Melrose Industries — Releasing the potential

Melrose is splitting into two groups through the demerger of the automotive operations into a separately listed company. The full details of the demerger will have to wait for the prospectus, which is expected to be published following the announcement of 2022 full year results and the publication of the audited accounts, suggesting an effective date in early Q2/Q3 2023.

The automotive businesses are largely restructured, suggesting that they should be entering the ‘sell’ phase of the Melrose strategy. However, the state of the automotive market with the well-documented supply chain issues and the time lag in passing through inflationary cost increases, has held back the anticipated margin recovery. At the same time, potential automotive buyers, where the best synergy benefits lie, are facing similar market issues and do not have strong balance sheets, hence are not inclined to undertake a significant acquisition. As a consequence, realising full value through a formal auction process is, at the current time, unlikely.

From a Melrose perspective, the lower multiples the market ascribes to automotive companies has clearly affected the group valuation. With management starting to consider the next ‘buy’ element of its strategy, the rating on the shares clearly has an impact on the ability to finance any purchase and increases the hurdles management would have to overcome to achieve the targeted return to shareholders.

With shareholders’ best interests in mind, management is not prepared to sell the automotive businesses, including Powder Metallurgy, cheaply, neither is it in its DNA to sit and wait for the markets to improve. Hence the decision to move to a demerger to provide a route forward for both businesses, both with a currency in the market to pursue their own corporate strategy, either acquisitive or acquired, and which should accelerate the value creation/realisation of both businesses relative to the status quo.

Melrose structures its businesses as separate entities, reflecting the strategy to sell businesses once the ‘improve’ process has been completed. In addition, there are limited synergies between the Aerospace and Automotive businesses, which suggests no significant operational hurdles to overcome in forming two separate companies.

Melrose philosophy is to run decentralised head offices for its separate businesses, suggesting limited reorganisation of the corporate structure will be required. The group will have to restructure the financial arrangements as these rest at group level. Melrose is predominantly bank financed (plus a £300m bond maturing in 2032, which came with GKN). These facilities are due to be refinanced in 2023, limiting the additional cost associated with the demerger, albeit the refinancing is expected to account for around half of the estimated £100m total demerger fees.

Our valuation uses quoted peer group ratings for 2022 through to 2025, when the end markets and operating margins are expected to have recovered, along with a cash flow valuation of the Aerospace Risk Reward Sharing Partnerships (RRSPs). Net debt at demerger of £1.5bn is higher than our current 2022 year-end estimate due to additional demerger/refinancing costs expected in 2023.

Note, this does not take into account the management incentive scheme, which matures in May 2023 and would if the shares were to trade at 200p be valued at c 2.5p a share.

This valuation is c 20% below our last SOTP valuation of 246p detailed in our note Aerospace rising following the capital markets presentation in June. The primary reason being that our SOTP valuation assumes cash disposal of the businesses and hence delivery of the control premium, whereas our 200p assumes purely listed corporate valuations.

Melrose will not be the first company to demerge its automotive operations. Indeed, ABB announced earlier in the year that it intends to demerge its automotive turbocharger business.

Exhibit 3 looks at some of the more recent transactions and performance of the new entities against the global auto components sector and the relative index (S&P for US/DAX for Germany). The overall result would appear positive, with both parent and demerged company outperforming the relative index. However, perhaps not surprising for single stocks, the range in performance is stark.

It is also worth noting that three of these deals have led to corporate transactions within three years. Note, the Continental/Vitesco demerger was only completed 12 months ago.

Risks and sensitivities

The key differences for shareholders in owning two separate shares rather than a combined Melrose share include:

The new business will consist of the two automotive divisions and the nascent Hydrogen storage activity:

Driveline will be the dominant business. Margins in the first half were particularly affected by the auto supply chain issues and the lag in recovering inflationary cost increases, which management expect to be recovered in the second half.

A key strength of the automotive operations is their strong market-leading positions.

