Melrose Industries — A proven, high-value creation model

Melrose Industries (LSE: MRO)

Currency in GBP

Last close As at 07/02/2023

GBP1.44

−2.50 (−1.66%)

Market capitalisation

GBP5,855m

Research: Industrials

Melrose Industries — A proven, high-value creation model

Melrose has a proven track record for creating shareholder value through its ‘buy, improve, sell’ model. Focus on financial returns and close management alignment with shareholders ensures tight discipline in the acquisition and disposal phase to combine with the key value enhancement achieved in the improvement phase of the strategy. The circularity of the model provides clarity: monies are raised to finance individual transactions with the disposal proceeds subsequently returned.

David Larkam

Written by

David Larkam

Analyst, Industrials

Industrials

Melrose Industries

A proven, high-value creation model

Initiation of coverage

Industrials

29 October 2021

Price

159p

Market cap

£6,951m

Net debt (£bn) at 30 June 2021
(proforma post capital return)

1.03

Shares in issue

4,372m

Free float

98.7%

Code

MRO

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(10.4)

(2.9)

30.2

Rel (local)

(15.8)

(7.2)

(21.9)

52-week high/low

191p

120p

Business description

Melrose Industries acquires underperforming industrial companies. It undertakes operational improvements through restructuring and investment before disposing of the assets. Deals are individually financed through new equity (and debt) with proceeds returned in cash post value realisation.

Next events

Full year results

March 2022

Analyst

David Larkam

+44 (0)20 3077 5700

Melrose Industries is a research client of Edison Investment Research Limited

Melrose has a proven track record for creating shareholder value through its ‘buy, improve, sell’ model. Focus on financial returns and close management alignment with shareholders ensures tight discipline in the acquisition and disposal phase to combine with the key value enhancement achieved in the improvement phase of the strategy. The circularity of the model provides clarity: monies are raised to finance individual transactions with the disposal proceeds subsequently returned.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/19

11,592

889

14.2

1.70

11.2

1.1

12/20

9,361

153

2.4

0.75

66.3

0.5

12/21e

7,335

189

3.1

1.50

51.3

0.9

12/22e

7,955

405

7.2

2.50

22.1

1.6

Note: *PBT and EPS are pro-forma adjusted for disposal and cash return and normalised, excluding amortisation of acquired intangibles and exceptional items.

A unique business model

Melrose’s ‘buy, improve, sell’ model is unique on the UK market. It acquires underperforming industrial businesses, restructures them and invests to improve performance, and exits through a sale process. Acquisitions are funded through equity markets alongside conservative leverage (net debt/EBITDA c 2.5x) and disposal proceeds are returned to shareholders in cash. The value realisation element ensures a keen focus on internal rates of return (IRRs) also supported by a management incentive scheme fully aligned with shareholder value creation. It is a hybrid model blending elements from private and listed equity. Melrose’s key asset is GKN an automotive and aerospace components group acquired in 2018.

Accessing the value creation curve

Key to Melrose’s model is the ‘improve’ phase, with a focus on margin expansion. This drives both higher profits and an expansion of the multiple of profits achieved on disposal. This ‘double benefit’ is key to generating value. The ‘sell’ element of the strategy ensures that Melrose can monetise the control premium.

Track record

Since listing in 2003, Melrose shares have generated an annual return of 19% against 7.6% for the FTSE All Share. Indeed, Melrose calculates that £1 invested in the original fundraising, with all dividends reinvested, would be worth £15 today. This has been achieved through four completed acquisition/disposals (one small Nortek business remains), which have generated an average IRR of 29%.

Valuation

Melrose’s ultimate value creation comes from the sale of its assets. Assuming GKN margin improvement of 400bp, in line with management targets of 10.5% for GKN (historical record +600bp), and 150bp expansion in the exit multiple over acquisition (historical record +250bp) translates to a discounted valuation of 226p. Note this assumes only a partial recovery in end markets (sales -15% from pre-pandemic levels), a full recovery would increase our valuation to 255p a share.

Investment summary

Company description

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.

Exhibit 1: Deal summary since listing

Bought

Company

Activity

Sold

ROE (x)

IRR (%)

2005

McKechnie/Dynacast

Aerospace components/zinc die casting

2007–11

3.0

30

2008

FKI

Turbogenerators, lifting products, wire, door hardware

2013–21

3.4

33

2012

Elster

Water and gas meters

2015

2.3

33

2016

Nortek

Ventilation

2021–

2.2

21

2018

GKN

Aerospace and automotive components

Source: Edison Investment Research

Financials

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.

