Dowlais Group — A premium automotive business

Dowlais is a global automotive components group with market-leading positions. The primary business, GKN Automotive, produces drivetrain components, predominantly sideshafts. The smaller division, GKN Powder Metallurgy, manufactures sintered metal components and metal powders.

A major restructuring programme (£486m since 2018) has seen a reduction in the manufacturing footprint along with a shift to ‘best cost’ locations. In addition, there has been a focus on internal operational efficiency programmes, including purchasing, and on commercial terms for new business. The benefits have been masked by the weak automotive market. However, as global light vehicle production recovers (S&P expects a return to 2019 levels in 2025/26), operational gearing benefits should generate a strong margin recovery. Management’s target on full market recovery is for operating margin of c 11% (>10% in GKN Automotive and 14% in Powder Metallurgy) against 6.6% reported in 2022. These would be peak margins but are in line with the improvements that Melrose has achieved in other ‘improvement’ programmes of 400–500bp.

Electrification is important given the exposure of both businesses to the automotive powertrain (motor, gearbox and driveline). GKN Automotive will see the need for propshafts and some of the AWD gearing/torque vectoring products affected to be replaced by more and higher-value sideshafts and eDrive components and/or systems. Our expectation is for a neutral impact with upside dependent on the level of eDrive system business wins and the development of the magnets business. The complete integrated systems market is competitive and, with management’s commitment to profitability and GKN Automotive’s limited scale, management is being selective with the programmes being pursued. The Powder Metallurgy division has c 50% of the business at risk, through exposure to engine and gearbox components. New electrification components and a push into the industrial markets will cushion this impact, but developments in magnets for the eMotor will be key. Again, we expect a broadly neutral impact with upside if the magnets business can deliver on management’s expectations.

Management is clear that shareholder value creation is a key focus, reflecting its Melrose cultural roots. It has made a commitment to revisit the ownership of Powder Metallurgy in the next two to three years, once the electrification impact and magnets business development becomes more evident, which could provide a value trigger. In addition, the strong balance sheet, combined with positive cash generation, provides optionality over corporate development of the GKN Automotive business, from bolt-on acquisitions to enhance the growth profile, to consolidation plays. The nascent hydrogen storage business, if successful, is likely to require additional funding/capabilities, which could involve finance or partnership with third parties.

The shares are currently going through a period of volatility post the demerger, hence offering an attractive valuation with a pathway to a premium rating over the next two to three years. Our DCF valuation of c £2.6bn translates to a share price of 186p, or using the automotive peer group, £2.3bn or c 168p a share. Strong market-leading positions within the portfolio suggest a premium automotive business. Margin recovery to management target levels, driven by the restructuring and market recovery, would support such a hypothesis and should see the shares rerate towards premium auto stocks such as Autoliv and Brembo; this would suggest a valuation of £3.7bn or 264p a share. Note this would also boost our DCF valuation due to the lower volatility to £3.1bn or 225p a share.

The key sensitivity for the group is automotive volumes globally but particularly in North America and Europe. 2022 global sales were c 10% below the 2019 peak (North America c 12% and Europe c 25%), partially due to supply chain issues, in particular a shortage of chips, which are now abating. While there appears to be pent-up demand in Western markets, softer economic conditions are likely to provide a headwind. Current market expectations are for limited growth in global automotive markets in 2023; Edison’s assumption is +3%, in line with S&P forecasts.

Internal operational sensitivities include the impact of inflation and passing such cost pressures on to clients or offsetting them through internal action. 2022 witnessed positive pass through, primarily relating to material costs, with margins in automotive increasing from 4.6% to 5.9%, albeit with some time lag. Employee cost inflation may prove more difficult to pass through and require greater efficiency programmes to offset. Contract wins or losses and the EV transition provide sensitivities both upwards and downwards. The visibility that automotive contracts provide is positive, enabling early actions to be taken to adjust capacity as the order book requires.

Dowlais is a global automotive components group with strong market-leading positions. GKN Automotive produces drivetrain components, predominantly sideshafts, where it is the market leader. Powder Metallurgy manufactures sintered metal components, where it is the market leader, and metal powders. The Hydrogen division is a nascent hydrogen storage business.

