30 September, while earnings before interest, tax, depreciation and amortisation (EBITDA) rose by 37% to $1.7bn.

One concern with this business is that it carries a lot of debt. The group’s total borrowings fell by $3.1bn to $15.1bn during the six-month period, although net debt (including cash) rose slightly to $9bn, due to dividends paid by the group’s subsidiaries.

Strong cash generation

Unusually for me, I’m not too worried about Vedanta’s debt levels. The reason for this is that this group generates a lot of cash. I don’t see debt repayments as a big challenge if the commodity market remains stable.

This cash also enables the group to pay an attractive dividend. The company’s measure of free cash flow was $232m for the first half. That’s more than three times the cash needed to fund the interim dividend of $0.24 per share.

Shares in this mid-sized mining group currently trade on a P/E of 13.5, with a prospective yield of 4.4%. I’d be happy to buy at this level.

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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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