Melrose's turnaround plan is working

Melrose is best known for its gutsy acquisition of FKI, a sickly industrial conglomerate more than twice its size, in the dying days of the last bull market. That wouldn't normally be a promising backdrop, but Melrose has seemingly used the recession as the turnaround opportunity of a lifetime, and is now operating at levels of profitability that would have been unthinkable in FKI's independent days. And that's before most of its end markets have even started to recover.

Turning companies around is what Melrose is all about. Its management formed the company in 2003 with the explicit aim of buying basically sound but underperforming industrial businesses, restoring them to health and selling them. The obvious comparison is with private equity, but chairman Chris Miller, who learned his craft at Lord Hanson's knee, stresses that operational improvement is the main source of returns. For Melrose's portfolio of engineering companies, that means cutting staff, offshoring factories, prioritising higher-margin product lines, chasing after-market sales and outsourcing less profitable operations.

The group's first-half results for 2010 offered evidence that the plan is working. Even as sales fell slightly, profit margins jumped over three percentage points to 13.6 per cent. That's all the more impressive because engineers typically have lots of fixed costs in their cost base, making it easier to raise margins when sales are rising. This effect, known as operational gearing, should kick in for Melrose when the recovery arrives, boosting margins further. Mr Miller used to say Melrose, post-turnaround, would make margins of 15 per cent. Now he thinks it can hit a 17 per cent return on sales.

That won't happen this year, but Melrose may come close next. The hotchpotch of manufacturing businesses Melrose bought through FKI tend to cater to heavy industrial markets like oil and gas, which have long lead times for capital expenditure. That means their sales cycle lags the economy, but order books recover early. So, while first-half revenues were down 14 per cent on the previous year at Brush Turbogenerators, a generator manufacturer that sits in the group's energy division, its order intake was 15 per cent higher. Cheered by a confident trading update in November, City analysts now expect Melrose's full-year sales to be ahead of last year's.

Melrose still has one major business that predates the FKI deal: Dynacast, which makes die-cast metal components for consumer products; from cars to mobiles phones. Because these markets fell into recession early, Dynacast hit a trough in the first half of 2009 but is now operating at record levels again.

That suggests it may be ripe for sale, which would be good for shareholders. Melrose bought Dynacast along with McKechnie Aerospace in May 2005 and sold the latter two years later to clear its balance sheet and return cash to shareholders. With an average holding period of three to five years, management plans to do the same with Dynacast when corporate activity picks up.

That would shunt aside a major obstacle to a stock market re-rating for Melrose - its debt. It paid nearly £1bn for FKI and still has £331m of net borrowings. At 1.6 times cash profits, that's affordable, but it partly explains the discount to both the engineering and wider mid-cap universes at which Melrose's shares trade. Another explanation could be Melrose's relatively high exposure to European clients, compared with some of its sector peers who are focused on Asia.