Valuation

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.

Exhibit 2: Valuation per share (p)

Operating margin

8.5%

9.5%

10.5%

11.5%

12.5%

Margin improvement (bp)

200

300

400

500

600

Rating enhancement
(bp to EV/EBITDA)

0

162

175

189

202

215

50

173

187

201

215

229

100

184

199

214

229

243

150

195

211

226

242

258

200

206

223

239

255

272

Source: Edison Investment Research

Sensitivities and risks

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.

Introduction

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.

Exhibit 3: Total return index (including special and ordinary dividends)

Source: Refinitiv

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.

The Melrose business model

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:

An integrated approach. The three stages provide an obvious timeline to Melrose’s model. However, the process is far more integrated. Indeed, the process arguably works in reverse, starting with the exit potential in terms of the number of likely buyers and valuation, and secondly the operational due diligence and how much improvement management believes it can generate. These aspects, along with the expected timeframe, normally three to five years, drive the acquisition phase and price discipline. This strategy also explains why the management is prepared to pay a reasonable price for a quality business as opposed to simply looking for cheap assets.

Exhibit 4: The integrated Melrose model

Source: Edison Investment Research

Equity funded and cash returns. Each acquisition is partly funded through the equity markets and the disposal proceeds on asset realisation are returned to shareholders in cash distributions. This provides transparency on each deal and clear management focus on generating returns.

Management alignment with shareholders. The management incentive plan is fully aligned to the value created for shareholders, calculated on the equity enhancement (share price performance) adjusted for deals and charged for a cost of capital (see Appendix 2 for details). Note management currently holds 1.0% of group shares.

Three key benefits of the Melrose model

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

Accessing the sweet spot in the value creation curve

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).

Exhibit 5: UK listed industrials transactions

Exhibit 6: Value enhancement potential

Source: Edison Investment Research

Source: Edison Investment Research

Exhibit 5: UK listed industrials transactions

Source: Edison Investment Research

Exhibit 6: Value enhancement potential

Source: Edison Investment Research

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.

Exhibit 7: Melrose value creation

Exhibit 8: Melrose deal details

Source: Melrose

Source: Edison Investment Research

Exhibit 7: Melrose value creation

Source: Melrose

Exhibit 8: Melrose deal details

Source: Edison Investment Research

Accessing the disposal premium

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.

Exhibit 9: Take-out premiums (2020–21)

Premium to undisturbed price

Sole bidder

Multiple bidders

Immediately prior

39%

54%

3–6 months prior

51%

65%

Source: Edison Investment Research

Cash returns to shareholders

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:

shareholders receive cash not paper returns,

transparency on individual deals and returns generated,

it permits shareholders to decide on participation in individual deals, and

it provides a management discipline with each deal as a stand-alone transaction.

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.

Exhibit 10: Cash/equity raise and cash returns (£m)

Source: Edison Investment Research

Melrose business model unwrapped

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.

Exhibit 11: Summary business model characteristics

 

Private equity

Melrose

Traditional listed industrial

Strategy

Buy and leverage

Buy, improve, sell

Buy and build

Acquisition criteria

Cashflow stability

Operational potential

Strategic rationale

Activity profile

Diverse

Industrial

Focused

Leverage

High

Medium

Medium-low

Risk

Financial

Operational

Operational

Risk mitigation

Portfolio diversity

Cash management/flexible banking

Low debt/equity markets

Management operational involvement

Low

High

High

Operational priorities

Cash generation

Operational improvement

Growth and margin 

Investment

Limited

High

High

Management incentive

Equity returns

Share price appreciation

Financial targets

Returns to shareholder

Cash return on fund life span

Cash returns on transaction

Capital appreciation

Time horizons

10 years/3–5 years per investment

3–5 years

Long term

Liquidity

Low

High

High

Access disposal premium

Yes

Yes

No

Source: Edison Investment Research

Below we considering these factors in more detail.

Strategy and acquisition criteria

Exhibit 12: Strategy and acquisition criteria

Private equity

Melrose

Listed industrial

Strategy

Buy & leverage

Buy, improve, sell

Buy & build

Activity profile

Diverse

Industrial

Focused

Acquisition criteria

Cash generation

Value potential

Strategic fit

Source: Edison Investment Research

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.