Management is targeting operating margins of 14% for Powder Metallurgy and over 10% for Automotive, suggesting a blended margin of around 11% on an equivalent revenue basis (or over 10% including central admin costs). This compares to c 8% prior to acquisition by Melrose, as highlighted in Exhibit 7, suggesting improvements from the restructuring of c 300bp, which compares with management’s track record on past deals of 600bp expansion. Restructuring programmes are largely complete, although profitability has been affected by the state of the automotive market and the well-documented supply chain issues along with delays in recapturing inflationary cost increases, which is expected to reverse from H222.

The business has significant EV growth potential. However, as a standalone and focused pure play automotive group, the demerged business will be able to set its own corporate agenda.

The key for the business is growth in the new hybrid and EV platform environment. While certain products such as propshafts are likely to become obsolete, there is significant overall growth in the market potential, as Exhibit 8 shows. Key is the electric drive unit, which controls the power source and vectors the power to the wheels, effectively replacing the gearbox in an internal combustion engine powered vehicle. This is a fragmented market with systems and protocols still emerging. Being a standalone business will enable Automotive to acquire companies, providing additional technology or market share. For the Powder Metallurgy business, being the market leader with only 17% market share highlights the fragmented nature of the sector, offering consolidation opportunities. The cash generative nature of the Automotive businesses as margin recovery comes through will assist in funding the nascent Hydrogen storage business.

Our forecast is for net debt to EBITDA of 1.7x on 2022 forecasts, falling to 1.3x in 2023, providing some headroom for bolt-on deals, but any significant transaction is likely to require additional equity financing, which being a listed company will provide access to.

The automotive market continues its metamorphosis with 2021 total deal value of $169bn from 1,369 transactions, according to Refinitiv. While a listing does not put a ‘for sale’ sign up, it offers the potential for equity/merger opportunities as well as a cash transaction. This is particularly important given the scale of the business relative to peers as reflected in the 2018 approach from Dana, which included equity as well as cash.

Our valuation looks at the potential valuation relative to quoted automotive peers and at the potential take-out based on the 2018 offer from Dana and other recent automotive transactions.

This would give an overall blended (average) valuation of £3,410m. Additional valuation should be ascribed to the Hydrogen storage business, which we have put at £150m (see below). Suggesting an overall enterprise value of £3.6bn.

This is based on the previous offer from Dana for the Driveline business and recent auto transaction valuations for the Powder Metallurgy business.

At the time of the Melrose offer for the GKN Group, Dana agreed to acquire its Driveline business. The total value of the deal was c $6.3bn split into equity cash and assumption of pension liabilities as shown in Exhibit 11.

Our Driveline valuation assumes the price offered by Dana excluding the pensions figure. While the UK pension is significantly improved, the original Dana offer related primarily to the overseas schemes, which are largely unfunded and still remain in situ.

Melrose was widely rumoured to be looking to sell the business in 2018 for in excess of £1.5bn, prior to the travails of the automotive industry seen over recent years. Exhibit 12 highlights the valuation for two of the largest deals in the automotive sector in 2022.

Using the average EV/EBIT multiple of 12.7x would seem conservative given that Powder Metallurgy margins are expected to be around 10% in 2022 and therefore ahead of both targets. Based on 2022 forecast EBIT of £103m, this provides a valuation of £1.3bn ($1.5bn), which should prove conservative given the improvements and positive margin trajectory.

Putting this together with the Hydrogen business (see below) suggests a take-out valuation of £5.8bn.

Note that we have ascribed a valuation of £150m to the hydrogen storage business. This 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 EVs and has a market capitalisation of c £600m. Hexagon is arguably more advanced than GKN Hydrogen, with sales for the current year expected to be £75m (GKN Hydrogen first commercial sales achieved in H222). To reflect the level of investment at over £10m a year and progress to trial units, we have pencilled in an arbitrary £150m. We appreciate this is an unstructured estimate reflecting the lack of information available and uncertainties.

The forecasts are provisional, reflecting the limited amount of information available until the demerger documentations are released. Numbers are pro forma although the demerger is not expected to become effective until the second half of 2023.

Post demerger, the Melrose group will consist of Aerospace and the Melrose corporate ‘buy, improve, sell’ function.

