Melrose Industries — The stars are aligned

Melrose has successfully implemented its ‘buy, improve, sell’ strategy over the last 20 years and four major transactions. The last acquisition was the purchase of automotive and aerospace group GKN in 2018. The businesses were affected by COVID-19, in particular aerospace, but by 2022 the restructuring programmes were largely implemented, especially in the automotive activities. Melrose management is keenly focused on shareholder value and is pragmatic, hence, with the market not conducive to a disposal, it decided to demerge the automotive operations. This was completed with the listing of Dowlais in April 2023, leaving Melrose as an aerospace business. Subsequently, management has signalled a change in strategy, saying it ‘will not seek to do another acquisition of an unrelated industrial business or, in the near term, a material aerospace acquisition’, providing investors with clarity for a strategy as a focused, high-quality aerospace group and an end to ‘buy, improve, sell’. The direction will shift from Melrose corporate turnaround to development of aerospace’s long-term potential. Management held an in-depth capital markets event on 17 May, providing greater granularity on operations including significant forward guidance. This review looks to assess the key elements of the capital markets event, in particular the financial guidance, which includes profit more than trebling between 2022 and 2025.

The Aerospace business was developed by GKN through internal investment and acquisitions, most notably Volvo Aero in 2012 for £633m and Fokker Technologies in 2015 for €706m. The business manufactures a range of components in metallics and increasingly composite materials. Through its ‘design & build’ capabilities it is positioned as a strategic technology partner to the OEMs. Such a position provides greater returns and longer ‘life of programme’ contracts than ‘make to print’ component business. Participation in the Airbus ‘Wing of Tomorrow’ programme to develop the next generation of composite wing structures highlights the technological capabilities and elevated partnership position.

The business has c 70% exposure to civil aerospace and c 30% to defence, and is split into two divisions: engines and structures.

The Engines business manufactures a range of components such as cases, frames, fans and other structural components. These are generally in the static part of the engine and are therefore not a ‘wear part’, offering limited aftermarket potential. However, the cost and timescales for developing an engine often lead to a consortium approach. Key suppliers are invited to take a stake in the full life profitability and cash flows of an engine programme, reducing the financial cost and risk to the prime engine manufacturer. These RRSPs offer a key revenue source and are discussed in more detail in the following section.

The primary activity of the Structures business is the production of wing structures including winglets and empennage as well as other fuselage components. The business has capabilities in both metals and composites, the later highlighted by the position as a key partner and supplier on the A350 programme, the first fully composite wing. Electrical Wiring Interconnection Systems (EWIS) build electric network within the aircraft, a growing market as aircraft increasingly move to electronics as highlighted in ‘fly by wire’ systems. Other smaller activities include landing gear, specialist canopies and de-icing systems. The business also has a growing repair business with three centres globally.

The RRSPs are a key part of the Engines division. They offer an investment in the economics of an engine programme to run alongside the supply agreement for physical components. Participants tend to be strategic partners capable of providing technical input in the design and development stage as well as a financial contribution. These arrangements offer long-term income from the more lucrative aftermarket, providing a significant uplift and increased longevity to the revenue stream from an engine programme given that the components supplied are predominantly ‘life of engine’ (ie limited to the initial new build phase). Melrose has a portfolio of 19 RRSPs on a range of civil aircraft.

Each RRSP is structured differently; here we provide an overview of the financials for a typical arrangement. While the cash is relatively straight forward, IFRS 15 contract accounting along with the interaction between the components supplied and the RRSP provides significant complexity to profit recognition.

Partners subscribe to the RRSP through participation fees, generally cash but it can be through technology. This occurs through the development stage of the engine, often around 15 years. At the same time, Melrose Aerospace invests in its own general development and production capital required to supply components to the engine. As the engine enters production, components are supplied and cash received. Pricing reflects a ‘should cost’ which is determined within the business model of the engine programme, reflecting anticipated profitability of the programme. The engine programme moves into cash positive territory in the build phase, increasing as the installed base and hence the aftermarket becomes established. The RRSP partners cash follows a similar profile. Key is the aftermarket when the ‘portfolio’ of engines provides a long tail, c 30 years, of cash to the RRSP ‘investors’ depending on the success of the engine.

Profit recognition is more complex due to the requirements of IFRS 15 contract accounting. The component parts business profit recognition is generally akin to a standard commercial programme, hence profit is dependent on production costs relative to ‘should cost’. However, there are a number of contract accounting rules to be applied, often requiring significant forward assumptions. One of particular note reflects that the delivery of a component is a pre-requisite for the engine to be built and the RRSP to make a profit on its aftermarket business. Given that Melrose has fulfilled its performance commitments on delivery of the part, reflecting that its parts are ‘life of engine’, ie do not participate in the aftermarket, there is a requirement to book a proportion of the anticipated future profit at this point. The extent of this can be seen in revenue terms in the ‘unbilled work done’, which stood at £450m at the 2022 year end (see note 17 in the Melrose report and accounts). This unwinds as the RRSP cash is received. Accounting for the RRSP, the initial investment is capitalised (no P&L charge) and then amortised as the income from RRSP aftermarket materialises. The income from the RRSP aftermarket is effectively a dividend stream so revenue equates broadly to cash. There is an associate cost from the amortisation charge and the unwind of the profit within the ‘unbilled work done’, explaining why the profit recorded is less than cash, although, with minimal cost of goods etc, margin is particularly high.

