Earlier this week, shares in Melrose Industries (LSE:MRO) jumped 9% as JP Morgan set a price target of £8.50 for the stock. The current price is £5.70.
Analysts compared the stock to Rolls-Royce, which is up around 500% over the last two years. And while it’s easy to see why, I think investors shouldn’t get ahead of themselves.
What is Melrose?
Melrose Industries makes parts that go into aeroplanes. One division makes parts for engines and the other produces bits that go into airframes.
The company’s products feature in 100% of the world’s major aircraft. And – as is often the case in this industry – it’s difficult for other businesses to disrupt this.
Over 650 patents prevent other firms from copying its products and regulatory requirements make it impossible for customers to go elsewhere. That puts Melrose in a strong position.
So far, so good. But there’s nothing particularly new here, so the question for investors is why JP Morgan analysts think right now’s an especially good time to buy the stock.
The next Rolls-Royce?
The reason is Melrose looks set for a period of higher sales and lower costs as short-term issues give way. And that combination sent Rolls-Royce shares soaring after the Covid-19 pandemic.
Part of this comes from an expanding aftermarket business. This is expected to produce strong revenues from the next generation engines the firm has been producing over the last 15 years.
On top of this, Melrose has been dealing with expenses from the restructuring of its business and recalls on its GTF engines. As these issues subside, overall costs should come down.
Higher sales and lower costs are indeed a powerful combination for higher profits and cash generation. But is that enough to justify a share price 50% above the current level?
Price targets
My price target for Melrose shares would be much lower than £8.50. There are a few reasons, but the biggest is I’m not convinced the investment equation stacks up.
JP Morgan analysts are expecting free cash flow to reach £595m a year by 2030. That would be impressive, but a share price of £8.50 values the entire firm at just over £10bn.
An investor buying the stock at that level would have to wait five years to earn 6% a year. Given the opportunities elsewhere in the stock market, I don’t see this as attractive.
I agree that there are some short-term challenges for Melrose that could well improve over the next few years. But I’d be setting my price target for the stock at around £5.25.
Why I’m not buying?
I can see why Melrose is similar to Rolls-Royce in some ways, but I don’t think the situation’s the same. The difference is free cash generation.
With Rolls-Royce, I could see even at the start of this year how the firm’s market-cap looked cheap compared to the cash it might generate in the future. That’s not the case with Melrose.
I certainly think the stock could do well in 2025 and beyond. But the current share price looks to me like it’s already factoring in a pretty decent outlook.
This post was originally published on Motley Fool
