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