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A FTSE 100 stock I think can smash the Rolls-Royce share price

Alan Oscroft
Business man on stock market financial trade indicator background.

Melrose Industries (LSE: MRO) has a reputation as a bit of a predator, keeping its eyes peeled for companies falling behind the pack and swooping when their weakness is most painfully exposed. And while that might be an emotive way to think of it, it’s not without merit.

Plenty were hurt by the Melrose takeover of GKN, with factory closures and job losses coming as part of the restructuring plan to turn the business round. But it was an unfortunate necessity, and it’s surely far better for experts like Melrose to come along and rejuvenate an ailing company than let it linger and perhaps eventually die a painful death.

It makes money for shareholders too, which is what we’re about here. And Melrose shares ticked up 7% on Thursday morning in response to first-half results.

Adjusted figures

The year-by-year lumpiness caused by the very long-term nature of Melrose’s investments and profits makes individual sets of results tricky to evaluate, but the company reported a 76% jump in adjusted pre-tax profit, leading to a 12% rise in adjusted EPS. That’s in line with 2019 expectations with, as the firm says, “the three main divisions of GKN on track to achieve previously announced targets.”

Chairman Justin Dowley said: “These results show the initial fruits of the ‘improve’ stage of Melrose’s ownership of GKN and, with the overall GKN margin increasing positively, we are excited about what is possible.”

Melrose is a company that’s very good at what it does, and I rate it highly as an investment — but you need to like them lumpy, and have a serious long-term horizon.

Down again

I’ve been looking at Rolls-Royce (LSE: RR) recently, after its fledgling recovery has started to tank again, and after the share price dipped sharply in response to the aero engine maker’s first-half results on 6 August. Revenue remained steady, and adjusted operating profit was given as 32% higher. But the double-whammy of a loss per share of 1.6p and a massive free cash outflow of £429m clearly didn’t go down well.

But Rolls is still in a restructuring phase, which it reckons is still on track, and the firm is expecting free cash flow of at least £1bn in 2020. The question is, does the latest share price crunch mean there’s worse to come and this is a stock to avoid, or are we looking at a cheaper buying opportunity for the long term?

One thing that puts me off is a P/E just shy of 40, based on 2019 expectations — even on today’s depressed share price.

But the cash?

If all that lovely free cash should turn up in 2020 and power the level of earnings the forecasters are eyeing up, we’d see the P/E drop to 24. But that still seems a bit scary to me, and I can’t help feeling there’s too much optimism still in the share price — and that it could be shaken out over the next 12 months.

New boss Warren East is very much the man for the job, in my view. But turning round such a complex business as Rolls-Royce was always going to be a seriously long-term job — longer than I think investors, and perhaps even the City analysts, thought. Buy for recovery? Not yet.

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Alan Oscroft has no position in any of the shares 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.

Motley Fool UK 2019