Seventeen of the 19 RRSPs are in the cash-generative phase, Exhibit 8, and the portfolio has good market penetration and spread, with RRSPs on 75% of global narrowbody/regional flight hours and on 70% of global widebody flight hours. The relative predictability of flying hours and the prescriptive maintenance requirements provide a solid platform to forecast the cash and profits from the RRSPs. Exhibit 9 provides Melrose’s cash expectations.

Management has provided detailed guidance for the next three years, and the combined aerospace numbers are provided in Exhibit 10. These show significant improvement on 2022 results and on pre-Melrose ownership 2017 underlying results. Note that 2023 is likely to be the first year that revenues are similar to 2017, adjusting for disposals and exits, as the market recovers from the COVID-19 downturn. This section looks to assess the roadmap to delivering these targets.

Below we look at the divisions in more detail.

Exhibit 11 and 12 show management guidance and profit bridge for the Engines business.

We have created our own profit bridge using peer returns and our industry knowledge to stress test management guidance. Our assumptions are outlined in Exhibit 13. The key driver is the growth in the RRSPs aftermarket combined with the high margins, which we have assumed at 90%. Original equipment component revenue growth is extracted from the stated targets of the airframe primes (see Appendix 1), although we have assumed lower original equipment (OE) revenue growth to the RRSPs due to the lack of exposuire on the LEAP engine programme. We have factored in broadly static margins, pre restructuring benefits, which should prove conservative given volume growth. Restructuring includes a reduction in sites from 12 to nine along with investment in automation and general operational improvements. Overall, our analysis suggests that the change in mix due to the growth from the RRSP aftermarket increases margins in line with management guidance.

Exhibit 14 and 15 show management guidance and profit bridge for the Structures business.

Again, we have created our own profit bridge using peer returns and our industry knowledge to stress test management guidance. Our assumptions and profit bridge are set out in Exhibit 16. Growth in civil reflects original equipment supplier plans as per the Structures business. Defence reflects US Department of Defense (DoD) budget growth forecasts. Defence has been a key area of difficulty, which is being addressed with additional actions including exit of £150m of business and repricing of c 70% of the ongoing business for inflation pass throughs. Restructuring activities including a 40% reduction in the footprint with 40 facilities cut to 24 along with a focus on quality to reduce rework and scrap, these actions are expected to generate significant improvements by 2025. Restructuring savings of £30m have been factored in. Therefore, the key to achieving management forecasts is likely to be drop through from additional volume as end markets recover.

A key element of Melrose’s ‘buy, improve, sell’ strategy has been the ‘improve’ phase. Melrose has set out margin expectation of 10–11% in 2023 and 17–18% in 2025, a significant uplift on the underlying 8.0% reported in 2017, the last year before Melrose purchased the business, and even the 10.2% in 2016 before significant operational issues surfaced. Exhibit 17 highlights the group’s track record, with average 6 percentage point increase in margin achieved under Melrose’s ownership. This is below the near 10% management is pointing to. However, we estimate that c 2.5pp of this improvement comes from the enhanced RRSPs mix, suggesting an underlying operational improvement requirement of c 7pp, which is more in line with management’s previous achievements. Combined with our roadmap analysis, this provides confidence that management guidance should be attainable, especially if the aerospace market recovery continues to accelerate.

Management highlighted significant expectations for improved cash flow and potential for additional capital returns, in addition to ordinary dividends. Exhibit 18 summarises our cash flow expectations (full details in Exhibit 26) and supports management’s projections for 12% unlevered, untaxed cash margin by 2025. Note that the cash from the RRSPs aftermarket requires no investment or working capital, significantly enhancing cash generation. Our analysis also suggests that, in the absence of additional returns to shareholders, the group will be in a net cash position by the end of 2026.

Management also stated that, through a combination of levering the balance sheet (up to 2.5x EBITDA) and cash generation, it would be able to buy back 5–10% of its market capital each year from 2024. Our analysis suggest that this could be on the conservative side.

Key to the overall valuation of Melrose is appreciating the value within the RRSP portfolio. The split provided between engines and structures permits the two activities to be valued against their different peer groups. However, the peers for the engines business, MTU and Safran, are expected to report margins of 12–13% in 2023 rising to 13–16% in 2025, around half the level of Melrose engines business: 22% rising to 28%. Hence such a comparison is unlikely to capture the true value. To reflect this and the level of granularity provided, we value the RRSPs separately using a discounted cash flow and the conventional operations (including the remainder of the engines activities) against a peer group of aerospace companies.

Exhibit 19 provides a summary of our discounted cash flow or net present value (NPV) of the RRSPs’ cash flows relative to discount rates. Our 7.6% WACC is consistent with leverage of 2.5x EBITDA, which management sees as appropriate for the group and provides a valuation of £5.3bn. This is not dissimilar to management’s £5.5bn valuation using a ‘midpoint’ discount rate of 7.5%. Note this excludes any cash investment and returns on future RRSPs.

Exhibit 20 provides a peer valuation for the group’s non RRSP activities using a quoted peer group of relevant aerospace component suppliers. Note that the margins that the Melrose businesses are expected to generate are higher than the peer average.

Combining these two valuations provides an overall valuation for the group. Note that the valuation does not take into account the management incentive plan, which matures in May 2024. We estimate that full pay-out would reduce the valuation by c 20p share.

The following forecasts adopt guidance provided by Melrose adjusted for the minor changes in our assumption analysis, explained earlier in the document.

The following tables highlight the past deliveries, back to pre-COVID peak numbers, and Edison’s forward expectations based on company commentary.