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An­a­lysts sug­gest you could make 30% share price gain in a year plus pos­si­ble cash re­turns on top

Shares - - CONTENTS -

Buy it, fix it, build it, flog it: this is Mel­rose In­dus­tries’ (MRO) busi­ness model mantra in a nut­shell. We think now is a su­perb time to buy the shares.

The £10.3bn FTSE 100 turn­around spe­cial­ist op­er­ates more like a pri­vate eq­uity firm than a tra­di­tional com­pany. The man­u­fac­tur­ing-fo­cused en­tity has also been called an as­set strip­per by less char­i­ta­ble mar­ket watch­ers but its ethos has lit­tle in com­mon with cor­po­rate raider Gordon Gecko, that cold-eyed wheeler dealer from Oliver Stone’s film Wall Street.

WHAT DOES IT DO?

The recipe for suc­cess is not com­pli­cated. It stream­lines ac­quired busi­nesses, strip­ping out du­pli­cated and un­nec­es­sary costs, which bol­sters profit mar­gins and cash flows. This ef­fi­ciency and im­prove­ment is grad­u­ally picked up by in­vestors, cre­at­ing more ap­petite for the stock and driv­ing a higher rat­ing for the share price.

As cash builds on the bal­ance sheet from busi­ness sales Mel­rose doesn’t just sit idly on the read­ies, it hands back sur­plus cash to in­vestors. Since 2007 it has re­turned cash on five oc­ca­sions worth a com­bined 463p per share.

Mel­rose is now fac­ing the big­gest chal­lenge in its 15-year his­tory, hav­ing fi­nally won the £8.1bn bit­ter bat­tle for con­trol of UK auto and aero engi­neer GKN, end­ing 260 years of in­de­pen­dence.

But out of ad­ver­sity comes op­por­tu­nity, set­ting up what in­vest­ment bank JP Mor­gan calls an ‘at­trac­tive multi-year eq­uity story’.

The most op­ti­mistic an­a­lysts be­lieve you could make 30% share price gain in the next year, plus a good chance of sig­nif­i­cant cash re­turns too.

TRIED AND TESTED IM­PROVE­MENT

There are very good rea­sons why Mel­rose won the sup­port of GKN’s share­hold­ers, not least be­cause the tar­get com­pany had been stum­bling along for years.

In con­trast, Mel­rose has an ex­cel­lent track record of cre­at­ing share­holder value us­ing its ‘Buy, Im­prove, Sell’ model to iden­tify un­der­per­form­ing as­sets, drive im­proved per­for­mance and then sell the as­sets on, re­turn­ing the pro­ceeds to Mel­rose share­hold­ers.

The com­pany has paid out big in the past. It has pulled off a small hand­ful of deals for

tar­gets val­ued at £1bn or more, in­clud­ing the £1.8bn pur­chase of gas, elec­tric­ity and wa­ter flow mea­sure­ment firm El­ster in 2012.

This was even­tu­ally sold to Honey­well at the end of 2015 for £3.3bn and trig­gered a £2.4bn cash re­turn to Mel­rose share­hold­ers. That’s an im­pres­sive achieve­ment in barely three years.

In 2016, Mel­rose shelled out £2.2bn for air man­age­ment and home au­to­ma­tion engi­neer Nortek, an as­set still un­der the Mel­rose wing. But per­haps not for long now that man­age­ment time and energy is needed for GKN’s re­ha­bil­i­ta­tion.

An­a­lysts at Deutsche Bank reckon Nortek’s Er­gonomics arm could be sold be­fore the end of this year, po­ten­tially for £787m. While those pro­ceeds are more likely to go to­wards pay­ing down some of the £3.4bn net debt es­ti­mated for the end of 2018, it’ll likely be a dif­fer­ent story when Nortek’s se­cu­rity and air man­age­ment di­vi­sions go, prob­a­bly some­time next year.

Pos­si­bly part of a joint deal, Deutsche Bank’s an­a­lysts reckon the busi­nesses could raise £3.1bn, a good chunk of which could be handed back to Mel­rose in­vestors.

IM­PROVE­MENT AT THE MAR­GINS

The main way Mel­rose plans to boost GKN’s re­turns is by im­prov­ing profit mar­gins, the key fo­cus for the next two or three years. And there is sub­stan­tial scope to do just that.

Nu­mis an­a­lysts cal­cu­late that op­er­at­ing profit mar­gins of 9% to 10% are quite achiev­able at GKN’s main auto busi­ness, Driv­e­line. They are cur­rently run­ning at about 7%. On the aerospace side Nu­mis an­tic­i­pates 13% to 14% mar­gins, an am­bi­tious jump from 2017’s un­der­ly­ing 7.8% run rate.

En­cour­ag­ingly for new and ex­ist­ing in­vestors, Mel­rose seems to al­ready have a very clear pic­ture of the prob­lems to be solved, their scale and the so­lu­tions.

This in­cludes sort­ing out op­er­a­tional short­com­ings in the loss-mak­ing US Aero arm, and chang­ing the com­mer­cial cul­ture at Driv­e­line, from sim­ply chas­ing vol­ume to con­cen­trat­ing on profit and cash.

Other chal­lenges in­clude manag­ing a pen­sion scheme in deficit in­her­ited with GKN, not al­low­ing re­struc­tur­ing charges to run amok and manag­ing the typ­i­cally ex­tended sales cy­cle, all while aim­ing to lower debt. This is pretty much busi­ness as nor­mal for Mel­rose, just on a big­ger scale.

While the GKN turn­around is pitched on a three to five year ba­sis we be­lieve that the share price will be­gin to re­act once Mel­rose man­age­ment have spelled out the scale and scope of tar­geted fi­nan­cial up­side, sched­uled for Septem­ber. That could act as a cat­a­lyst for the stock and is a very good rea­son to in­vest in the Mel­rose story now. (SF)

Mel­rose floated on AIM in Oc­to­ber 2003 as a £13m buy-and-build cash shell. Fif­teen years later it is in the FTSE 100 and worth £10.3bn.

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