GKN Automotive supplies drivetrain components and systems, transmitting the mechanical power from the engine/gearbox to the wheels. The primary business is sideshafts and constant velocity joints (CVJs), which take the power laterally outwards to the wheels. Propshafts takes power longitudinally from the engine/gearbox to the rear axle. ePowertrains control the torque from the engine/gearbox to the sideshafts/propshafts for both AWD ICE-powered vehicles and electric eDrive. The business is global, including a 50/50 joint venture (JV) with HASCO in China.

Automotive drivetrain originated primarily as a rear-wheel drive configuration – a front-mounted engine driving a propshaft via a gearbox to a fixed rear axle, the front wheels being purely for directional steering. The Austin Rover Mini launched in 1956 came with a new design CVJ that provided constant power levels to the wheels as they turned through corners. These CVJs were attached to sideshafts to provide a torque transfer system from the engine/gearbox. Hence the modern front-wheel drive was born. The adoption of front-wheel drive increased through the 1970s to the dominant drivetrain architecture seen today, with CVJs becoming the standard technology.

The CVJ for the Mini was designed and manufactured by Birfield Group, which GKN acquired in 1966. The business had first-mover advantage as well as strong intellectual patent protection. Combined with GKN’s ability to fund expansion, the business grew globally to support original equipment manufacturers (OEMs) as they developed front-wheel drive platforms. This included being the first CVJ producer in China through a 50/50 JV established in 1988.

Exhibit 5 provides an overview of the group’s product set.

The sideshaft and two CVJs form a system connecting the motor/gearbox to the wheel in order to transfer the torque to the wheel (see Exhibit 6). Critical aspects are the efficient transfer of torque with minimal rotational losses while permitting the required angular variation. The system consists of three components:

A propshaft is a rotating metal rod/tube to take the power from the engine/gearbox in the front of the car to the rear axle. Like a sideshaft this is a relatively simple component, albeit having to handle significant torsional stress.

GKN Automotive has developed a range of products designed to control torque transfer, which include vectoring capabilities enabling varying levels of torque to be delivered to each wheel, thereby improving traction and cornering. Traditional systems utilised the braking system on individual wheels, which the GKN system does not. This family of products includes clutches and differentials.

A full eDrive powertrain system converts the battery’s electrical energy into mechanical rotational torque required to drive the wheels. The system incorporates an electric motor to generate the mechanical power, power electronics/invertor to control the motor and gearbox/differentials/torque management systems to condition the torque and transfer to the sideshafts, all within an overarching software control system. The entire system is termed 3-in-1 (motor, gearing and invertor) whereas systems without the invertor are known as 2-in-1. GKN Automotive’s involvement came from its torque management expertise, vertically integrating to provide the full drive package along with internally developed control software. Exhibit 10 highlights the key components in the system.

GKN is the clear market leader in sideshafts and CVJs, claiming relationships with 90% of the world’s OEMs and a c 50% of share of driveline wallet from its top 10 customers. We note that previous GKN management (pre-Melrose acquisition) claimed a c 50% share of the outsource market (around 10% being in-sourced by the OEMs). Competitors generally have additional activities and regional strengths and/or association with particular OEMs. Some key competitors are American Axle, Dana (primarily trucks), Magna, Nexteer, NTN, BorgWarner, Hyundai WIA, Linamar, Vitesco (spin-off of Continental’s powertrain business) and Valeo (which acquired Siemens auto business in 2022).

The business has produced solid and stable financial performance apart from over the oil shock/financial crisis and COVID-19 pandemic, when auto volumes declined.

Powder Metallurgy’s main business is the sintering of metal parts from powder under high temperature and/or pressure to fuse the powder together in an alternative process to traditional liquid poured metal castings or forgings. The process permits ‘near net shape’ components to be formed limiting the requirement for additional machining and inherent scrap generation. The business also produces powders for sinter production through its Hoeganaes brand. The division also has a nascent additive manufacturing business. The business primarily serves the automotive market, 78% of sales, with the remaining 22% to the broader industrial market.

