Engineering Comebacks

06/16/2010 1:13 pm EST

Focus: GLOBAL

Peter Shearlock

Editor, Growth Company Investor

UK turnaround specialist Melrose is a very well-run play on an industrial recovery, writes Peter Shearlock in The IRS Report.

Until last month’s stock market shenanigans, engineers had led the market recovery from the lows of March 2009. Many then suffered heavy selling as investors locked in profits and started to fret about a double-dip recession.

Some of those concerns may be justifiable, though most of the bigger names are still seeing a steady increase in order flow. [But] on any long-term assessment, there is once again value to be found in a sector that boasts some of Britain’s best and brightest companies.

One that qualifies under that heading is Melrose (London: MRO), the closest you can come to a quoted private equity business focused on engineering. Melrose is a turnaround specialist—it buys other engineering businesses, improves them, and then looks to sell them at a profit, normally within three to five [years. But] unlike most of the true private equity firms, it has managed to do so without amassing a pile of debts.

Taking all the Melrose businesses together last year, management took out £80 million of annual payroll costs and reduced net debt from £543 million to £322 million. The annual results statement in March made it plain that the company was keen to do more deals—both sales and acquisitions.
 
Melrose accepts that buyers for any of its businesses are thin on the ground right now. In part, that reflects the tough time experienced by so many private equity firms, which might have been keen bidders a couple of years ago. Now, the debt on which they relied to fund their deals is simply not available. But while that makes selling businesses harder, it should be helpful when Melrose comes to buying new ones.

The Melrose management believes that market and economic conditions are favorable for acquisitions. The management is looking for a deal in the £500 million-£1 billion range, preferably a private concern rather than a publicly quoted one. For that reason, any investor now considering buying Melrose shares has to be aware that a rights issue is an odds-on probability at some time in the coming months. That should not be a deterrent, but it does mean holding some cash back in order to be able to participate when it happens.

After the pullback in the market, Melrose is looking attractively valued again. At 218 pence, the shares are selling for a little over 11x likely 2010 earnings. After a 10% increase in the dividend last year, they yield 3.5%.

The case for Melrose rests on the quality of its management. Time and again, the top team has shown itself capable of turning around big acquisitions, cutting costs, generating impressive amounts of cash to pay down debt, and then finding buyers at good prices for the businesses it wants to sell. Following the recent pullback in the shares, investors can get the benefits of that management quality without having to pay a premium.

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