Melrose Industries — Aerospace rising

Melrose held in-depth presentations on the Aerospace division on 8 June. The key takeaways are described below.

Management had historically set an operating margin target of 12%, which had been flexed to 12% post the pandemic on full market recovery and 10% without. Management has increased guidance to 14%+ on a fully recovered basis (ie 2019 excluding businesses sold or closed). From 2021 reported operating margins of 4.4%, 6% of the upside is expected to come from operational benefits generated by end market recovery and 4% from internal actions to achieve the 14%+ target. These actions are detailed in Exhibit 1 along with the benefits outlined in 2018 from the original restructuring.

GKN Aerospace was badly affected by the downturn in aerospace, with revenues in 2020 declining 27% and operating margin falling to 0.5%. Management is now expecting annual underlying growth (ie excluding activities exited) of over 10% a year to 2025 (7% post 2025). This reflects GKN’s bias toward civil over defence (59% to 41%) and a positive mix within civil highlighted by airframe and components exposure to narrow bodied and regional aircraft (39% and 37%) against the slower-to-recover wide bodied segment (24%). This recovery, along with the margin progression expectations, is reflected in updated Edison forecasts shown in Exhibits 2 and 3. Note that revenue is not expected to return to absolute 2019 levels due to disposals/exits.

Growth potential

Given the recent difficulties in the aerospace sector and to highlight that the ‘improve’ element of Melrose’s strategy is not solely focused on margin, it is worth noting some of the continued investment being undertaken to promote organic growth as highlighted in the presentation:

The RRSPs relate to participation in engine programmes and came with GKN’s acquisition of Volvo Aerospace. In RRSPs, the supplier and engine manufacturer cooperate in the design, production and life cycle support of an engine and, for additional financing/risk taken on board (eg there are no volume guarantees), the supplier is considered as a partner and therefore entitled to a share of the future revenues. GKN’s components are life-of-product rather than wear items. As a consequence, GKN is effectively investing at lower margin or a loss on supply of its components to the new build engine and is compensated as the aftermarket spares revenue comes through over the life of the engine, despite not supplying any aftermarket product.

Currently RRSPs account for 17% of aerospace revenues. However, this is expected to increase significantly, as highlighted in Exhibit 4. Note that, given the limited cost associated as GKN produces no aftermarket product, the cash generation and profit are expected to be of a similar magnitude.

Melrose’s latest disposal completes the 2016 Nortek transaction and, along with the cash retained from the 2021 disposals, provides further cash to return to shareholders.

Melrose has agreed to sell Ergotron, a high-margin ergonomic furniture business and the final element of the Nortek acquisition, to The Sterling Group, a private equity group, for c $650m (c £520m). The deal is expected to close in early Q322. The price translates to EV/EBIT of 9.0x and EV/EBITDA of 8.4x based on 2021 reported numbers.

The disposal of Ergotron completes the Nortek transaction and the fourth cycle of the group’s ‘buy, improve, sell’ model. Exhibit 5 highlights the returns with an average IRR of 28% and return on equity of c 2.7x.

Melrose has historically returned cash to shareholders through a capital return and associated share consolidation, the last being 15p/share in 2021. However, management has announced its first buyback programme following the proposed disposal of Ergotron. A £500m programme is expected to be completed by the end of October 2022. The impact will inevitably depend on the price paid, but at 150p a share would reduce shares in issue by c 7.6%. Post the return, leverage (net debt/EBITDA) would increase to c 1.5x.

Our valuation is based on a sum-of-the-parts to reflect the different activities within the group. Within this model, valuations used primarily reflect quoted company valuations and are based on recovered earnings to reflect the ‘improve’ element of the strategy and the more likely value on disposal.

Exhibit 6 highlights the valuation of the aerospace peer group used based on 2025 expectations, when the sector is expected to have returned to more normal (pre-pandemic) levels of activity and we expect GKN Aerospace margins to be in the target range.

RRSPs have long held a potential value and are now starting to come to fruition, offering meaningful cash flows in the near future, as shown in Exhibit 4. Exhibit 7 highlights the net present value (NPV) of these cash flows as provided by Melrose. Our model, using the limited information provided, supports these numbers and adds a further conservative valuation using a discount factor of 12.5%. Melrose points to the mid-point valuation of £5bn. Our view is that it is unlikely that this cash stream can easily be divested as a standalone operation, and if it were, it would arguably reduce the likely interest and value in the core aerospace business. We use Melrose’s cost of capital valuation of £3.7bn and reduce this by £900m or 20% of the underlying value of the aerospace division to avoid double counting, as RRSPs account for 17% of Aerospace sales, giving a valuation of £2.8bn. It is also worth noting that the cash flows extend beyond the International Air Transport Association’s target for ‘net zero’ by 2050, including the use of alternative fuels and power sources (ie different engines).

Exhibit 8 highlights the valuation of the automotive peer group used based on 2024, when IHS Markit and other industry forecasters anticipate a more steady state, after current supply chain issues affect 2022 and an anticipated bounce back in 2023. In our view, this is also the likely time frame for any transaction.

Melrose was widely reported to be looking at a sale of Powder Metallurgy in 2018, with a price tag of £1.5–1.6bn, but a declining automotive market precluded the possibility of a deal. This would have suggested a valuation of 11x 2018 EBIT (Powder Metallurgy’s 2018 operating margin was 11.8%). The only previous deal of scale in the sector was the 2013 acquisition of Höganäs, GKN’s key competitor in powders, at a valuation of c 13.8x 2012 EBIT (operating margin 13.5%). The Powder Metallurgy business is automotive orientated (c 80%), and there are concerns over key end markets such as transmission gears in the future electric vehicle environment, which might suggest a slight reduction in potential valuation, albeit there is also potential upside from Powder Metallurgy magnet production, which the business is investing in. However, we are expecting the business to be sold in 2023, when we are forecasting margins of 11.5%, which is still some way below Melrose management’s target of 14%, suggesting upside potential. Hence, we see our valuation multiple of 10x on 2023 forecasts as balanced.

The group’s hydrogen storage business is a nascent technology company currently entering field trials, suggesting full commercialisation is still a number of years away, making any valuation somewhat subjective. The closest peer, in our view, is Hexagon Purus (HEXAB.SS), which supplies high-pressure cylinders for hydrogen storage along with battery packs for electric vehicles and has a market capitalisation of c £750m. Hexagon is arguably more advanced than GKN Hydrogen, with sales for the current year expected to be £75m (GKN Hydrogen: less than £10m) and has two business streams, suggesting GKN Hydrogen at present should be valued at a discount, at least until there is greater acceptance of the technology. To reflect the level of investment at over £10m a year and progress to trial units, we have pencilled in an arbitrary £200m. We appreciate this is an unstructured estimate reflecting the lack of information available and uncertainties, but at c 1.5% of the total group valuation, the overall impact of any error is small.

Overall valuation

Exhibit 9 combines the operational activity valuations discusses along with the pension contribution at zero following the improved funding position, net debt forecast at the end of 2022 and management long term incentive plan (LTIP). Note that our sum-of-the-parts valuation per share is adjusted for the full share buyback (assumed at 150p).

There have been no changes to current trading; see our update note published on 12 April. However, we have updated our forecasts to reflect:

Overall, the Ergotron disposal dilution is not fully reversed by the buyback, and the Aerospace upgrade, while suggesting some benefit in the short term, has a greater impact in 2024 and onwards.