Leverage and risk mitigation

Exhibit 13: Leverage and risk

Private equity

Melrose

Listed industrial

Leverage/debt levels

High

2.5x EBITDA

<2.5x

Risk

Financial

Operational

Operational

Risk mitigation

Diversified portfolio

Cash management/flexible banking

Low debt/equity markets

Source: Edison Investment Research

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.

Operational priorities

Exhibit 14: Key operational priorities

Private equity

Melrose

Listed industrial

Management involvement

Limited

High

High

Operational actions

Limited

High

Medium

Investment

Low

High

Medium

Source: Edison Investment Research

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.

Value realisation and liquidity

Exhibit 15: Value realisation and liquidity summary

Private equity

Melrose

Listed industrial

Returns to shareholders

Cash return on fund maturity

Cash returns on individual investments

Capital appreciation

Timescale

c 10 years

3–5 years

Long term

Disposal premium

Yes

Yes

No

Liquidity

Illiquid

Liquid

Liquid

Source: Edison Investment Research

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.

Management incentives

Exhibit 16: Management incentive criteria

Private equity

Melrose

Listed industrial

Performance based (c 20%)

Share performance base (7.5%)

Primarily profit based

Source: Edison Investment Research

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.

Exhibit 17: Average listed UK industrial LTIP criteria

EPS/profit based

TSR relative to peer group

Return on capital

55%

28%

17%

Source: Edison Investment Research, company accounts

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.

Summary

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.


Melrose’s performance, past and present

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.

Summary of past performance

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.

Exhibit 18: Completed transaction summary

Acq date

Value

£bn

Company

Activity

Sale date

Sale price (£bn)

Buyer

Margin enhancement (bp)

Multiple expansion (bp)

ROE
(x)

IRR
(%)

2005

0.4

McKechnie

Aerospace components

2007–11

0.8

JLL Partners

550

150

3.0

30

Dynacast

Zinc die casting

Kenner & Co

2008

1.0

FKI

Lifting products

2013–21

1.5

KKR

500

150

3.4

33

Specialist wire

Ontario Teachers

Turbogenerators

One equity

Door hardware

Tyman

2012

1.8

Elster

Meters

2015

3.3

Honeywell

900

500

2.3

33

2016

2.2

Nortek

HVAC

2021–

3.2*

Madison Ind.

500

250

2.2

21

Average

c 600

c 250

2.7

29

Source: Company information. Note: *We assume Ergotron sold for £500m.

We note the following:

The average margin expansion has been c 600bp.

The average rating expansion has been c 250bp.

The average deal ROE has been 2.7x and IRR has been 29%.

Acquirors of the Melrose assets have included private equity (five) and industrial (three), highlighting the attractiveness of the assets.

The following highlights the area of value creation:

Exhibit 19: Melrose value creation

Source: Melrose

GKN response to the Melrose model

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.

Operations

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.

Exhibit 20: GKN divisional operating margin

Source: Edison Investment Research, company information

Cash generation and investment

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.

Exhibit 21: GKN cashflow profile since acquisition

Source: Melrose

Pension

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:

£350m from cash contributions. These included £150m initial contribution along with enhanced annual contributions.

£450m from improved investment strategy and other 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.

Exhibit 22: GKN defined benefit scheme deficits (IAS19)

Source: GKN, Melrose report & accounts

Overall

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.


Activity profile

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.

Aerospace

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.

Exhibit 23: Aerospace activity profile

% of sales

Market position

Description

Airframes

68

#2

Wing and fuselage components in composite and metals. Specialist smaller businesses such as transparencies and de-icing systems

Engine systems

32

#2

Engine components and nacelles. Aftermarket exposure through risk reward partnerships with OEMs

Source: Edison Investment Research, Melriose

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

Margin expansion. Management is targeting a 10% operating margin on partial aerospace recovery. Improvements are expected from SG&A, procurement and restructuring and include ‘fixing’ the North American structures business, which was loss making on acquisition.

Growth opportunities. Investment continues in areas such as composites, where GKN is a market leader, additive manufacturing, utilising the powder metal division’s expertise, and alternative propulsion technologies. Given the conservative nature of the industry, none are expected to be transformational in the short term.

Exhibit 24: Revenue and growth

Exhibit 25: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts

Source: Melrose, Edison Investment Research forecasts

Exhibit 24: Revenue and growth

Source: Melrose, Edison Investment Research forecasts

Exhibit 25: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts

Automotive

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.