The business was a smaller operating unit within GKN, which was seen as a growth opportunity and was expanded rapidly in the late 1990s through some 20 acquisitions. The transformational deal was the $386m purchase of Sinter Metal in 1998, which brought with it the Hoeganaes powder business. Operational issues, primarily related to the lack of acquisition integration, and poor financial performance led to significant restructuring, particularly in North America, in the early 2000s, and its performance has significantly improved since.

Traditionally metal components were cast from liquid metal into sand moulds, cooled and machined. Sintering uses metal powders, which are compressed into a metal mould, then fused through heat and pressure. This offers a number of advantages including the ability to produce ‘near net shape’ components, thereby reducing both machining requirements and scrap, while the process also uses less energy. Sintering also provides opportunity for light weighting due to the reduced density of the component and the ability to use different metal powder formulas to customise the properties of the final component. GKN produces over 10 million components a day.

In the production of high-quality metal powders, the shape and consistency of granules is critical to the quality and hence performance of the sintered component. GKN specialises in the atomisation method of powder manufacture, where molten metal is jetted in droplet form and rapidly cooled under controlled conditions to form solid powders. GKN produces around 250,000 tonnes of powder a year, with a third of production used in the group’s own sinter component production.

Additive manufacturing constructs a component by layering the material, which is then fused, often using a laser. By controlling the deposition of the metal, accurate and complex shapes can be constructed, offering greater structural freedom, increasing the design potential compared to traditional manufacturing techniques. To date the cost of the process, including the relatively slow cycle times, has limited its adoption to prototyping and high-value niche products. GKN offers binder jetting and laser sintering technologies for metals and, through the 2019 acquisition of FORECAST 3D, plastics.

The sinter metal business is fragmented, with GKN claiming the market-leading position. Competitors include smaller divisions of large industrial groups such as Sandvik and Ametek, and specialist companies such as Miba and hGear. The powder market is relatively concentrated, with Höganäs being the market leader and GKN Hoeganaes the clear number two. Combined these companies have over 50% of the market, according to Dowlais management.

Since the restructuring in the early 2000s and the financial crisis, the business has produced a strong and relatively stable performance, even limiting the impact from the COVID-19 pandemic downturn. Note that margins are affected by commodity prices as seen in 2022.

GKN Hydrogen has developed a compact hydrogen storage system using metal powders. Traditionally, hydrogen is stored as a high-pressure gas or a cryogenic (low temperature) liquid. Chemical storage offers an alternative technology through the hydrogen bonding with a compound in a reversible reaction. The GKN system uses a proprietary metal hydride enabling significant volumes of hydrogen to be held at close to ambient conditions. Benefits claimed by the GKN storage system include long life (15+ years), low pressure, no capacity losses and 100% recyclability. The system generates heat on regeneration, which, along with the weight of metal hydride, makes such a technology best suited to stationary storage solutions. The system is designed to be modular to provide flexibility for individual applications. The business reported its first commercial revenues (£1m) in 2022.

Melrose acquired GKN as an under-performing group of companies with the aim of improving the prospects and the financial performance. To achieve this, £486m of restructuring charges have been taken to date. In this section, we consider some of the actions taken and the anticipated impact on the financial performance against management expectations.

Right-sizing the operations has been a broad process of reducing the fixed-cost infrastructure, addressing the plant network and associated staffing, along with moving the centre of gravity to ‘best cost’ regions. Exhibit 19 shows the reduction in the plant network from 85 to 74, with, more importantly, the balance of ‘best cost’ facilities moving from 37% to 45% of the network. Requirements to be close to customers given the ‘just-in-time’ demands of automotive supply chains, combined with closure costs and pay-backs, limits the ability to move to ‘best cost’ locations. Similarly, Exhibit 20 shows the reduction in headcount of 12%, which, with the shift to lower-cost regions, will have had a greater impact on the cost line. Unfortunately, the decline in auto volumes over the period has seen sales decline by c 11%, hence sales per plant and sales per employee have made limited progress. As a consequence, while the group is benefiting from the move to best/lower-cost regions as witnessed by the margin improvements in 2022, there is significant operational gearing potential from the excess capacity as the end markets and sales recover.

