Interactive Investor

Edmond Jackson's Stockwatch: A company in need of a good crisis

16th September 2014 09:58

Edmond Jackson from interactive investor

Has quantitative easing thwarted Melrose? Is this a sign, asset prices are out of sync and distorting business cycles? Despite starting 2014 with a proposal to return £600 million to shareholders, mid-cap engineering turnaround specialist Melrose Industries has seen its shares slide from 328p to near 250p, testing a five-year trend-line from 90p.

The strong chart and financial results (see table) are caused by the interplay between Melrose's business model and the macro environment, helping it buy and sell at attractive prices - besides improving those firms. Its executive chairman was one of the last associates of Hanson Trust, a takeover colossus of the 1980s which honed this approach, selling some firms for profit and keeping others for cash flow. It prospered especially after the 1979 election of Margaret Thatcher led to industrial recession as interest rates soared then a bull market got going in equities.

While Hanson did enhance returns from businesses, there was a gap between what it was possible to buy them for and Hanson's share price in its go-go years. As it matured, however, the larger acquisitions needed to deliver an earnings boost became harder - and riskier - to achieve. Then some of its key executives started their own off-shoots - e.g. Greg Hutchings at Tomkins. The history of Melrose effectively started when two others set up Wassall, and three of its previous directors are now part of Melrose. Tomkins and Wassall went the same way as Hanson, however, as investors started to doubt some of its ambitious moves, the shares lost their halo and Wassall was snapped up by US private equity in 2000. Not to disregard Melrose's progress from an AIM tiddler into the FTSE 100 index before the return of capital and shares' de-rating has put it in the Mid-250.

Secular stagnation

Melrose Industries - financial summary
Consensus estimate
Year ended 31 Dec2009201020112012201320142015
Turnover (£m)12981035108010511733
IFRS3 pre-tax proft (£m)82109916.3171
Normalised pre-tax profit (£m)97.797.513171.2192237259
Normalised earnings/share (p)7.69.7106.511.515.917.4
Earnings/share growth rate (%)0.227.13.1-34.375.738.29.7
Price/earnings multiple (x)22.416.214.7
Cash flow per share (p)19.513.26.51.211.2
Capex per share (p)2.52.62.43.93.5  
Dividend per share (p)3.94.86.610.97.788.6
Yield (%)33.13.3
Covered by earnings (x)22.10.411.522
Net tangible assets per share (p)-46.4-33-37.3-103-33.4  
Source: Company REFS.

The directors have astutely shown shareholder priority and tempered the group's size so its financials are easier to keep on a growth dynamic; but their reporting theme has got in a rut: "We are in the process of identifying the next suitable candidate. The rise in asset prices over the last 18 months has not made this task easier and we have been careful to apply our strict criteria particularly as regards price." Such discipline is good, there are indeed going to be times when it is not sensible to buy. Yet Melrose is compromised after monetary stimulus has done more to boost asset values than underlying activity. "Economic recovery in Asia, the USA and the UK, while somewhat underwhelming by historical standards, nevertheless looks strong compared with continental Europe..."

Its industrial businesses are showing good profit and margin performance, although a 10% fall in like-for-like interim operating expenses is what you would expect "Hanson-type" stewards to ensure when revenue growth is challenged: normalising for exchange rates, revenue has fallen 5%. It exemplifies secular stagnation, which the US economist Larry Summers warns will be a constraint unless there are bolder reforms:

"The economy continues to operate way below any estimate of its potential made before the onset of financial crisis in 2007..." The last annual accounts showed Melrose's revenue deriving 33% from Europe, 31% the US, 23% "Other" and 12% UK. Continental Europe is obviously challenged and the sense of higher US interest rates ahead is likely to keep the dollar strong hence an on-going exchange rate issue.

No margin of safety

So the dilemma is businesses approaching limits to margin enhancement, with revenue growth compromised, while acquisition prices are beyond what is sensible to engage. This should be a general warning to investors chasing stocks as the global equities party continues: in the real business world Melrose's disciplined managers can't find any margin of safety.

Despite the shares' de-rating, their price/earnings (P/E) multiple still has quite a halo. If earnings per share re-rate to 16-17p as forecast (see table) the forward P/E is about 15 times. My recollection of Hanson, Tomkins and Wassall was P/E's drifting into single figures as the stockmarket became disillusioned, then predators moved in. So I would take care towards current 'buy' recommendations for Melrose from brokers and journalists - do they recall how the likes of Hanson and Tomkins rose and fell, or were they in school shorts then? Yes this is a proven business model, but its history has yet to show genuine longevity instead of "dog-eat-dog". Melrose faces the unprecedented environment of high asset prices and secular stagnation.

Genuine crisis needed

The normal dividend yield could be about 3.3% twice covered by earnings (and strong cash flow), which may provide some support. Melrose's balance sheet, however, typifies a determined acquirer with substantial goodwill and significant debt. The end-June balance sheet has £865.9 million longer-term debt reduced from £1.17 billion, although this meant a chunky £18.6 million net interest charge. Net assets near £1.5 billion are overwhelmingly supported by £2.5 billion goodwill and intangibles. These two aspects are tolerated by investors while the acquisition formula works, but once dynamism is lost they can weigh on a share's rating.

There's no doubting this management's capability to buy, improve and sell; the issue is the macro context now that Melrose is a big company. While I rate the stock "potentially over-priced" that's because capital preservation should be an investor's primary objective; but in fairness it's a fine line whether Melrose can remain a growth play; it largely depends on what deals flow. What this operation really needs is a genuine crisis in the world to upset asset values, such as the US Fed getting into a fix. Bulls might pray a Scottish "Yes" vote unleashes global separatist chaos. My historical sense tells me anyway to be cautious once this kind of company achieves FTSE 100 status. BTR and Hanson Trust used to be lion kings of the London stockmarket, but Tesco - for all its woes - has survived them. Who among current market professionals can even recall BTR/Hanson?

For more information see melroseplc.net.

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