In this article from The IRS Report published in June 2010, Peter Shearlock discusses private equity...

Private equity without the pain at Melrose

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. What is certain is that, 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, which is 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 on at a profit, normally within a three to five year time span. A key difference is that unlike most of the true private equity firms, it has managed to do so without amassing a pile of debts.

Five years ago, for instance, it bought the Dynacast and McKechnie engineering businesses for a combined £429m. By May 2007 it had recouped its entire outlay with the sale of the largest chunk of McKechnie and then returned £220m to shareholders. The company had hoped to sell Dynacast by now, but the precision engineer, which uses its own proprietary die-casting technology, saw a sharp downturn in business last year from which it is only now recovering.

In mid-2008, Melrose made its biggest acquisition to date, buying FKI, whose principal businesses are in lifting products and energy technology. Melrose paid £970m including debt. To date, the company has made just two disposals, worth around £50m. But despite the subsequent downturn, it has done a very good job of reining in FKI’s costs and expanding its margins.

That can be said for the whole business. Taking all the Melrose businesses together last year, the management under chairman Christopher Miller and chief executive David Roper took out £80m of annual payroll costs and reduced net debt from £543m to £322m. One wonders what they might have done if 2009 had been a boom year. The annual results statement in March made it plain that the company was keen to do more deals – both sales and acquisitions. It has a handful of companies with a “for sale” sign over them. The two biggest are Dynacast, where it will have to be patient a while yet, and Truth, which came in with FKI.

Truth makes hardware, hinges and locks for North American producers of windows, patio doors and skylights. While new housing starts in the US halved in 2009 and Truth’s own revenues fell 10%, profit more than doubled after new management was appointed in June last year. That trend is set to continue in 2010.

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 favourable for acquisitions. The management is looking for a deal in the £500m - £1bn range, preferably a private concern rather than a publicly quoted one. Given the scarcity of bank finance, it is likely to involve a rather greater proportion of equity than the FKI deal, where the acquisition was half funded with debt.

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 in itself. 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. In 2009 a difficult year by any measure, it lifted profit before exceptional costs from £73m to £119m and earnings per share from 16.1p to 16.6p. The outlook for both the major divisions – energy and lifting products – is positive. Late cycle businesses are said to be seeing an upturn in orders which should translate into sales later this year. At 218p, the shares are selling for a little over 11 times likely 2010 earnings. After a 10% increase in the dividend last year, they yield 3.6%.

The shares should have special appeal to anyone who expects a further sharp fall in sterling.Melrose calculates that every 10 cents rise in the dollar against the pound adds £4m to profit. There is a similar effect for every 10 cents rise in the euro/sterling rate, though lately the euro has been going in the opposite direction.

But 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.

You can see all of Peter Shearlock's articles at www.TheIRSReport.com

Peter Shearlock writes in The IRS Report regularly

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