Exhibit 26: Automotive activity profile

% of sales

Market position/ share (%)

Description

Electrification implications

Sideshafts

59

#1

47

Constant velocity joints and sideshafts for transmitting power to the wheels. C 50% world market share including 40% in China. Supplies 90% of global automotive OEMs

Centralised power unit ensures sideshafts still required

Propshafts

13

Shafts transmitting power from the engine/gearbox to the rear differential.

Dual motor configuration likely to replace propshafts

All Wheel Drive (AWD)

25

#1

30

Intelligent power vectoring and torque management for 4-wheel drive applications

Unclear but likely retention on more complex systems

eDrive

2

#1

14

Systems for controlling and delivering electric engine torque to the drive system

Essential for hybrid and full electric vehicles

Source: Edison Investment Research, company information

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

Margin expansion. Management is targeting at least 10% operating margins despite the continued investment in the eDrive business providing a negative impact at present. The key sources include improved sourcing, fixed cost from rationalisation of the manufacturing footprint, other operational improvements and improved ‘go to market’ commercial strategy.

Growth in electrification. Sideshafts are still very much required in EVs to transfer power from the central motor to the wheels although propshafts will be negatively affected as the architecture tends to use dual electric motors rather than mechanical transfer of power from front to rear. GKN is the market leader in this nascent, fragmented sector with 14% market share. The All Wheel Drive business is likely to become more associated with the additional functionality of higher-end vehicles. Overall, the total available package that GKN can offer will increase around fourfold from ICE to electric vehicle (EV). To maintain its market leading position, Melrose is investing c £100m in EV technology and systems in 2021.

Exhibit 27: Revenue and growth

Exhibit 28: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts

Source: Melrose, Edison Investment Research forecasts

Exhibit 27: Revenue and growth

Source: Melrose, Edison Investment Research forecasts

Exhibit 28: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts

Powder Metallurgy

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.

Exhibit 29: Powder metallurgy activity profile

% of sales

Market share/
position

Description

Electrification implications

Sinter metal components

82

17%
#1

Sinter metal components using metal powder under high pressure and temperature. 80% exposure to automotive

Significant exposure to gears/gearbox hence negative impact expected

Powder

16

24%
#2

Metal powder for sinter manufacturing for in-house and third-party sales

Additive manufacturing

2

#1

Supplier of metal and plastic 3D components and specialist metal powders

Hydrogen storage

0

N/A

Development of metal hydride system for low pressure hydrogen storage

Source: Edison Investment Research, Melrose

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

Margin expansion. Management is targeting 14% operating margins. Internally this is being driven by refocusing, including exiting low-margin business, and a focus on new higher-margin segments along with restructuring of the manufacturing footprint and internal operational improvements. The final element comes from leverage as the automotive markets recover. Note investment in hydrogen technology is reducing margins by 1% at present.

Investment for growth. Melrose is investing in two nascent sectors utilising powder technology: Additive manufacturing to leverage the market leading position in metal powders combined with recent production infrastructure from the acquisition of Forecast 3D and development of a low pressure, multi-cycle and recyclable hydrogen storage system using metal hydride powders.

Exhibit 30: Revenue and growth

Exhibit 31: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts

Source: Melrose, Edison Investment Research forecasts

Exhibit 30: Revenue and growth

Source: Melrose, Edison Investment Research forecasts

Exhibit 31: Operating profit and margin

Source: Melrose, Edison Investment Research forecasts


Sustainability

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.

Exhibit 32: Melrose’s UN Sustainable Development Goals

Source: UN, Melrose

Environmental

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.

Exhibit 33: New environmental technologies

Electric automotive drive

Hydrogen storage

Additive manufacture

Hydrogen powered aircraft

Source: Melrose

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 COe/£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.

Exhibit 34: Key environmental metrics

Melrose

Peers

 

2019

2020

Change

Average

Max

Min

Scope 1 & 2 (tCOe)

1,028,490

916,431

-10.9%

Intensity (tCOe/£k)

0.092

0.105

14.1%

0.11

0.25

0.05

Energy usage (MWh)

3,398,629

2,910,974

-14.3%

Energy intensity (MWh/£k)

0.304

0.332

9.2%

0.44

1.5

0.2

Waste (T)

206,852

150,475

-27.3%

Waste intensity (T/£k)

22.9

18.7

-18.3%

19.0

36.3

5.1

Recycling (%)

86.3%

81.0%

-5.3%

77.3%

97%

47%

Waste to landfill (%)

4.0%

10.4%

6.4%

8.5%

25%

3%

Water usage (m³)

4,165,220

3,880,393

-6.8%

Water intensity (m³/£k)

0.38

0.44

16.6%

0.43

0.68

0.29

Source: Edison Investment Research, company information

Social

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.

