Melrose Industries — Building returns

Melrose Industries (LSE: MRO)

Last close As at 17/05/2024

GBP6.70

74.80 (12.57%)

Market capitalisation

GBP8,167m

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Research: Industrials

Melrose Industries — Building returns

The improving aerospace market, original equipment and aftermarket, combined with internal restructuring, are driving strong profit recovery. This is offering the potential for significant returns to Melrose shareholders as seen with the additional share buy-back announced.

David Larkam

Written by

David Larkam

Analyst, Industrials

Industrials

Melrose Industries

Building returns

Interim results

Aerospace and defence

8 September 2023

Price

540p

Market cap

£7.3bn

Net debt (£m) at 30 June 2023

553

Shares in issue (m)

1,351

Free float

98.7

Code

MRO

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(1.1)

3.4

86.0

Rel (local)

0.6

6.2

82.5

52-week high/low

543.2p

200.5p

Business description

Melrose Industries is a focused aerospace group with activities in engine components and structures, operating in both metallic and composite materials. The group has significant risk reward sharing partnership investments on multiple engine programmes.

Next events

Capital markets day

October 2023

Analyst

David Larkam

+44 (0)20 3077 5700

Melrose Industries is a research client of Edison Investment Research Limited

The improving aerospace market, original equipment and aftermarket, combined with internal restructuring, are driving strong profit recovery. This is offering the potential for significant returns to Melrose shareholders as seen with the additional share buy-back announced.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/22

2,957

62

4.1

2.3

131.7

0.4

12/23e

3,410

288

16.8

4.2

32.1

0.8

12/24e

3,605

415

24.9

6.3

21.7

1.2

12/25e

4,068

616

37.5

9.4

14.4

1.7

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments. FY22 restated post the Dowlais demerger.

Results overview and forecast upgrade

Underlying sales grew 19% in H123, driven by strong recovery in Civil aerospace. A combination of operational gearing and mix, with more higher-margin aftermarket and increasing benefits from the restructuring programmes, drove strong Aerospace operating margins, up from 4.9% to 10.7%. The Engines division was the main driver, assisted by 46% growth in the higher-margin aftermarket business, with Structures posting strong top-line growth but margin upside still waiting for the benefits of the restructuring and contact repricing. PBT increased from £9m in H122 to £134m and EPS increased from 0.2p to 7.5p. The strong H1 has led management to upgrade Aerospace operating profit guidance by c 8% and, while there are no changes to medium-term 2025 expectations, due to the strength of the Engines division management has upgraded this division’s post 2025 margin expectations to over 30%. Our revised FY23 forecasts are EBIT of £350m (from £320m), PBT of £288m (from £264m) and EPS of 16.8p (from 15.4p).

Share buy-back

Melrose announced a £500m share buy-back programme to commence in October and to run over a 12-month period. We expect this to lead net debt to peak at c £1bn in 2024, yet, with the anticipated profit recovery, for net debt/EBITDA to be c 1.7x, comfortably below management’s stated policy threshold of 2.5x.

Management succession

Simon Peckham (CEO) and Geoffrey Martin (CFO) will step down on 7 March 2024 reflecting the change in strategy from a ‘buy, improve, sell’ industrial restructuring approach to a focused aerospace group. They will be replaced by internal appointments: Peter Dilnot, currently COO, will become CEO and Matthew Gregory, currently CFO GKN Aerospace, will become group CFO.

Valuation: 3% upgrade

Adjusting for the improved trading and higher debt at the half year leads to a valuation of 628p/share, up from 608p. This is before any impact from the buy-back (c 10p/share upside, assuming the buy-back is at current price) or crystallisation of the management incentive scheme due in May 2024 (maximum c 20p a share).

Interim results

Overall

Exhibit 1: Underlying results

H122

H222

H123

Sales (£m)

1,364

1,591

1,633

Aerospace operating margin

4.9%

7.5%

10.7%

Group operating margin

3.3%

6.4%

9.7%

Operating profit (£m)

45

102

159

Profit before tax (£m)

9

53

134

EPS diluted (p)

0.2

3.9

7.5

Source: Melrose

Sales growth for the period was 19% (15% including business being exited) driven by strong recovery in the Civil aerospace new build and aftermarket. A combination of operational gearing, mix, with more higher-margin aftermarket, and increasing benefits from the restructuring programmes drove strong margin recovery. This operational performance was levered further over the central costs and financing leading to strong EPS growth on both H122 and sequentially on H222.

