The Melrose Industries (LSE:MRO) share price took an enormous hit at the start of the pandemic. But now that the vaccine rollout is progressing relatively quickly, it’s back on the rise. And over the last 12 months, it has nearly doubled.
The company has yet to make a complete recovery. But the question is, can it return to its pre-pandemic levels this year?
The business and the impact of Covid-19
I’ve previously explored Melrose’s business model. But as a quick reminder, it works similarly to private equity firms. Using its ‘Buy, Improve, Sell’ strategy, it identifies companies within the engineering sector that aren’t living up to their full potential. Melrose then acquires them and begins making necessary improvements to maximise their profitability. And after a few years, it looks to sell them on as much stronger and more valuable businesses.
The pandemic has and continues to disrupt many industries. But the aerospace sector has been particularly hit hard by Covid-19. And unfortunately, Melrose has considerable exposure to it. The firm recently published full-year results for 2020, and the impact of the pandemic was made perfectly clear. Total revenue fell by 20%, while losses came in at £523m. So why is the Melrose share price going up?
The rising Melrose share price
Despite these seemingly poor results, upon closer inspection, there are some encouraging signs of growth. The increase in losses is not too concerning to me. Why? Because the management team stated in advance that it had adjusted its strategy to focus on cash generation rather than profits in 2020.
While this resulted in dividends being cut, shareholders gave their blessing. And it seems to have worked. Free cash flow increased by 6% to £628m, despite the unfavourable operating environment. This helped bring down total debt by around 25% and ensured R&D budgets weren’t compromised. As a result, Melrose appears to be in a much stronger financial position, despite reporting a massive loss – quite an unusual achievement. So I’m not surprised to see its share price rise.
In terms of its enterprises, only the civil aerospace portion of Melrose’s portfolio seems to be struggling. Its automotive and power metallurgy divisions both saw margins and sales improve. Meanwhile, the company is also disposing of its Nortek Air Management business for $3.6bn. It originally acquired Nortek in 2016 for $2.8bn. But considering this business generated around $1bn of cash flow, it effectively places the purchase price at $1.8bn. In other words, the investment generated 15% annualised returns for the last five years. That’s not bad at all if I say so myself.
The bottom line
Overall, Melrose looks in relatively good health, with plenty of cash to see it through the remainder of the pandemic. What’s more, with travel restrictions beginning to ease, its civil aerospace division may soon be returning to growth.
Having said that, I don’t believe the Melrose share price will return to its pre-pandemic levels in 2021. Nortek generated around 13% of the revenue stream last year, which is obviously going to disappear when the disposal is complete. But the sale proceeds will ultimately be used to pay down debts, contribute to pension funds, and the excess will be returned to shareholders. Therefore, I won’t be selling my shares any time soon.