Exhibit 35: Key social metrics

 

2019

2020

Accident frequency rate (accidents per 200,000 hours worked)

0.43

0.30

Accident severity rate (hours lost per accident)

19.0

20.4

Sites with ISO 14001 or OHSAS 18001

75%

Training hours per worker

15

13

Total training spend (£m)

12.2

8.6

Workforce voluntary attrition

10%

10%

Source: Melrose

Governance

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.

Exhibit 36: Melrose’s gender diversity

 

Male

Female

Board

70%

30%

Executive committee

65%

35%

Management

86%

14%

All employees

80%

20%

Source: Melrose

Other governance factors include:

Audit quality. No qualifications were made by the auditors in their opinion statement. Of note were comments that the inventory valuation issue within GKN Aerospace, inherited from pre Melrose times, is no longer considered a key audit matter due to the reduction in value of the inventories held at the aerospace business. Not surprisingly given the softer trading, the auditors suggested that the risk of impairment to goodwill and acquired intangibles has increased.

Remuneration. Melrose’s executive pay is eschewed to a long-term incentive scheme, low basic and high performance related variable element, which is fully aligned with shareholders. In 2020 Melrose’s CEO’s pay was 16x the median level of UK employees against an 84x average for the UK FTSE 100 CEOs and in the lowest decile of FTSE 100 CEOs (source: High Pay Centre). The remuneration report received 99.6% of votes in favour.

Tax strategy. The company maintains a straightforward tax structure, often unwinding the complexities of previous owners. This generally assists in any disposal. The current underlying corporate tax rate is 22%.


Valuation

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:

Sales decline of 15% since acquisition adjusted for disposals and currency movements. This is in line with management’s ‘partial recovery’ guidance but potentially conservative for the automotive division.

Cash generation at zero going forward (we forecast net debt of £1.1bn at December 2021), as this is expected to fund dividends and the continued investment and restructuring.

An exit date of 2024, being an average of the expected disposal of the constituent parts as shown in Exhibit 37.

Exhibit 37: Anticipated disposal timeframe

Business

Date of disposal

Powder metallurgy

2023

Automotive

2024

Aerospace

2025

GKN (average)

2024

Business

Powder metallurgy

Automotive

Aerospace

GKN (average)

Date of disposal

2023

2024

2025

2024

Source: Edison Investment Research

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).

Exhibit 38: Valuation per share (p)

Operating margin

8.5%

9.5%

10.5%

11.5%

12.5%

Margin improvement (bp)

200

300

400

500

600

Rating enhancement
(bp to EV/EBITDA)

0

162

175

189

202

215

50

173

187

201

215

229

100

184

199

214

229

243

150

195

211

226

242

258

200

206

223

239

255

272

250

217

234

252

269

286

Source: Edison Investment Research

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%.

Exhibit 39: Implied valuation metric at 226p a share

2019

2020

2021e

2022e

2023e

EV/EBITDA (x)

7.1

14.1

14.2

11.3

9.3

EV/EBIT (x)

9.8

31.9

31.5

19.7

14.2

P/E (x)

15.6

93.1

71.8

31.1

20.2

Source: Edison Investment Research, Refinitiv


Financials

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

Automotive benefited from a strong start to the year but is being affected by the well documented supply chain issues, particularly a shortage of chips. Softer volumes, with the market now expected to be similar to 2020, are being compounded by significant scheduling changes from the OEMs affecting GKN’s operations. The restructuring improvements made are expected to enable margins to reach around twice the level reported in 2020. Further restructuring benefits are expected in 2022 although the timing of supply chain resolution and hence volume recovery is unclear at present.

Aerospace markets continue to recover with sales up 16% in Q3 leading to an improving performance, which is accelerating through the second half as restructuring benefits accrue. While this is encouraging and defence remains strong, there is still some way to go before the impact of the pandemic, which saw organic sales down 27% in 2020, is fully reversed.

