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Why I’d dump dividend dud Rolls-Royce for this FTSE 100 income champion

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Rolls-Royce (LSE: RR) is one of the UK’s most recognisable companies with a rich heritage, but when it comes to shareholder returns, the business has struggled over the past five years.

Indeed, since the middle of 2013, shares in the company have fallen by more than 10%, excluding dividends. Even after including shareholders payouts (which have been cut to the bone), returns are not much more attractive.

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That said, Rolls’ management remains adamant that it’s making progress on all its key objectives. According to a statement issued today, ahead of its annual general meeting, CEO Warren East believes that “Rolls-Royce continues its ambition to deliver its full potential, both operationally and financially.” This goal has been held back by service issues on some of the group’s newest jet engines, including the Trent 1000. 

Engineering issues 

Rolls is currently rushing to fix problems developing with the intermediate compressors in these engines. Specifically, airlines have been identifying cracking and corrosion in the compressor and turbine blades of the Trent 1000 jet, which Rolls has to put right. 

When it published its full-year results at the beginning of this year, the firm flagged up an expected £300m-plus price-tag over the next two years for repairing these issues. However, with airlines still complaining of problems even after engineering updates, I believe the eventual bill could be much higher for this debacle.

And this is the main reason why I dumped my shares in Rolls. Even though the company has reportedly completed two-thirds of its initial programme of accelerated inspections, repairing the reputational damage caused by these issues will take years. And it’s even possible the firm may never recover from this self-inflicted wound.

With this being the case, I’m sceptical that Rolls can ever return to its former glory. What’s more, the stock looks expensive, trading at a 2019 P/E of 27, a premium multiple that doesn’t leave much room for error if issues at the company continue.

Cash cow

I’m much more positive on the outlook for fashion champion Burberry (LSE: BRBY)

The fashion industry might be unpredictable, but Burberry has managed to stay ahead of the game for decades. Today the group is an international fashion giant, and over the years, shareholders have been well rewarded for its success. 

For fiscal 2017 the company returned nearly £300m to shoulders via dividends and buybacks, and it looks as if the firm will beat that total this year with £300m returned in the first half of fiscal 2018 alone. This total distribution is equal to 68p per share (including dividends and buybacks) or 136p on an annualised basis giving a total shareholder yield of 7.4% at current prices.

With just over £650m of cash on the balance sheet, the company can certainly afford these healthy distributions to investors. Further, as the group continues to churn out cash, they should continue.

However, despite Burberry’s cash cow nature, the shares trade at a deep valuation to those of Rolls. The stock currently trades at a forward P/E of 24.4, or around 21.1 if you strip out the cash on the balance sheet. In my opinion, this discount valuation coupled with Burberry’s desire to return all excess funds to investors means that it is a much better buy.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Burberry. 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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