The £134m underlying PBT translated to statutory loss of £62m. The key elements of the difference were £131m amortisation of intangibles, £49m of restructuring charges and £26m of equity settled compensation. There was also a loss recorded from the discontinued operations of £1.020bn reflecting the demerger of Dowlais completed in the period.

Engines division

Exhibit 2: Divisional underlying results – Engines division

H122

H222

H123

Sales (£m)

484

551

608

Underlying operating profit (£m)

77

85

149

Underlying margin

15.9%

15.4%

24.5%

Source: Melrose

In the Engines division, revenues increased 19%, with the aftermarket particularly strong, up 46% as both new build rates and flying hours continued to recover (flying hours are currently c 94% of pre COVID-19 levels). Operational drop through and mix with greater aftermarket assisted the margin expansion from 15.9% to 24.5%. Investment remains positive including £40m additive manufacturing facility investment in Sweden. The only negative came from the Pratt & Whitney PW1100G engine; Pratt & Whitney announced issues with particular components, requiring inspection and replacement. Melrose does not manufacture these components but, as a partner in the programmes (4% stake), is exposed to any associated costs and liabilities.

The outlook remains positive, particularly the investments in individual engine programmes (risk reward sharing partnerships) with the aftermarket expected to account for 85% of profits from 2025. In the shorter term, management expects slower growth in H223, reflecting the exceptional performance in H123, but for the margin to continue to strengthen.

Structures division

Exhibit 3: Divisional underlying results – Structures division

H122

H222

H123

Sales (£m)

880

1,039

1,025

Underlying operating profit (£m)

(10)

34

26

Underlying margin

-1.1%

3.3%

2.3%

Source: Melrose

In the Structures division, revenues increased 18% (13% including business being exited) driven by Civil up 24%, with Defence up 6%. Operating profit improved from a loss in H122 to an operating margin of 2.3%. This has been driven by operational drop through, the benefits of the repricing certain Defence business (25% of business to be repriced has been completed) and benefits from the restructuring programme. The restructuring programme is expected to be largely completed in 2023 with two further plants to be closed, which will have significant benefits in 2024 on the road to the 9% target margin for 2025.

Investment continues to develop the business in the medium term, including the investment in China through a JV with COMAC and further investment in new technologies, including electric aircraft sub-systems and expansion of the hydrogen propulsion development with a multi partner £40m HyFIVE programme, on top of the H2GEAR programme already being undertaken.

Cash generation and financial position

Exhibit 4: Summary cash flow

£m

Operating profit

159

Depreciation & amortisation

71

EBITDA

230

Net change in working capital

(169)

Restructuring

(53)

Other

(21)

Operating cashflow

(13)

Net interest including leases

(50)

Tax

(15)

Capex

(40)

Net cash flow

(118)

Operating profit

Depreciation & amortisation

EBITDA

Net change in working capital

Restructuring

Other

Operating cashflow

Net interest including leases

Tax

Capex

Net cash flow

£m

159

71

230

(169)

(53)

(21)

(13)

(50)

(15)

(40)

(118)

Source: Melrose

Improving profitability has assisted cash generation although significant increases in working capital to support growth and cash spend from restructuring have held back net cash performance. Net debt increased to £553m at 30 June 2023, with leverage (net debt/EBITDA) of 1.5x. As part of the progressive dividend policy, management announced an interim dividend of 1.5p a share.

Outlook and guidance upgrade

The aerospace market is recovering strongly. This recovery, combined with the operational improvements, has led management to upgrade expectations for 2023 for the third time in the year, as well as increasing its medium-term margin expectations for the Engines business. The key elements are:

Full year 2023: management has increased Aerospace adjusted operating profit guidance from £350m to £375–385m, with improvements in both divisions but a greater contribution from Engines, reflecting the strong H1. There was no change to sales guidance for the year. Leverage is set to improve, reducing towards net debt/EBITDA of 1x for the year (before the buy-back was announced).

Beyond 2025: management expects the Engines division margins to increase above 30% post 2025. There was no further change to guidance for Structures (9% in 2025).