The balance sheet remains conservative after the return of cash to shareholders. Net debt (ex finance leases) is expected to be c £1.1bn at the year end, which, with lower profitability, still leaves a robust net debt/EBITDA of 1.5x. Edison’s expectation is for net debt to increase in 2022 due to the cash cost of restructuring and investment in capital required to drive the targeted operational improvements, although lending ratios will remain unchanged as operating profit recovers.

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.

Exhibit 40: Profit & loss

Year to December (£m)

2019

2020

2021e

2022e

2023e

Aerospace

3852

2804

2560.2

2747.7

3022.5

Automotive

4739

3797

3611.2

3984.4

4382.8

Powder Metallurgy

1115

905

938.2

988.1

1057.3

Other Industrial

708

628

225.0

234.7

244.1

Nortek

1178

1227

Group turnover

11592

9361

7334.6

7954.9

8706.7

Operating margin

Aerospace

10.6%

0.5%

4.0%

6.5%

8.0%

Automotive

7.7%

2.2%

4.2%

6.5%

8.5%

Powder Metallurgy

10.5%

4.3%

9.5%

11.0%

13.5%

Other Industrial

12.1%

10.0%

25.0%

25.0%

25.0%

Group operating margin

9.5%

3.6%

4.7%

6.9%

8.8%

Operating profit

Aerospace

409.0

14.0

102.4

178.6

241.8

Automotive

367.0

82.0

151.7

259.0

372.5

Powder Metallurgy

117.0

39.0

89.1

108.7

142.7

Other Industrial

86.0

63.0

56.3

58.7

61.0

Nortek

175.0

188.0

Central costs

(52.0)

(46.0)

(55.0)

(55.0)

(55.0)

Group operating profit

1102.0

340.0

344.5

550.0

763.1

Goodwill amortisation

(534.0)

(526.0)

(450.0)

(450.0)

(450.0)

Release of fair value items

153.0

118.0

Exchange adjustments

55.0

182.0

Reorganisation costs

(238.0)

(220.0)

(250.0)

(250.0)

(200.0)

Write downs

(179.0)

(184.0)

Other

(41.0)

(48.0)

EBIT (reported)

318.0

(338.0)

(355.5)

(150.0)

113.1

Financing charges

(213.0)

(187.0)

(155.0)

(145.0)

(135.0)

Exceptional financing charges

1.0

(10.0)

PBT reported

106.0

(535.0)

(510.5)

(295.0)

(21.9)

PBT before exceptionals

889.0

153.0

189.5

405.0

628.1

Exceptional tax

139

46

42

89

144

Adjusted tax

(190)

(34)

(42)

(89)

(144)

Tax rate reported

48%

2%

Tax rate underlying

21%

22%

22%

22%

23%

Reported profit after tax

55.0

(523.0)

(510.5)

(295.0)

(21.9)

Adjusted profit after tax

698.8

119.3

147.8

315.9

483.6

Minority interest

-9.0

-3.0

-2.0

-2.0

-2.0

Reported retained earnings

46.0

-526.0

-512.5

-297.0

-23.9

Source: Melrose accounts, Edison Investment Research

Exhibit 41: Financial summary

Year to 31 December (£m)

2019

2020

2021e

2022e

2023e

IFRS

IFRS

IFRS

IFRS

IFRS

INCOME STATEMENT

Revenue

11,592.0

9,361.0

7,334.6

7,954.9

8,706.7

Cost of Sales

(8,732.0)

(7,492.0)

(7,334.6)

(7,954.9)

(8,706.7)

Gross Profit

2,860.0

1,869.0

0.0

0.0

0.0

EBITDA

1,534.0

770.0

764.5

960.0

1,163.1

Normalised operating profit

1,102.0

340.0

344.5

550.0

763.1

Amortisation of acquired intangibles

(534.0)

(526.0)

(450.0)

(450.0)

(450.0)

Exceptionals

(250.0)

(152.0)

(250.0)

(250.0)

(200.0)

Reported operating profit

318.0

(338.0)

(355.5)

(150.0)

113.1

Net Interest

(213.0)

(187.0)

(155.0)

(145.0)

(135.0)

Profit Before Tax (norm)

889.0

153.0

189.5

405.0

628.1

Profit Before Tax (reported)

105.0

(525.0)

(510.5)

(295.0)

(21.9)

Reported tax

(51.0)

12.0

0.0

0.0

0.0

Profit After Tax (norm)

698.8

119.3

147.8

315.9

483.6

Profit After Tax (reported)

54.0

(513.0)

(510.5)

(295.0)

(21.9)