Automotive contracts tend to be multi-year and aligned to expected but not guaranteed volumes, which depend on the ultimate success of any particular programme. Adding in the traditional automotive annual price down expectations and the initial commercial terms become critical. Actions taken include:

The automotive sector is notorious for price down pressures, reflecting the competitive nature of the market as OEMs, often with excess capacity, look for market share. Annual operational improvements are required by suppliers to offset these pressures, leading the sector to be at the forefront of new manufacturing techniques such as just-in-time, lean, six sigma, etc, along with investment in areas such as automation. Under the Dowlais/Melrose management, these actions have included reassessment of the supply chain looking at consolidation of suppliers and lowest landed cost to reduce total brought in material costs.

The above highlights some of the key aspects of the turnaround programmes, albeit the headwind from the decline in auto volumes has limited the benefit to the overall financial performance. These actions are expected to continue reflecting the dynamic state of the auto world and management determination to target operational issues as they arise, as witnessed in North America Powder Metallurgy in 2022 where underperformance at a single site has led to further actions.

Dowlais management has set a target of increasing the operating margin in GKN Automotive to at least 10% and in Powder Metallurgy to around 14%, dependent on commodity prices. This translates to c 11% margins for the group, excluding the hydrogen business and central costs. Management expects that this will be achieved largely from the operational gearing benefits from the automotive market with volumes returning to 2019 levels. These would be peak margins but are in line with the expansion that Melrose has achieved in other ‘improvement’ programmes of 400–500bp.

Exhibit 25 models the recovery potential, that is the operating margin for GKN Automotive against the growth in sales (recovery of the auto markets) and the drop through from incremental revenue. The negative drop through when the automotive markets declined in 2020 was 30% (ie each lost £1m of revenue reduced EBIT by £300k). A recovery of the auto markets to the 2019 level, expected by S&P in 2025/26, would suggest sales growth of c 15%, which, combined with the 30% drop-through we estimate, would translate to margins of 9.7%, approaching target margins before considering further commercial actions or additional restructuring benefits.

Powder Metallurgy’s negative drop through in 2020 was 37%. Exhibit 26 plots the operational gearing impact on margin. A 15% market recovery along with a 35% drop through would therefore see the business achieve the target margin; note that this also assumes a reversal of the recent commodity price rises.

Overall, this suggests that the management target margins should be achievable as end markets return to 2019 levels. Management expects that this is likely to be 2026 when the hydrogen business and potentially the Powder Metallurgy magnets business should also be profitable.

The automotive industry is undergoing a shift from traditional ICEs to a range of electric powered vehicles. These are categorised as mild (MHEV) and full hybrid (FHEV) vehicles powered by a regular combustion engine and rechargeable batteries and stop/start systems, plug-in hybrid (PHEV) driven by an electric motor powered from batteries as well as by an ICE and battery electric vehicles (BEV) powered solely by electric motor and batteries. FCEVs are fuel cell powered EVs.

EV production has accelerated in recent years led by China, where 22% of the new vehicle market was EV related in 2022. This trend is becoming global, boosted by various levels of local legislation and incentives for both consumers and OEMs. Over the next four years traditional ICE cars are expected to decline from 65m to 50m units while EVs, led by full electric, are expected to increase from 16m units to 40m. This major change to the vehicle powertrain affects both of Dowlais’s key businesses.

Power from an electric motor has different characteristics to an ICE. Primarily this is in the torque characteristics with an EV able to operate through a far larger range than an ICE (hence why ICEs stall). The ‘torque advantage’ of the electric motor requires a different drive system to smoothly transfer the rotational power of the engine to the wheels. This is perhaps best evidenced by the gearing system, where many cars currently have six or eight speed gearboxes while an electric powered car can work off a single take-off with reverse achieved by simply switching the electrical direction and hence motor direction. It is worth noting that, to maximise performance, EVs generally have some limited gearing system. EVs also have alternative challenges to deal with such as braking and regeneration under braking, along with higher rotational speeds. This provides differing challenges and opportunities to the individual sub-units.

