Is today’s 10% decline a buying opportunity for this falling knife?

Shares in engineering group Melrose (LSE: MRO) are sliding today after the company published a downbeat trading statement.

The company, which operates a private equity-style business model buying struggling engineering businesses and working to turn them around before a sale, reported today that its two subsidiaries are facing significant headwinds. 

The group said its Nortek subsidiary faces currency headwinds in 2018 and that the market for the Brush unit has been “very difficult“. 

Brush, which manufactures electricity generating equipment for the power generation, industrial, oil & gas and offshore sectors, has been impacted by wider industry trends and has been a thorn in the group’s side for some time now. 

Meanwhile, Nortek, which makes air management, security and home automation devices is suffering from exchange rate movements on products imported from China. 

Still, revenues in the period from 1 July to 29 October were up 3% year-on-year, and a  full review of Brush is currently under way to improve performance. 

Temporary setback

On the back of today’s news, shares in Melrose slumped by 9.7% in early deals before paring losses to trade down only 6% at the time of writing. However, I believe that these declines present an excellent opportunity for investors to buy into the Melrose story. 

It has a history of producing outsized returns for investors. Since inception in 2003, the company has acquired a handful of struggling businesses at knockdown prices before instigating a turnaround and selling the companies. 

Management is extremely good at this process having generated £5.2bn in shareholder value since 2003. The average annual return on investment during the period is 26%. 

Considering this historical performance, I’m confident that the current headwinds are only temporary. Even though Brush has been a problem area for some time, at the end of August, the firm reported that progress at Nortek is going to plan with £47m spent to cut staffing levels by 5% and boost profit margins by a third. Further margin expansion is expected in the years ahead. 

Placing a value on growth 

Even though I’m positive on the outlook for Melrose, it’s difficult to value the company’s shares. On a P/E basis, the shares trade at a forward multiple of 22.1, which looks expensive. However, the whole business model is based not on earnings growth, but book value growth through the transformation and sale of businesses. 

The average City estimate puts the current value of its business portfolio at 260p, with a bull case scenario of 290p, nearly 35% above the current price. It will take time for management to unlock this value, so investors shouldn’t expect a sudden share price rally overnight, but these figures show that the value is there.  

The bottom line 

Overall, today’s update is disappointing, but I believe it does not detract from the company’s long-term growth story. 

Melrose has a long history of producing impressive returns for investors, and progress at Nortek shows that the group hasn’t lost its edge. Over the next few years, investors should be able to reap the benefits, as they have in the past. 

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK owns shares of Melrose. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.