Rolls-Royce could be the most overlooked FTSE 100 income giant in the making

Plane on runway
Plane on runway

On the face of it, Rolls-Royce (LSE: RR) is one of the FTSE 100’s biggest dividend duds with last year’s payout unchanged at 11.7p per share, representing a meagre current yield of 1.1%. And with the company still in turnaround mode, there’s no reason to expect dividend payments to increase this year either.

However, for contrarian investors, I believe Rolls-Royce may be a great income share in the making. This is mainly because the company’s relatively new CEO, Warren East, is embarking on an ambitious cost-cutting and turnaround plan that is focused first and foremost on free cash flow (FCF).

This is great news for investors as Rolls has struggled for years to generate sufficient post-opex and capex cash that can be used for such things as paying down debt or paying dividends. While it’s still early days in East’s tenure, his turnaround is already bearing fruit with FCF last year rising from £100m to £273m. This progress has continued into 2018 with the group kicking off £10m of FCF in the first six months of the year against a £264m outflow in 2017.

East’s cash flow focus is being boosted not only by his plan to trim £400m in annual costs by 2020 but also the cycle that all engine developers go through. Initially, these manufacturers have to spend billions designing new engines and sell them at little to no profit to aircraft manufacturers. It’s only over the long lifespan of these engines that Rolls truly reaps the rewards through high-margin maintenance work and replacement parts.

Rolls is coming to the end of a long period of major investments in new engines, so it should begin seeing this much more profitable work flow in soon. We’re already seeing the early stages of this as in H1, revenue at the civil aerospace division rocketed 26% year-on-year, which drove total group-wide sales up 14% on an organic basis.

With sales momentum regained and a management team finally focused on taking advantage of Rolls-Royce’s fantastic market position to juice margins and reward shareholders, I expect the company’s stock could turn into a dividend dynamo in the coming years.

A current income star

But if you’re a bit more impatient and are after big dividend cheques today, another turnaround option with promise is oil & gas services provider Petrofac (LSE: PFC), whose shares yield 4.75% currently.

The company is still firmly in turnaround mode as its founder-led management team unwinds its expensive bet on moving into direct oil & gas production that failed to pan out and has led to major writedowns. So far this year the company has announced $0.8bn in divestments that are helping to return the focus to its core services business and whittle down its large net debt position.

As oil prices rise to levels not seen in years, we’re also starting to see a turnaround in Petrofac’s core business. In H1, net margins rose from 5.1% to 6.8% as the company won more contracts and worked more hours on contracts it already has. This led earnings per share to jump 22% to 56.1 US cents, more than covering the unchanged 12.7 cent dividend per share.

However, while Petrofac is making good progress and pays a hard-to-beat dividend, I’d urge caution right now with the SFO’s bribery investigation continuing to cast a shadow over the group’s future.

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Ian Pierce 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.