The electric motor has far greater torque than an ICE, requiring sideshafts/CVJs to be able to handle higher loadings and hence have greater inherent strength (ie be somewhat larger). Management estimates this impact at c 5% average value increase. A greater proportion of EVs than ICEs are likely to be four-wheel drive due to the improved performance, while rigid axles are also likely to be replaced by a motor/sideshaft system. This should lead to increased sideshaft/CVJs penetration, which management estimates at 2.4 units per vehicle on average up from 2.1. Hence the overall shift is expected to prove positive for this key activity.

It is worth noting the potential threat from in-wheel electric motors. This architecture puts the electric motor inside the wheel, thereby negating the requirement for sideshafts and CVJs. In-wheel motors claim greater efficiency, largely due to vehicle set-up and regenerative braking as well as enhanced safety, including improved braking. However, there are disadvantages, including weight (suspension issues), expense, motor size and life time concerns, given the harsh operating environment. Use at present is limited, although the Lordstown Endurance SUV is designed with in-wheel motors. Note that GKN Automotive is also researching this technology.

Propshafts will be a loser in the changing drivetrain architecture, with the rear axle driven by its own rear-mounted motor rather than a front-mounted engine and connecting propshaft. Propshafts currently make up 11% of sales.

Control of power to each wheel will still be critical, particularly in higher performance vehicles. However, the new vehicle architecture eliminates the propshaft and hence the requirement to convert/control torque at either end, thereby eliminating the need for certain AWD units, although the technology can arguably be used within the eDrive for power control and vectoring.

GKN clearly has capabilities in eDrive systems and components, having invested over £200m in R&D over the last five years, and highlighted by the award of a range of headline contracts such as a 3-in-1 system with ‘a leading German OEM’ and 2-in-1 systems with Stellantis (Fiat 500e) and Ford. However, the systems market is competitive, as traditional engine (often the OEMs themselves) and gearbox manufacturers look to replace their ICE businesses at the same time as new entrants, such as GKN, look to take advantage of the step change in technology. Hence the market for the complete integrated system is competitive, and, with management’s commitment to profitability and GKN Automotive’s limited scale, GKN Automotive is tending towards becoming a specialist in components such as differentials and torque management, where it already has an established presence. This is also reflects management’s financial focus and hence unwillingness to undertake certain eSystems business, which, with significant bought-in components and GKN’s limited scale, can be below group hurdle rates.

Exhibit 29 highlights the expected gains and losses for GKN Automotive. Note that the eDrive components in the ‘Agnostic’ category offer similar content per vehicle as the ICE specific category.

2022 new bookings were over £5bn with over 40% to EVs, hence management’s view that overall the group is powertrain (EV v ICE) agnostic as this is in line with the expected market by 2026 as shown in Exhibit 30. We note that the 2022 reported life-time order intake relating to EVs from peers were: American Axle 40%, Linamar 50%, Schaeffler 40% and Vitesco 75%. China is the most advanced market in this transformation, hence it is worth reviewing how the GKN JV is faring. Exhibit 31 highlights GKN Automotive’s share of revenue from its associate per vehicle produced in China, providing a high level analysis of the impact of electrification. Revenue per car has remained broadly flat, suggesting an overall neutral impact is being seen from electrification in China.

Exhibit 32 highlights the expected changes in revenue (excluding some of the smaller businesses, c 4% of sales) assuming flat automotive sales but purely a change in mix to assess the impact of electrification. Key assumptions are a 20% decline in ICEs and a doubling of EVs. This suggests that the division should be ICE/EV agnostic, arguably with upside depending on eDrive component wins.

The Powder Metallurgy business has 78% exposure to automotive including significant powertrain exposure. Management estimates that 30% is powertrain agnostic and will be unaffected by the transition, leaving c 50% of the division’s sales exposed and potentially at risk from the electrification shift. Management has a three-pronged strategy to address this:

Intention is to gain business in EV pumps and gears where Powder Metallurgy traditionally operates, as well as in new components such as thermal management for batteries, power cables, etc, which will provide additional opportunities. In addition, powder metal is suited to the more complex components for axial and transverse electric motors, which can produce greater levels of flux and therefore torque, which could offer opportunities. The lighter weight of sintered components assists in taking weight out of a vehicle, which is important given the weight of batteries and could lead to additional components converting to Powder Metallurgy. Note that 24% of bookings were pure EV in 2022 providing confidence in such opportunities.

