Melrose Industries — A proven, high-value creation model

Melrose’s model is encompassed in its ‘buy, improve, sell’ strategy. The company focuses on acquiring underperforming industrial companies, improving their performance, primarily their operating margin, through restructuring and targeted investment, prior to selling the asset to realise value. Acquisitions are funded through the equity markets and debt, with the disposal proceeds returned to shareholders. Since its listing, the group has successfully completed four transactions with one small disposal remaining (see Exhibit 1) and is currently in the ‘improve’ phase of its fifth and largest project, GKN, an automotive and aerospace business acquired in 2018 for £8.3bn.

The aerospace and automotive businesses are through the pandemic nadir, albeit automotive is facing significant aftershocks in the supply chain. Edison forecasts the GKN operating margin to be c 4.8% in 2021, up from 1.8% in 2020 but some way off management’s target of 10.5%. This is expected to be delivered from the restructuring currently underway and the benefit of end market recovery. The balance sheet remains robust with net debt forecast by Edison to be £1.1bn at the year end and net debt/EBITDA of 1.5x. The pension deficit has also been significantly reduced.

The ‘sell’ element of the Melrose strategy ensures that all businesses are sold and funds returned to shareholders. Hence, we assess the potential sale price of the assets, primarily GKN. Key variables are the margin expansion (management is targeting c 10.5%, up c 400bp from 6.4% in 2017 vs an average 600bp improvement in previous deals) and EV/EBITDA rating expansion from acquisition (Melrose has averaged a 250bp increase across all deals). Our 226p valuation is based on 10.5% margin and 150bp multiple expansion and assumes partial recovery in end markets (sales -15% from pre COVID-19 levels). Full recovery increases our valuation to 255p a share.

Acquisitions bring risk particularly when limited due diligence is available. In the improvement phase there are risks in undertaking such significant restructuring and how these interact with the inevitable operational sensitivities in the automotive and aerospace activities. Note that the pension risk that came with GKN has been significantly reduced.

Melrose is a unique investment vehicle on the UK market. Its returns have been impressive. Melrose calculates that £1 invested in the original fundraising, with all dividends reinvested, would be worth £15 today. Since listing, the shares have generated an IRR of 18.8% against the UK All Share’s 7.6% and UK industrial sector’s 11.5%, a healthy out-performance as demonstrated in Exhibit 1. The 2016–17 performance reflecting a major disposal (Elster) and acquisition (Nortek). The more recent performance has been somewhat more muted reflecting the challenges facing its key aerospace and automotive markets following the acquisition of GKN in 2018.

This report outlines the unique Melrose operating model and reviews the three key elements that drive the superior returns for shareholders. Given the hybrid nature of the model, often wrongly described as ‘publicly quoted private equity’, we provide a review of how Melrose compares to private equity and traditional listed industrial companies.

Melrose’s strategy is summarised through its ‘buy, improve, sell’ strapline. These elements can be summarised as follows:

Buy – Identify value

Management looks to acquire underperforming quality industrial companies. Identifying the underperformance and potential is critical. The key is to find high-quality businesses with strong market positions. This provides greater potential in the disposal phase and generally limits the cyclicality, with management not looking to back a single cycle or simply searching for a bargain that may prove difficult to move on. Transactions are funded through equity markets and relatively low leverage (c 2.5x EBITDA).

Improve – Generate value

Management restructure and invest in the business in order to realise its true potential. The focus is on operational improvements to enhance margins and investment in future growth prospects with internal cash generation to fund these actions. This often involves a change of management, a change of culture and implementation of the experience and template that Melrose brings. It also involves tackling issues such as pension deficits, which previous management may have not grasped but have an impact on value. The three- to five-year target time horizon provides clear focus to such actions.

Sell – Realise value

Assets are sold to crystallise the value created. Realisation provides clarity to each transaction, as management focus on returns and avoids the group becoming a diversified collection of industrial assets. It enables exiting of businesses once the ‘improvement’ benefits have been largely achieved and hence the rate of value creation from Melrose’s strategy is decelerating. The proceeds from disposals are returned to shareholders in cash, completing the equity cycle.