Minority interests

(9.0)

(3.0)

(2.0)

(2.0)

(2.0)

Discontinued operations

(106.0)

(10.0)

0.0

0.0

0.0

Net income (normalised)

689.8

116.3

145.8

313.9

481.6

Net income (reported)

(61.0)

(526.0)

(512.5)

(297.0)

(23.9)

Basic average shares outstanding (m)

4,858

4,858

4,695

4,372

4,372

EPS - basic normalised (p)

14.20

2.39

3.10

7.18

11.02

EPS - diluted normalised (p)

14.20

2.39

3.10

7.18

11.02

EPS - basic reported (p)

(1.24)

(11.03)

(10.92)

(6.79)

(0.55)

Dividend (p)

1.70

0.75

1.50

2.50

3.00

Revenue growth (%)

(1.2)

(20.0)

0.0

8.1

9.5

EBITDA Margin (%)

13.2

8.2

10.4

12.1

13.4

Normalised Operating Margin

9.5

3.6

4.7

6.9

8.8

BALANCE SHEET

Fixed Assets

14,322.0

13,515.0

11,489.0

11,179.0

10,679.0

Intangible Assets

9,822.0

9,299.0

7,649.0

7,199.0

6,749.0

Tangible Assets

3,432.0

3,133.0

2,700.0

2,840.0

2,790.0

Investments & other

1,068.0

1,083.0

1,140.0

1,140.0

1,140.0

Current Assets

3,918.0

3,165.0

3,205.0

3,298.0

3,410.6

Stocks

1,332.0

1,126.0

972.0

1,011.5

1,059.3

Debtors

1,970.0

1,658.0

1,317.0

1,370.5

1,435.3

Cash & cash equivalents

512.0

311.0

871.0

871.0

871.0

Other

104.0

70.0

45.0

45.0

45.0

Current Liabilities

3,486.0

3,363.0

2,763.0

2,897.0

2,981.0

Creditors

2,461.0

2,456.0

2,115.0

2,201.0

2,305.0

Tax and social security

106.0

188.0

146.0

146.0

146.0

Short term borrowings

284.0

165.0

44.0

100.0

100.0

Other

635.0

554.0

458.0

450.0

430.0

Long Term Liabilities

7,203.0

6,207.0

4,719.1

4,745.2

4,414.2

Long term borrowings

3,464.0

2,926.0

1,972.1

2,897.0

2,981.0

Other long term liabilities

3,739.0

3,281.0

2,747.0

1,848.2

1,433.2

Net Assets

7,551.0

7,110.0

7,211.9

6,834.9

6,694.5

Minority interests

26.0

29.0

20.0

20.0

20.0

Shareholders' equity

7,525.0

7,081.0

7,191.9

6,814.9

6,674.5

CASH FLOW

Op Cash Flow before WC and tax

1,534.0

770.0

764.5

960.0

1,163.1

Working capital

58.0

424.0

(50.0)

(62.0)

(75.2)

Exceptional & other

(519.0)

(265.0)

(260.0)

(260.0)

(250.0)

Tax

(117.0)

(70.0)

(41.7)

(89.1)

(144.5)

Net operating cash flow

956.0

859.0

412.8

548.8

693.5

Capex

(495.0)

(292.0)

(347.0)

(500.0)

(300.0)

Acquisitions/disposals

119.0

(11.0)

2,619.0

0.0

0.0

Net interest

(120.0)

(111.0)

(91.0)

(81.0)

(71.0)

Equity financing

0.0

0.0

(763.0)

0.0

0.0

Dividends

(237.0)

0.0

(46.8)

(80.0)

(116.5)

Net Cash Flow

223.0

445.0

1,783.9

(112.2)

205.9

Opening net debt/(cash)

(3,482.0)

(3,283.0)

(2,929.0)

(1,145.1)

(1,257.2)

FX

90.0

9.0

0.0

0.0

0.0

Other non-cash movements

(114.0)

(100.0)

0.0

0.0

0.0

Closing net debt/(cash)

(3,283.0)

(2,929.0)

(1,145.1)

(1,257.2)

(1,051.3)

Source: Melrose accounts, Edison Investment Research

Appendix 1: Return of capital to shareholders

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:

The issues of capital shares. The company issues special class unlisted B shares (for Nortek 1 B share for every 10 Melrose shares), which the company then buys back at face value (15p for the Nortek return). While this appears like a dividend, the mechanism ensures that it is a return of monies.

