While the Rolls-Royce (LSE:RR) share price has skyrocketed in recent years, the Melrose Industries (LSE:MRO) share price has remained depressed. They operate in similar industries and both have undergone restructuring efforts in order to make them leaner and more efficient. So why aren’t Melrose shares performing?
Catalyst required
Rolls-Royce shares were clearly undervalued for some time before the stock boomed. So what changed? Well, the stock started outperforming analysts’ expectations in early 2023 and this caught investors’ interest. And then it just kept delivering stellar results quarter after quarter. In fact, the stock tripled in price between my wedding in late 2022 and our first anniversary a year later.
Melrose isn’t doing that yet. Earnings have seemingly disappointed on several occasions and there’s some discrepancies between statutory earnings and adjusted earnings. For example, in 2024, the company reported an adjusted operating profit of £540m, while the statutory operating profit was a loss of £106m.
This appears to be a reflection on the company’s transition from an acquisition-oriented and diversified engineering company to a leaner company with a strategy geared around lucrative Risk and Revenue Sharing Partnerships (RRSPs). In short, the accounting procedures may be obscuring any progress. And a catalyst may be needed to gain the market’s interest.
A top-quality business
Melrose is a quality business. It has unique competitive strengths and exceptional financial performance. The company currently has stakes in 17 major RRSPs, giving it underlying royalty-like income on around 70% of global widebody and narrowbody aircraft programmes. These are typically long-term, high-margin contracts, securing stable and growing cash flows over decades.
And its business moat is very strong. Around 70% of Melrose’s revenue is sole-sourced, meaning it is the exclusive supplier for essential components in leading aircraft engine and structure programmes. And by consolidating operations and driving efficiency gains as part of an ongoing corporate restructuring, Melrose has seen its underlying margins more than double and its earnings more than triple since 2023.
| Company | Gross Profit Margin (2024) |
|---|---|
| Melrose | 23.7% |
| Rolls-Royce | 22.4% |
As we can see from the above, Melrose’s gross profit margin’s actually stronger than Rolls-Royce, although it lags on other metrics on a statutory basis.
Re-rating potential
In late 2022, Rolls-Royce shares were trading at just three times net income for 2023. When it became manifestly obvious that Rolls was truly on the road to recovery, it underwent a re-rating, several times. And it now trades at 37 times forward earnings.
Melrose’s valuation remains notably disconnected from its long-term growth prospects. It trades at a forward price-to-earnings (P/E) ratio of just 14.9 and a price-to-earnings-to-growth (PEG) ratio of 0.75, assuming more than 20% annual EPS growth through 2029. I believe it could be trading around 40 times earnings, and still be cheap when adjusted for growth versus Rolls and GE.
This places Melrose well below sector averages, despite upgraded earnings forecasts and ongoing margin expansion. For me, this means it stands out as potentially undervalued versus both its future potential and comparable FTSE 100 industrials. Despite my bullishness, I’m still wary of supply chain issues in the industry that may slow Melrose’s growth.
It’s now a large part of my portfolio and I believe it’s worthy of broader consideration.