There are three further key elements to the model:

Melrose is a unique value generation proposition on the UK equity market. We see three key benefits of the Melrose model.

The key to Melrose value generation is the ‘double benefit’ attained by increasing operating margins. Higher margins increase not only profits but also the value (multiple of profits) for which the business can be sold. Note that this management rationale for an acquisition and target to double equity value is premised on the same entry and exit multiples.

Exhibit 5 charts valuation (EV/EBITDA multiple) against operating margin for recent industrial transactions involving UK public limited companies (PLCs). There is a clear correlation between operating margin and valuation (EV/EBITDA multiple). That is, buyers are prepared to pay more for a company that has higher margins to reflect higher value added, better cash generation etc. Increasing margins also increases the absolute level of profit thereby providing a higher EBITDA to apply to the increased multiple. This provides a key double benefit to the valuation attained.

Exhibit 6 shows how this works. A margin increase of 500bp (10% to 15%) adds 50% to profits and hence directly to the valuation (index 100 to 150) while at the same time enhancing the rating (EV/EBITDA) achieved (we estimate from 10x to 13x) providing a further 30% upside to the valuation (index 150 to 180).

This ‘double benefit’ is key to the value creation for Melrose. Exhibit 7 shows the proportion of value creation that has accrued from this mechanism in each deal, with an average over the four completed transactions of 78%. The remainder comes from cash generation and sales growth. Exhibit 8 provides further analysis on the individual transactions completed by Melrose.

A key element of the Melrose strategy is the realisation of value created through the disposal of businesses. This permits Melrose to harness the premium that selling a business can generate, especially if a competitive auction can be facilitated. Exhibit 9 highlights the premium that UK PLCs have achieved on take-out since 2020 both for where a single offeror has emerged and where a more competitive auction has ensued. The importance of this premium relative to a traditional listed business, where the premium for control remains unlocked, becomes even more significant when considered in light of the average Melrose holding period of three to five years, or four completed transactions in 17 years.

Melrose has a simple business model of raising equity to fund acquisitions and returning proceeds from disposals to shareholders as cash. See Appendix 1 for details of the latest Nortek capital return. This has a number of advantages:

Exhibit 10 highlights Melrose cash/equity raises and cash returns. It excludes the GKN funding as no significant disposals have been undertaken to date whilst including the additional cash retained on the Nortek disposal and expected cash from the disposal of Ergotron, the remaining Nortek business. This suggests an aggregate of over £2.4bn net cash generated and returned to shareholders since the formation of Melrose, excluding ordinary dividends.

Melrose clearly has a different business model from a traditional industrial company and has often been described as a listed private equity group. This is somewhat of an over-simplification. Hence it is worth comparing Melrose’s hybrid model with the traditional listed industrial and private equity operating models.

Below we considering these factors in more detail.

Private equity tends to operate a ‘buy and leverage’ model. A key measure for private equity is the IRR. A simple route to improving the IRR measure is to minimise the equity component of the funding mix through high leverage and through refinancing as cashflows accrue. The activity profile tends to be diverse to provide a portfolio effect and reflecting management expertise in financing structures rather than specific industry operations. The preference is for stable cash flows to support the debt financing, which leads to a preference for higher margin, higher quality, less cyclical businesses requiring limited cash consuming investment or restructuring.

Melrose’s ‘buy, improve, sell’ model contains the critical ‘improve’ element. Value is realised through the ultimate sale process but is generated through the improvement phase. Melrose looks to acquire businesses that are underperforming, potentially including extraneous issues such as pensions, where it sees the maximum ‘improve’ opportunity. Its focus is on the industrial sector to leverage management expertise.

Listed industrials tend to operate a combination of organic and ‘buy and build’ strategies and are generally focused on a small number of sectors where they look to build strong market positions. This strategy has proved highly successful for the likes of Halma and Spirax-Sarco, now both FTSE 100 constituents. The focus tends to be on acquisition synergies in improving the market position or accelerating growth potential. They tend to prefer strongly performing businesses, limiting the restructuring requirement and accelerating the synergy process. Disposals are generally of business that have become non-core.

