A stock market recovery appears to have started since the announcement of multiple Covid-19 vaccines. The FTSE 100 and its constituents have begun to rise back towards pre-pandemic levels, but there are still many great companies that appear to me to be undervalued by the market — such as Melrose Industries (LSE:MRO).
The firm is currently trading at a level that looks incredibly cheap to me. But is it a value trap?
Getting rich with engineering
Melrose is a goliath within the engineering industry. Similar to a private equity firm, it identifies promising businesses within the engineering sector and acquires them.
However, instead of fully integrating these businesses, it performs a full evaluation of operations. Through this process, it can quickly identify where improvements can be made, or whether any products or services need to be discontinued. Typically Melrose holds onto an acquired business for several years, making improvements throughout. Eventually, it sells it at a higher price, returning the profit to shareholders.
This “Buy, Improve, Sell” strategy has been in place since the company was founded in 2003. And while acquisitions can be a risky approach to growth, the management team seem to be making smart decisions that have rewarded shareholders immensely.
How this FTSE 100 stock adapted to Covid-19
At the start of the pandemic, Melrose’s share price fell off a cliff, falling by almost 70% within a month. The catalyst for the decline appears to originate from fears surrounding the disruptions of the automotive and aerospace industries, both of which, Melrose is heavily invested in.
However, the share price has begun a steady recovery although it remains below its pre-pandemic levels. Today the company has a market cap of £7.9bn, which is only 1.8 times its revenue for the first six months of 2020. This would indicate the stock is relatively cheap, but a closer look is needed.
As expected, 2020 half-year revenues were significantly lower compared to a year ago. Melrose also made a loss of £560m over the same period. While this is concerning, it may not be a serious long-term problem.
At the start of the pandemic, the management team deliberately switched tactics to focus on cash generation instead of profits. They cut dividends as part of the tactical shift. Naturally, this only further exacerbated the declining share price, but it did increase cash available to the firm.
Overall, this new approach has brought the total cash balance to £1.5bn.
Stock market recovery: can Melrose rise again?
The pandemic continues to be a significant disruptive force within the market. But after taking a step back, I feel it’s only a short-term problem. Melrose’s decision to focus on generating cash over profits was a brilliant move in my eyes.
It now has an enormous cash war chest at its disposal to see it through the final few months of the pandemic. Therefore, it can easily pay its obligations on leases and debt without needing to raise additional capital.
The business is certainly not out of the woods, and there are many more challenges left to face. As a shareholder, I believe Melrose is fully equipped to deal with whatever comes its way, and expect the share price to recover and potentially reach new highs by the end of 2021.