The business has strong market positions in the engines and fragmented airframe components sectors. The business is over 40% exposed to defence with the large civil business orientated towards narrow-bodied aircraft. A key strength of the business is its composite technology, offering the potential of lighter fuel saving components.

The central Melrose team is responsible for delivering the ‘buy, improve, sell’ strategy. This will include oversight of the improve/restructuring of the Aerospace activities, although these programmes are all expected to be underway by the end of 2022. Management focus is therefore likely to shift towards the next acquisition target, providing the next leg in the Melrose journey, albeit timing will depend on the share price and the impact on cost of capital given management’s key metric for shareholder IRRs.

Management is targeting 14%+ operating margins for Aerospace on a fully recovered end market, a target that was increased from 12%+ earlier in 2022 as the restructuring progresses. Restructuring programmes are all underway or completed, low margin business has been exited while future defence activity is being focused on higher margin ‘design to build’ activities. In terms of end markets, external forecasts are for civil airframe deliveries to return to pre-pandemic levels in 2024, led by the narrow-bodied market, while defence continues to grow, including F35 fighter deliveries, which is a key programme for GKN Aerospace. In addition, civil flying hours are also expected to return to pre-pandemic levels by 2024 or 2025, which will drive the aftermarket and GKN Aerospace RRSPs and engines revenues.

Exhibit 18 highlights the margins pre-Melrose acquisition. The 14%+ target represents a c 400bp increase from the average over the six years pre-acquisition and c 200bp above previous peak, within Melrose track record for 600bp improvement.

Our valuation for the business is split into three elements: the ongoing aerospace activities, RRSPs and central Melrose function.

Aerospace manufacturing business is valued against a quoted peer group. Note that the valuation uses earnings post central costs attributable to the Aerospace business but not to the corporate Melrose function.

Our valuation uses the median valuation although note that the margins at Melrose Aerospace are already above the peer average with full recovery expected to be at ‘best-in-class’ levels, suggesting a conservative valuation metric is being used.

The overall average suggests a median of £3.2bn. Note that the fully recovered margin in 2025 would arguably warrant a rating closer to MTU (EV/EBITDA 7.6x) and Triumph (EV/EBITDA 8.5x). An increase from the sector mean of 5.0x to 7.0x would add over £1bn to the valuation.

The Aerospace Risk Reward Sharing Partnership is a long-term contractual cash flow based on aftermarket expectations and is valued on a discounted cash flow (DCF) basis. The company’s view is that the discount rate should be between the group’s cost of capital and debt, which we estimate would equate to a valuation of £4.5bn. We use Melrose’s cost of capital to provide a valuation of £3.5bn and reduce this by £700m or 20% to avoid double counting, as RRSPs account for c 17% of Aerospace sales, giving a valuation of £2.8bn.

The Melrose head office is responsible for delivering the ‘buy, improve, sell’ strategy and subsequent deals to GKN. While there is arguably an option value as existing shareholders will be entitled to participate in future transactions, we have not attempted to place a value on this and assumed zero value. Head office costs are expected to be running at c £37m per annum.

Our overall valuation comes to £6bn. This should prove conservative as the margin recovery comes through and the business increasingly commands a premium rating to the sector.

The forecasts are provisional, reflecting the limited amount of information available until the demerger documentations are released. Numbers are pro forma although the demerger is not expected to become effective until Q2/Q3 2023.

The interim results were in line with expectations with no change to guidance. The US dollar has been strong for much of the year providing a benefit to Melrose and has been joined by sterling’s recent precipitous falls. Hence, it is worth reviewing the potential impact on our forecasts.

Given the global reach and local manufacturing, particularly in Automotive, translation provides the greatest influence on the P&L. The impact on adjusted operating profit of a 10% movement in key currencies against sterling is shown in Exhibit 25.

It is also worth noting there will be additional impact from:

There is a straight translational impact reflecting the make-up of Melrose debt.

The following table provides our estimate of the potential impact on Edison’s forecasts if current rates (US$1.08, €1.12, CNY7.7) prevail longer term.