The Metal Powder Industries Federation, a US trade body, estimates that automotive accounts for c 70% of the Powder Metallurgy market in the United States, which provides a proxy for the world exposure. The remainder is broadly split including industrial motors, hydraulics, healthcare, defence, aerospace, construction, electronics and metalworking. GKN’s strategy is to win additional business in the non-auto markets. This will require a pivot in the marketing effort, which has been heavily automotive focused; the key will be to identify sectors with similar characteristics including volume requirements. Being the market leader and also able to add value through the materials/powder business should assist in these efforts.

EVs generally use permanent magnets due to their higher power density, torque density and efficiency (IDTechEx estimates 86% of the market use permanent magnets). The most widely used are neo magnets containing neodymium, iron and boron as well as a blend of other metals such as praseodymium, dysprosium and aluminium to refine the mechanical properties. The most common method of manufacture is to blend the materials in a furnace, cast and turn them into powders before sintering. Clearly this is an area of GKN Powder Metallurgy expertise, albeit additional steps are required to generate the requisite magnetic properties.

The EV magnets market will clearly grow as EV demand Increases. At the same time, both a range of incentives and concerns over security of supply are expected to see OEMs look to on-shoring supply, reducing reliance on Chinese production, which currently dominates the market (management estimates 92%). Management sees magnets as a significant growth opportunity and is planning a pilot line of 500 tonnes capacity in 2023, with a longer-term target of £300m annual revenue.

Exhibit 33 highlights our expected changes in revenue (excluding additive manufacturing) assuming flat automotive sales but purely a change in mix to assess the impact of electrification. Key assumptions are 20% growth in the industrial business and £100m in the new magnets business (note management’s target is £300m of revenue medium term). If achieved, this would see Powder Metallurgy as ICE/EV agnostic, arguably with upside if the magnets opportunity achieves management targets.

It is easy to assess the negative impacts from electrification (eg a decline in propshafts), but more challenging to assess the scale and likelihood of success in areas of opportunity such as eDrive or magnets.

Dowlais is a holding company, highlighting management’s view that value creation is the key driver and a willingness to entertain alternative scenarios to achieve this. A strong balance sheet and good cash generation helps provide optionality.

Management has committed to reviewing the ownership of Powder Metallurgy in the next two to three years. Such a timeframe is required to ensure that the margin recovery trajectory is fully established and to provide further evidence of the automotive electrification pathway including development of the magnets business, in order to maximise value. The business was marketed as part of GKN’s defence against Melrose’s approach and subsequently by Melrose, suggesting management already has some insight into potentially interested parties. It is also worth noting that Höganäs, the market leader in powders, was taken private in 2013, perhaps highlighting the most likely avenue if management does decide to dispose of the business.

For the development of GKN Automotive, management is suggesting potential from consolidation, vertical integration, technology acceleration or adjacency:

The nascent Hydrogen business now has a number of reference projects established and is starting to achieve commercial sales (2022 revenue £1m). The speed of adoption of hydrogen within the cleantech economy is still unclear, hence so is the scale of the opportunity and consequently the required investment. If successful there will clearly be a range of options open to management, from a disposal, to partnership, to fully funding continued development.

Margin recovery will improve operational cash generation, which will be assisted by the limited working capital requirements, reduced restructuring programmes and reducing Hydrogen investment albeit capex is expected to rise. This should see net debt, post dividends payments, which will be set at 25–35% of net profit, reduce from 2024, which will provide flexibility to management in terms of the corporate agenda or additional cash returns to maintain the target 1–1.5x leverage.

We use a discounted cash flow (DCF) analysis to provide an absolute valuation and a peer group comparison to provide a relative valuation.

Our DCF valuation is based on a 10-year cash flow and subsequent terminal valuation. Key assumptions for the cost of capital are shown in Exhibit 35. Note that the risk premium used reflects the current peer group average.