Private equity’s strategy is to minimise the equity involved, which inevitably means maximising leverage. From an individual business perspective this reduces cash generation and increases risk. However, from the private equity fund perspective this risk is mitigated through a portfolio of holdings, generally spanning sectors with different economic cycles.

Melrose looks to limit group net debt to around 2.5x EBITDA to provide the benefits of leverage but without excessive risk. Mitigation comes from investing in stable industrial businesses, close banking arrangements and the group’s strong focus on cash. We note that the group came through the financial crisis and the pandemic without recourse to shareholders despite having undertaken significant acquisitions (FKI and GKN) prior to such events.

Listed company management teams in the UK tend to look to keep net debt below 2x or at least have a pathway to achieve the sub 2x level. As a consequence, the mid- to large-cap industrial companies came through the pandemic without requiring additional equity funding. The exception was Rolls-Royce as the civil aerospace market collapsed.

Private equity management involvement tends to be at board level rather than an operational level, offering a control and monitoring function, depending on the performance of the investment. Given the focus on cash generation, investment in capex or R&D tends to be limited.

Melrose investments have separate management teams, albeit with significant involvement from the centre, able to bring expertise and controls, particularly around cash generation. The ‘improve’ element of the strategy is focused on margin enhancement from operational improvements. This generally requires significant restructuring, which inevitably comes with a significant cash cost. While such actions tend to require capital, Melrose has a good track record for investment with capex/depreciation historically running at 1.2x and has been prepared to invest in longer-term opportunities such as Nortek’s StatePoint data centre cooling technology or Powder Metallurgy’s hydrogen storage business. This combination of restructuring and growth investment suggests a relatively high overall level of investment, which management looks to fund through cash generation from the business. Melrose also brings significant experience in key areas such as pensions, as it looks to address other drains on potential value.

Listed entity management operational involvement depends on the operational structure, which reflects the scale and complexity of the company. Investment will depend on individual management teams’ view on payback timescales. Organic growth has become a key metric and hence investment in such activities are seen as key; capex/depreciation for the UK engineering sector has been running at 1.3x and R&D/sales at 2.6% over the last 10 years.

Private equity returns tend to come with the realisation on maturity of the fund. These tend to have a 10-year life span and generally offer very little liquidity, unless the fund is listed. Assets are sold to generate the return of funds, enabling any disposal premium to be realised.

Melrose returns cash to shareholders on a value realisation event, normally a disposal, effectively providing a liquidity event. The expected timescale for individual investments is three to five years. As previously discussed, the disposal premium provides a positive element to Melrose returns. As it is a listed company, shareholders also have access to liquidity through the life of the transaction. The company pays a dividend commensurate with the performance of the operations within the portfolio at any one time.

Listed companies generally look to create value through expansion of the business, growing profits to generate capital appreciation. The value is ascribed to the shares and holders have access to value realisation at any point in time through the markets. Note that there is a growing appetite for a partial disbursement through buy-backs. Public company valuations do not benefit from the control premium, hence the take-out premiums previously discussed, although the public nature of the price of a business ensures a floor through third-party interest should markets fail to appreciate value. Funds tend to be reinvested for growth or returned to shareholders. Listed industrials tend to pay dividends commensurate with earnings.

Private equity charges 1.5–2% on funds under management and 10% plus of the gain or carry on a deal on realisation. This carry is normally only payable provided a hurdle rate is achieved and can be post repayment of relevant previous charges. Incentives are therefore aligned with other holders.

Melrose’s long-term plan is a three-year programme (the current scheme matures May 2023), which equates to 7.5% of the value generated through total shareholder returns (TSR) adjusted for a cost of capital. The current scheme is based on a 170p share price at maturity hence the scheme is fully aligned with all shareholders (for further details, see Appendix 2).

Long-term incentive plans for listed industrials reflect performance across a number of parameters. Exhibit 17 provides a breakdown across Melrose’s UK industrial peer group. EPS or profit growth is the main contributor followed by TSR. These tend to be based on targets (often RPI+ based) or relative to peers. In particular for shareholder returns, this relative performance is very different from the absolute measure at Melrose and arguably less aligned with shareholders. The balance comes from return on capital or a similar metric.