The issue of new Melrose shares. The issue of the capital B shares separates value from the Melrose shares (for Nortek 15p a share), which would usually be reflected in the share price (for Melrose 150p less 15p = 135p). To avoid this Melrose consolidates the shares through the issue of new shares in the same proportions as the capital shares were issued (for Nortek 9 new shares for every 10 old shares). Share price consistency is maintained as is, most importantly, the percentage of the company that each share owns.

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.

Exhibit 42: Nortek return example

Before

After

Number of shares

100

90

Price per ordinary share £p)

1.50

1.50

Value (£) of shareholding

150

135

Number of B shares

100

Cash purchase of B share (£)

0.15

Value (£) of B shareholding

15

Total value (£)

150

135+15 = 150

Number of shares in issue

4,858

4,372

N/A

Source: Edison Investment Research


Appendix 2: Management incentive scheme

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:

Adjustments. Annual cost of 5% has been applied to the initial May 2020 price (147p) to arrive at the 170p price used in the formula. Further adjustments are made in relation to returns or raising of capital

Cap to the scheme. There is a cap on an individual member’s maximum annual benefit. This is set at 20m for the CEO’s 16% holding in the scheme. In addition, there is a maximum annual award of 6.7m shares along with a roll-over mechanism (ie if the maximum value is achieved the pay-out will be over three years). This effectively means a cap to the total pay-out at a share price of c 275p.

Aerospace adjustment. The aerospace business has been heavily affected by the pandemic and the scale and timing of recovery are clearly uncertain at present. To protect shareholders there is an adjustment factor in place in case the business recovers more quickly than expected. The adjustment increases the base level of capital by half the additional post tax profit in 2022 on a P/E of 15x. The additional post tax profit equates to the 2022 sales less 85% of 2019 sales multiplied by a profit margin of 12%. As an illustration, an additional £100m of sales above the threshold in theory increases the value to shareholders by £135m or 3p a share and adds £5.3m to the management incentive scheme.

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

Exhibit 43: Management incentive scheme value and dilution

Source: Edison Investment Research

Contact details

Revenue by geography

11th Floor, The Colmore Building
20 Colmore Circus Queensway
Birmingham B4 6AT
UK
0121 296 2800
www.melroseplc.net

Contact details

11th Floor, The Colmore Building
20 Colmore Circus Queensway
Birmingham B4 6AT
UK
0121 296 2800
www.melroseplc.net

Revenue by geography

Management team

Executive Vice Chairman: Christopher Miller

Chief Executive: Simon Peckham

Appointed as executive vice-chairman on 1 January 2019, having previously served as executive chairman from May 2003. Founding member of Melrose. Previously chief executive of Wassall.

Appointed as chief executive on 9 May 2012, having previously served as chief operating officer from May 2003. Founding member of Melrose. Previously executive director at Wassall.

Chief Operating Officer: Peter Dilnot

Group finance director: Geoff Martin

Appointed as an executive director on 1 January 2021, having served as chief operating officer since April 2019. Previously chief executive of Renewi.

Appointed as group finance director on 7 July 2005. Previously finance director at Royal Doulton.

Management team

Executive Vice Chairman: Christopher Miller

Appointed as executive vice-chairman on 1 January 2019, having previously served as executive chairman from May 2003. Founding member of Melrose. Previously chief executive of Wassall.

Chief Executive: Simon Peckham

Appointed as chief executive on 9 May 2012, having previously served as chief operating officer from May 2003. Founding member of Melrose. Previously executive director at Wassall.

Chief Operating Officer: Peter Dilnot

Appointed as an executive director on 1 January 2021, having served as chief operating officer since April 2019. Previously chief executive of Renewi.

Group finance director: Geoff Martin

Appointed as group finance director on 7 July 2005. Previously finance director at Royal Doulton.

Principal shareholders

(%)

Capital Group

12.8%

Bllackrock

7.7%

Select Equity

6.8%

Vanguard

3.8%

Aviva

3.3%

Invesco

3.3%

Ameriprise

3.2%


General disclaimer and copyright

This report has been commissioned by Melrose Industries and prepared and issued by Edison, in consideration of a fee payable by Melrose Industries. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2021 Edison Investment Research Limited (Edison).

Australia

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New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

General disclaimer and copyright

This report has been commissioned by Melrose Industries and prepared and issued by Edison, in consideration of a fee payable by Melrose Industries. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2021 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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