Exhibit 36 provides the output from our DCF model relative to two key variables, the cost of capital and terminal growth rate. We assume a WACC of 10% and terminal growth of 1–2%, which translates to a valuation of 178–194p a share (£2.5–2.7bn) and average of 186p/£2.6bn. One caveat with this valuation is the difficulty in taking into account the likely cyclicality of the business and its end markets.

Dowlais has no identical peers. Exhibit 37 provides a peer group with drivetrain/powertrain operations along with other predominantly automotive activities, and are either European or US listed. Note BorgWarner is currently undergoing its own demerger programme. Using three-year forward valuation metrics provides an average valuation of £2.3bn or 168p a share.

Dowlais’s market leading positions and high market shares arguably suggest a higher quality of earnings than general auto peers. Exhibit 38 shows the historical margin profile (pre central costs) for Dowlais (extracted from GKN/Melrose reports) and future Edison expectations. Historically, returns have been similar to the peer group discussed (peer current in Exhibit 38), but if management’s targeted return of over 10% can be realised then the valuation demanded by the likes of Autoliv and Brembo, our high margin ‘peer potential’ group in Exhibit 38, may become more relevant.

Exhibit 39 highlights what such a re-rating might mean to the value of the shares. In particular, the impact into 2024 and 2025, when we expect the evidence of the improved margin profile to become more evident. An average of 2025 multiples suggest a valuation of £3.7bn or 264p a share.

Our current DCF valuation of c £2.6bn translates to a share price of 186p. In the short term, markets may look towards automotive peer group metrics, which implies c 168p a share. As progression towards the margin targets becomes evident and the group delivers on its earnings potential, so investor focus will turn towards the higher rated automotive peer group, such as Autoliv and Brembo. A re-rating to this peer group would translate to a valuation of £3.7bn or 264p a share. Delivering such an operational performance should also lead to a reduction in beta and hence the cost of capital. Using a beta similar to Autoliv or Brembo would reduce the WACC by c 100bp, increasing our valuation to £3.1bn or 225p a share.

Dowlais has yet to publish its stand-alone sustainability performance or targets, although it has stated that 20% of the management bonus will be aligned with strategy and ESG goals. Dowlais’s strategy is expected to be aligned with that of Melrose. Some of Melrose’s key metrics and targets are:

We note that the latest ratings agency scores for Melrose (including the Dowlais operations) were: MSCI ‘A’, Sustainalytics ESG Risk Management score 53.6 and ESG Risk Exposure score 34.2, and CDP ‘C’.

Our automotive volumes and mix assumptions to 2026 are shown in Exhibit 28. This suggests that the market will return to 2019 volumes in 2025, although Europe is still likely to be below 2019 levels given the extent of the decline (30%).

Automotive is notorious for its ‘price down’ pressures. However, in the current inflation environment we have allowed for a 2% pass-through increase in the current year. In Powder Metallurgy we have assumed a reduction of 8% in metal prices return to 2021 levels by 2025. While this may not occur, management’s 14% margin target is based on such a scenario.

As a manufacturing business, the group is relatively capital intensive with capex/depreciation running at around 6% of sales. Trade working capital was £249m or 6% of sales in 2021, down from £476m and 9% of sales in 2019. This reflects tight management control as well as the benefits of high inventory turns required in just-in-time manufacturing for the automotive sector and standard payment terms of OEMs. This will limit the cash requirement as the top line recovers.

The group was refinanced as part of the demerger process, providing it with muti-currency facilities of c £1.8bn. Pro-forma net debt stands at £834m (gross debt £1,104m). Key covenants for the senior facilities are: for interest cover, consolidated EBITDA to net finance charges of at least 4.0x (2022 pro-forma 7.5x); and for debt cover, net debt to consolidated EBITDA less than 3.5x (2022 pro-forma 1.4x).

Significant progress has been made in reducing the deficit of the UK defined benefit pension schemes including additional cash contributions and buy-outs. In the UK, the size of the fund (liabilities) has reduced from c £1bn to c £650m, with an accounting surplus of £15m based on a full actuarial review carried out in April 2022 and updated for the financial year end. The most significant schemes are arguably in Europe where unfunded pension schemes are the norm. The overall group deficit at 31 December 2022 was £461m (31 December 2021: £528m; 31 December 2020: £748m).