The Melrose scheme is clearly closer in structure to a private equity scheme, albeit carrying a lower margin of the value created (management is not rewarded for sitting on uninvested cash). It is also far more closely aligned to shareholders than listed equity schemes, which tend to carry an array of factors with shareholder returns only a secondary element.

Melrose’s hybrid strategy endeavours to take the best from private equity and traditional listed companies within its ‘buy, improve, sell’ model. Public markets enable access to financing and liquidity while being more understanding of the restructuring, investment and cash consumption of the Melrose model. The private equity element brings discipline in terms of the financial returns focus and disposal element of the strategy, along with the alignment of the management incentive scheme.

The benefit of the Melrose hybrid model is perhaps best illustrated by its corporate deals. On the acquisition side, of the deals that have become public, none have tempted a private equity offer albeit two have been lost to higher offers from listed industrial entities (Novar to Honeywell and Charter to Colfax, the latter operating a similar model to Melrose at that time). This is unfortunate but demonstrates Melrose’s pricing discipline. On the disposal side, five have been to private equity and three to industrial buyers, demonstrating preference for strongly performing acquisitions post the improvements Melrose has made. That is, the assets Melrose looks to acquire are attractive to both private equity and listed industrial companies but their models are not conducive to the time, cost and investment of turnaround situations, providing the opportunity for Melrose.

The following section provides details of the returns that have been generated through the Melrose transactions since inception followed by an update on the performance of GKN, the latest project.

Exhibit 18 provides a summary of the deals undertaken and exited to date (note that Melrose still owns the Ergotron division of Nortek). Focus tends to be on the operational improvement and margin progression although it is worth noting the significant improvements made in the pension situation, particularly at McKechnie/Dynacast and FKI, which contributed to the value creation.

We note the following:

The following highlights the area of value creation:

Melrose acquired GKN in 2018 for £8.3bn. The pandemic has had a significant impact on the key aerospace and automotive markets and has clearly delayed some of the improvements planned. Nevertheless, it is worth considering how the businesses are performing and management’s aspirations.

The pandemic has had a significant impact on the aerospace and automotive markets, with the latter being further affected by global supply chain issues, primarily chip shortages. Consequently, the operational progress being made has inevitably been reversed in terms of financial performance due to lower volumes. While disappointing, lower activity levels permit accelerated restructuring and the potential for further initiatives. These actions should allow for greater margin expansion as end markets recover. Exhibit 20 highlights divisional margin progress and Edison’s expectations for 2021, along with management’s target returns. Note that since original guidance, management targets for operating margins for the Automotive division have been increased from 10% to ‘over 10%’, Aerospace reduced from 12% to 10% due to the end market softness, while Powder Metallurgy remains unchanged.

GKN has responded well to Melrose’s cash management, which has always been a key element of its strategy. Despite the more difficult trading environment and even after restructuring and pension contributions, the business has generated c £0.8bn of free cash since acquisition, a significant improvement on the negative cash performance seen by GKN previously when an independent listed entity.

Melrose has significant experience in dealing with defined benefit pension deficits as seen with McKechnie/Dynacast and FKI. The funding deficit for the GKN defined benefit schemes has reduced from £938m to £150m through a combination of cash contributions and internal actions:

Exhibit 22 shows the progress from a balance sheet (IAS19) perspective, which, given the additional contributions should, all things being equal, improve further by the end of 2021. As a result, annual cash contributions have halved to £30m and additional contributions from disposals (previously 10% on GKN assets/5% on non-GKN assets) will no longer be required. Note that there remain significant unfunded schemes, primarily in Germany.

GKN is responding to the Melrose treatment with pensions firmly addressed and strong cash generation. The state of the key end markets is clearly frustrating and hampering progress in profit improvement (see the financial section for the latest trading update), although this is facilitating restructuring in terms of both speed and depth, the benefits of which are still expected to provide good margin progress. Our view is that these testing trading conditions have merely extended the timescale rather than changed the value creation potential.

