US Edition Melrose
154.3p +2.3
Questor says BUY
AT this stage in the cycle, investors still need to be defensive, but they also need to be looking for companies that will outperform once the economic recovery takes hold. Questor feels that Melrose is one such company.
The company has an easy-to-understand business model. The group buys underperforming industrial assets, shakes them up, turns them around and then sells the businesses. Shareholders then benefit from the value that has been created.
The group presently owns a number of businesses, which interested investors can read about on its website. Perhaps the most well-known business the group owns is engineering group FKI. Melrose bought the engineer, which makes products such as wire rope and the handles for Gillette razors, in July 2008 for just under £1bn.
The businesses Melrose buys have to meet a number of criteria. They need to have strong fundamentals, such as a leading market share, and high-quality products. Importantly, they need to have a problem that Melrose believes it can fix.
For example, at FKI, Melrose believed that the company was "unfocused, with a weak balance sheet and borrowings due to be refinanced in the near term." Refinancing has been completed and the company is now more focused on cash generation.
Most of Melrose's management worked together at Wassall in the 1990s, a business that transformed itself from a shoe retailer into holding company for industrial businesses that operated on a similar model.
Over a 12-year period, Wassall generated a compound total shareholder return of more than 18pc a year, which is a pretty impressive track record.
The group's recent interim results were good, with pre-tax profits rising to £38.8m from £15.2m after acquisitions, prompting a 5pc increase in the interim dividend to 2.9p a share. Melrose is likely to continue with its progressive dividend policy.
Net debt was reduced by £127m to £416m over the course of the first six months of the year. Given the difficult market backdrop, this level of cash generation and cost savings are particularly impressive.
The company is also on the lookout for acquisitions up to a value of £1bn over the next 18 months, as the group argued we are in a buyers' market.
This will, obviously require new finance to be raised. However, with management's track record and access to credit markets improving, this should not be a major problem. The company is expected to target any distressed selling from the private-equity industry.
The shares have recovered substantially since the early part of the year, but are still trading on a December 2010 price earnings multiple of 10 times and yielding a solid 4.6pc.
When the global economy picks up again – however long that takes – the company should see significant margin and sales improvements. On this basis, the shares are a buy.
Investors should note the company is Melrose plc and is listed under the symbol MRO. It is not Melrose Resources, which is listed as MRS.
BP
536.45p -5.2
Questor says BUY
BP's announcement this week was arguably its best in years. The deep-water discovery of oil in the Gulf of Mexico at its Tiber prospect is the largest discovery since Tony Hayward became chief executive in May 2007.
The company estimates that the discovery could contain 3bn barrels of oil and BP has a 62pc working interest in the find. Petrobras has 20pc and ConocoPhillips has 18pc. Potentially, it could produce 1m barrels of oil equivalent per day.
The lack of future production has been a major issue affecting the oil industry for a number of years. The announcement will be positive for a very important figure for BP – its reserve replacement ratio (RRR).
The RRR is the ratio of new reserves discovered to the amount of oil produced over a period. Ideally this should be greater than 100pc. Last year it came in at 117pc.
Of course, there will be significant technical challenges in getting the oil out of the ground. To find the oil, BP had to drill one of the deepest wells ever undertaken by the oil and gas industry. Recovery rates are likely to be low.
The shares are trading on a December 2009 earnings multiple of 12.8 times and yielding 6.6pc. When the oil price slumped earlier this year fears grew that the group would have to cut its dividend this year. In March, however, Mr Hayward said he would not be cutting the payout, but briefed investors not to expect an increase. The group has committed to increase gearing to meet its dividend commitments.
However, the oil price has recovered substantially since the earlier part of the year and now trades at around $70 a barrel. This should boost the group's operating cash flow and ease dividend concerns.
The company is also rapidly removing costs from its business and it needs to continue "driving deflation down the supply chains" as Mr Hayward said earlier this year.
Of course, if the oil price slumps again then the dividend will be at risk, but Questor is doubtful that this will happen. The shares are up 10pc since their recommendation in February.
With the yield looking more secure, the shares are a buy.