Share buy-back programme

The company has announced a £500m share buy-back programme to be commenced in October and to run over a 12-month period. This forms part of management’s plans to return value to shareholders along with the progressive dividend, yet it will still leave the group comfortably below the net debt/EBITDA 2.5x management threshold (Edison expects c 1.7x).

Forecast changes

The following changes to our estimates incorporate the improved operating performance and management guidance, along with the associated buy-back announced.

Exhibit 5: Summary forecast changes

£m

2023e

2024e

2025e

Old

New

Change

Old

New

Change

Old

New

Change

Revenues

3,400

3,410

0.3%

3,584

3,605

0.6%

4,034

4,068

0.9%

Normalised operating profit

320

350

9.3%

448

476

6.2%

673

672

-0.1%

Normalised operating profit margin

9.4%

10.3%

0.8%

12.5%

13.2%

0.7%

16.7%

16.5%

-0.2%

Normalised PBT

264

288

9.0%

388

415

7.1%

616

616

-0.1%

Normalised basic EPS (p)

15.4

16.8

9.2%

22.7

24.9

9.9%

36.0

37.5

4.1%

Dividend per share (p)

3.9

4.2

8.9%

5.7

6.3

11.1%

9.0

9.4

4.1%

Net cash/(debt)

(529)

(720)

36.0%

(499)

(1,023)

105.1%

(258)

(787)

205.2%

Source: Edison Investment Research

Management changes

Simon Peckham (CEO) and Geoffrey Martin (CFO) will step down on 7 March 2024, reflecting the change in strategy of the group from a ‘buy, improve, sell’ industrial restructuring and value realisation approach to a focused aerospace group. Peter Dilnot, currently COO, will become CEO and Matthew Gregory, currently CFO GKN Aerospace, will become group CFO. Simon Peckham, Geoffrey Martin and Christopher Miller, an original founder, will not stand for re-election as directors at the 2024 AGM.

Valuation

Our valuation methodology remains unchanged (see previous note for additional details). We split the company into Structures and Engine component manufacture and the engine Risk Reward Sharing partnerships (RRSPs), which are longer-term profit and cash-generating investments on engine programmes.

Our valuation for the RRSPs is based on a long-term discounted cash flow (DCF) and remains unchanged at £5.3bn. However, the change to short-term forecasts has led us to upgrade our valuation for the main manufacturing activities based on a peer group valuation.

Exhibit 6: Aerospace ex RRSPs peer valuation

 

Currency

Share price

Market cap

EV/EBIT (x)

EV/EBITDA (x)

 

 

Local

£m

2023

2024

2025

2023

2024

2025

FACC

6.3

246

27.1

15.3

11.3

8.7

6.9

5.9

Magellan

C$

7.4

248

7.7

5.3

5.3

5.8

4.4

3.5

MTU

213

9,815

15.2

13.8

12.1

10.9

10.0

9.0

Safran

146

52,280

20.2

16.0

13.2

14.5

12.1

10.4

Senior

GBp

176

740

19.4

14.6

11.2

9.1

7.8

6.7

Spirit

US$

21.0

1,760

N/A

11.7

6.7

18.3

6.3

4.8

Triumph

US$

9.1

556

11.8

9.7

8.7

9.5

8.0

7.2

Average

15.2

12.3

9.8

11.0

7.9

6.8

Melrose ex RRSPs (EBIT/EBITDA – £m)

225

245

452

375

405

622

Melrose ex RRSPs valuation (£m)

3,415

3,028

4,424

4,110

3,214

4,221

Source: Refinitiv (6/9/2023), Edison Investment Research

Putting these together, and allowing for the increase in net debt seen at the half year, adds 20p to our valuation. This is before taking into account the share buy-back, which, if undertaken at the current share price, would be positive, adding c 10p a share to our valuation, or adjusting for the management incentive scheme due to mature in May 2024, which, at the maximum pay-out, would reduce our valuation by c 20p a share.