Melrose consists of the three GKN businesses and Ergotron within the ‘Other industrial’ division. Given the scale and likely disposal of Ergotron, our activity profile focuses on the GKN operations.

The aerospace division is a tier 1 supplier of aerospace components with particular expertise in composites as well as metallics. The current sector split is 59% commercial and 41% defence, reflecting the softness of the commercial sector (pre-pandemic it was 70/30). Its commercial exposure is towards Airbus while remaining strong with Boeing. Marginally greater exposure to narrow body over wide body is anticipated post pandemic. The company is primarily an original equipment supplier.

Key elements of Melrose’s strategy for the aerospace business include:

The core of the automotive business dates back to the mid 1960s as the developer of a constant velocity joint (CVJ), which permitted front wheel drive and hence the launch and commercial success of the Mini. This has been developed into more complex drivetrain components enabling power vectoring in all wheel drive and advanced powertrain management systems.

Key elements of Melrose’s strategy for the aerospace business include:

The powder metallurgy division is a manufacturer of specialist metal powders and sintered components. Sintering involves condensing powders under heat and pressure to form a metal component. The technology enables more complex components and structures along with near net shape components to be made. Development is focused on the rapidly developing additive manufacturing and hydrogen storage sectors.

Key elements of Melrose’s strategy for the powder metallurgy division include:

Melrose’s strategy of ‘buy, improve, sell’ ensures a different sustainability starting point at the beginning of each deal cycle depending on the efforts of the previous owner. Key for Melrose is therefore the improvement strategy put in place.

Key to Melrose’s overall emissions footprint are the Scope 3 ‘in-use’ emissions at around 75% in automotive and over 90% in aerospace. The group has a number of development projects underway that will reduce emissions and assist in the transition to a low carbon economy. These include automotive drive products for EVs, light-weighting to reduce power consumption and hence emissions through composites in aerospace and additive manufacturing to permit more complex and hence lighter components in automotive and aerospace. Evolving new technologies include hydrogen storage using metal hydride powders to provide storage capacity for the grid, aviation fuel technology (biofuels and hydrogen based), an electric commuter aircraft programme (Alice) and liquid hydrogen propulsion systems for civil aerospace (H2GEAR). Demonstrating Melrose’s commitment, the group invested over £150m in products aimed at cutting emissions in 2020.

Key internal environmental measures are shown in Exhibit 34 along with changes, many of which have been affected by COVID-19 disruptions. A peer column provides a degree of benchmarking although activity profiles are inevitably different and include both automotive and aerospace focused groups. Internal Scope 1 and 2 emissions decreased in 2020 by 11%, but this appears to be due to pandemic closures with intensity increasing 14% to 105kg CO₂e/£k. The company sources only 0.4% of its electricity from renewables and did not report on Scope 3 emissions. The group’s ambition is to achieve net zero greenhouse gas emissions by 2050. At the end of 2020, 81% of sites were certified to ISO 14001 (environmental management systems) and 16% had achieved ISO 50001 (energy management). The figures are dominated by the GKN businesses hence it is worth noting that Melrose’s central corporate structure is far more advanced in terms of its carbon footprint, with group offices having attained CarbonNeutral certification for the last three years.

In terms of waste management. The group generated 150kt of waste in 2020, a reduction of 27%. More importantly the intensity improved by 9.7%. 81% of waste is recycled with 10.3% sent to landfill. According to the company, the deterioration is primarily due to the increased level of reporting from 78% to 86% of all sites but will be a key focus going forward. Water usage decreased by 7% also partially due to the increase in the number of sites reporting, which now covers 93% of physical sites, and higher intensity from the shutdown disruptions.

Internally, health and safety at Melrose is driven by ISO/OHSAS standards for which 75% of group sites are accredited. Accident rates improved in 2020 and are significantly better than the peer group average (0.3 vs 0.7). The severity rates increased marginally in 2020. Each business has set its own targets for improving overall standards by at least 10% a year. Investing in employee training and development declined slightly due to COVID-19, with an average of 13 hours per employee, and 25% of vacancies were filled internally. Melrose has a £10m five-year skills fund focused on training in the UK. Employee diversity statistics are not published, but at BOARD level BAME accounted for 10%. Externally the group has a comprehensive supply chain audit process taking into account human rights and resource intensity, particularly for specialist metals.