Exhibit 7: Overall Melrose valuation

£m

Old

New

Melrose ex RRSPs average of EV/EBIT and EV/EBITDA

3,393 

3740

RRSPs DCF valuation

5,300 

5300

Melrose net cash/(debt) on demerger

(484) 

(553)

Melrose equity valuation

8,209 

8487

Number of shares in issue (m)

1,351 

1351

Value per Melrose share (p)

608 

628

Source: Edison Investment Research


Exhibit 8: Forecast summary

£m

2022

2023e

2024e

2025e

Year to 31 December

IFRS

IFRS

IFRS

IFRS

INCOME STATEMENT

Revenue

2,957

3,410

3,605

4,068

EBITDA

292

505

638

842

Operating profit (before amort. and excepts.)

147

350

476

Amortisation of acquired intangibles

(260)

(300)

(300)

(300)

Exceptionals

(157)

(200)

(50)

(10)

Reported operating profit

(270)

(150)

126

362

Net Interest

(85)

(62)

(61)

(56)

Profit Before Tax (norm)

62

288

415

616

Profit Before Tax (reported)

(355)

(212)

65

306

Reported tax

99

0

0

0

Profit After Tax (norm)

48

227

328

487

Profit After Tax (reported)

(256)

(212)

65

306

Minority interests

(5)

0

0

0

Discontinued operations

(80)

0

0

0

Net income (normalised)

43

227

328

487

Net income (reported)

(341)

(212)

65

306

Average Number of Shares Outstanding (m)

1,406

1,350

1,317

1,297

EPS - normalised (p)

4.1

16.8

24.9

37.5

EPS - normalised fully diluted (p)

4.1

17.2

26.2

36.0

EPS - basic reported (p)

(18.6)

(15.7)

5.0

23.6

Dividend (p)

2.33

4.20

6.30

9.38

Revenue growth (%)

8.5

15.4

10.1

12.5

Gross Margin (%)

14.3

35.0

36.0

37.0

EBITDA Margin (%)

9.9

14.8

17.7

20.7

Normalised Operating Margin

5.0

10.3

13.2

16.5

BALANCE SHEET

Fixed Assets

11,114

5,391

5,123

4,857

Intangible Assets

6,882

3,498

3,198

2,898

Tangible Assets

2,599

821

853

887

Investments & other

1,633

1,072

1,072

1,072

Current Assets

2,873

1,524

1,596

1,689

Stocks

1,025

568

596

634

Debtors

1,426

849

892

947

Cash & cash equivalents

355

85

85

85

Other

67

23

23

23

Current Liabilities

2,978

1,564

1,607

1,670

Creditors

2,347

1,248

1,311

1,394

Tax and social security

141

32

32

32

Short term borrowings

63

63

63

63

Other

427

221

201

181

Long Term Liabilities

3,841

1,676

1,372

831

Long term borrowings

1,433

742

1,045

809

Other long term liabilities

2,408

935

326

21

Net Assets

7,168

3,675

3,740

4,046

Minority interests

39

0

0

0

Shareholders' equity

7,129

3,675

3,740

4,046

CASH FLOW

Operating Cash Flow

292

505

638

842

Working capital

(148)

(79)

(52)

(46)

Exceptional & other

(83)

(170)

(140)

(80)

Tax

(8)

(67)

(87)

(129)

Net operating cash flow

53

189

359

587

Capex

(31)

(190)

(194)

(204)

Acquisitions/disposals

(7)

0

0

0

Net interest

(82)

(62)

(54)

(52)

Equity financing

0

(150)

(350)

0

Dividends

(77)

(20)

(64)

(95)

Other

Net Cash Flow

(144)

(233)

(304)

236

Opening net debt/(cash)

343

487

720

1,023

Closing net debt/(cash)

487

720

1,023

787

Source: Edison Investment Research


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 £60,000 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 2023 Edison Investment Research Limited (Edison).

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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 £60,000 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 2023 Edison Investment Research Limited (Edison).

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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

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London, WC1R 4PS

United Kingdom

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Accsys Technologies — Warning of lower demand

In its trading update for the first four months of FY24, Accsys warned of weaker building materials and construction markets, caused by the higher interest rates and high inflation environment. Distributors are facing significantly lower volumes and high levels of destocking, which is now also felt by Accsys. Assuming market uncertainty continues, Accsys expects FY24 revenue to be below consensus and EBITDA to be significantly below consensus. We contacted the company and according to management it expects to be (just) compliant with debt covenants. On lowered estimates and a raised risk profile, our discounted cash flow (DCF) now points at a value of €0.93 per share (previously €1.25).

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