As a constituent of the FTSE 100, Melrose is subject to significant scrutiny in terms of governance and is required to comply with relevant codes. The AGM received an average of 98.0% of votes in favour all resolutions. As at 31 December 2020, Melrose had 30% female representation on its board, marginally below the Hampton-Alexander Review target of 33%, which will be achieved with the recent appointments of Heather Lawrence and Victoria Jarman as non-executive directorss. The board currently consists of four executive directors and eight non-executive directors, including a non-executive chairman. Gender diversity at the end of 2020 is shown in Exhibit 36.

Other governance factors include:

Melrose’s assets are realised through the ‘sell’ process with the funds returned to shareholders. Our valuation adopts a similar process to assess the expected proceeds of assets on disposal with the valuation discounted back to 2021. GKN is the critical asset (we have assumed Ergotron is sold for £500m in 2022). For GKN we have assumed:

The valuation also takes into account management pay-out and any pension, tax or further liabilities. As per our analysis earlier, the key value creation levers are likely to be the margin expansion and increase in the rating (EV/EBITDA) achieved on disposal. Exhibit 38 provides a valuation matrix depending on the improvement achieved at GKN as a single entity from acquisition (2017 operating margin of 6.4% and acquisition EV/EBITDA multiple of 7.9x).

Management’s target margins for the GKN businesses would suggest a blended margin of 10.5%, or a c 4% (c 400bp) increase from pre-acquisition level (note this compares to c 600bp across previous deals). Combining this with an assumption of a 150bp increase in the rating to 9.4x (note this compares with c 250bp across previous deals – see Exhibit 18 for details) provides a target valuation price of 226p per share. Note that on a return to pre COVID-19 revenues this would increase to 255p a share before taking into account any further potential benefit to margins.

The following table provides a translation of the valuation using current Edison forecasts. Note these include an operating margin of 8.8% for 2023 against management’s medium-term target of c 10.5%.

The company issued a Q3 trading statement on 5 October. The key elements were:

Edison forecasts assume a recovery in both the automotive and aerospace markets leveraging performance, assisted by the restructuring. Automotive market supply chain issues appear unlikely to be resolved until H222, following which we expect strong recovery growth before a return to more normal GDP type levels. The timing of an aerospace recovery is also unclear, although the primes, Airbus and Boeing, appear more optimistic, at least for narrow bodied short-haul aircraft. Our assumptions are for the civil aerospace market to return to pre-pandemic levels in 2025. A combination of restructuring and operational gearing from volume growth is expected to provide continued positive margin progression.

Disposals of businesses provide the funds for the return of capital to shareholders. Key is that this is a return of capital and not a dividend. That is, for private shareholders returns are attributable to capital gains tax (CGT) rather than income tax.

The returns are arguably a reversal of an equity issue carried out through a two-stage process:

Exhibit 42 highlights how this worked for the £730m Nortek associated return. Assuming 100 shares at 150p provides an initial valuation of £150. After the return and consolidation, the holding has become 90 news shares at 150p plus 150p in cash (10B shares at 15p). Hence the total value is unchanged. In terms of ownership of the group, the number of shares has reduced by 10% (100 to 90) but the number of Melrose shares has also reduced by 10% (4,858m to 4,372m), hence the percentage ownership of the business has not changed.

Melrose’s long-term incentive scheme is linked to the value generated for shareholders. This is measured by the share price at maturity against the share price at the start of the scheme, adjusted for an annual cost of capital, providing clear transparency. Key elements of the scheme are as follows.

The scheme matures in May 2023. It takes the average share price in May 2023 less 170p (ie the increase in the share price) multiplied by the number of shares to get the increase in value created. The scheme issues shares equal to 7.5% of this value created.

Additional elements of the scheme include:

Exhibit 43 shows how the scheme will work relative to the share price and also highlights the level of dilution