Melrose Industries — Increasing trajectory

Melrose Industries (LSE: MRO)

Last close As at 23/05/2024

GBP6.70

74.80 (12.57%)

Market capitalisation

GBP8,167m

More on this equity

Research: Industrials

Melrose Industries — Increasing trajectory

The aerospace cycle is in strong recovery mode and Melrose Industries, assisted by the restructuring actions, is taking full advantage at both the top line and profit level. Internal momentum and market recovery provide confidence that management’s target returns set out for FY25 will be achieved, offering a further positive valuation catalyst.

David Larkam

Written by

David Larkam

Analyst, Industrials

Industrials

Melrose Industries

Increasing trajectory

Trading update

Aerospace and defence

17 November 2023

Price

522p

Market cap

£7bn

Net debt (£m) at 30 June 2023

553

Shares in issue

1,339m

Free float

98.7

Code

MRO

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

9.2

0.5

93.1

Rel (local)

11.2

0.1

93.0

52-week high/low

543p

260p

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

FY23 results

March 2024

Analyst

David Larkam

+44 (0)20 3077 5700

Melrose Industries is a research client of Edison Investment Research Limited

The aerospace cycle is in strong recovery mode and Melrose Industries, assisted by the restructuring actions, is taking full advantage at both the top line and profit level. Internal momentum and market recovery provide confidence that management’s target returns set out for FY25 will be achieved, offering a further positive valuation catalyst.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/22

2,957

62

4.1

2.3

127

0.4

12/23e

3,372

317

18.6

4.2

28.1

0.8

12/24e

3,657

441

27.0

6.3

19.3

1.2

12/25e

4,150

589

37.2

9.3

14.0

1.8

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Trading update: Positive momentum continues

The group continues to benefit from the strong recovery in the aerospace sector, both original equipment and aftermarket. In the four-month period to the end of October, Engines revenue increased by 18%, with the operating margin ‘comfortably in excess of’ 25% (H123: 24.5%), assisted in particular by the strong aftermarket, which was up 24%. Structures revenue increased by 17%, with the operating margin above 4% (H123: 2.5%). The strong margin improvement came from business improvement projects, including the restructuring benefits from global plant consolidation, repricing contracts and exiting of inherently unprofitable business.

Forecast changes: Further upgrades

Management has increased its guidance for FY23 and provided initial guidance for FY24. These are factored into our new forecasts. We have increased FY23 PBT by 10.2%, from £288m to £317m, and EPS from 16.8p to 18.6p. We have increased FY24 PBT by 16.1%, from £415m to £441m and EPS from 24.9p to 27.0p. Note that we have not changed our FY25 forecasts, which reflect management’s initial margin targets set in May. Depending on divisional revenues, these targets suggest an overall operating margin of c 16.8% in FY25. Margins of c 12% in FY23 and c 15% in FY24 suggest a positive trajectory to achieving these targets which, despite the better-than-expected trading, remain unchanged.

Valuation: Upgrade by 2.3%

We have adjusted our valuation for the improved trading to 643p/share, up from 628p. We use a combination of peer valuations and cash net present value (NPV) for the Risk and Revenue Sharing Partnerships (RRSPs) activities. In addition, we estimate potential upside from the share buyback of c 5p/share and dilution from crystallisation of the management incentive scheme due in May 2024 at a maximum of 20p/share.

Trading update

The group continues to benefit from the strong recovery being seen in the aerospace sector, both in terms of new build rates supporting the original equipment business and in the important aftermarket as flying hours recover, boosting the RRSPs business within the Engines division. Management has increased guidance for FY23 and provided initial guidance for FY24.

Trading in the four-month period July to October

Engines revenue growth of 18% (H123: 19%) with operating margins ‘comfortably in excess of’ 25% (H123: 24.5%). The business continues to benefit from the strong aftermarket, up 24%, which also assists the margin mix, while overcoming some of the supply-side constraints currently being seen in the industry. Structures revenue growth was 17% (H123: 13%) with operating margins above 4% (H123: 2.5%). Along with market recovery, business improvement projects, including the restructuring benefits from global plant consolidation, repricing contracts and exiting inherently unprofitable business, are assisting positive margin recovery.

FY23 management guidance

Management guidance for Aerospace revenue is £3.3–3.4bn and for Aerospace adjusted operating profit (pre-central costs) is between £400–410m with a margin of over 12% (Engines 25% and Structures 4% or more). The guidance for Aerospace adjusted EBITDA is £545–555m. Leverage at the year-end is expected to see net debt/EBITDA of 1.3x.

FY24 initial management guidance

Management guidance for Aerospace revenue is £3.5–3.7bn and Aerospace adjusted operating profit is £520–540m with adjusted operating margin c 15%. Guidance for Aerospace adjusted EBITDA is £680–700m. Leverage post the buy-back (£500m currently underway) and GTF cash requirements (see our update note for details) are to be below net debt/EBITDA of 2x.

Our key takeaways

End-markets remain strong. Aerospace end-markets continue to recover strongly, with order books for civil at record levels and production schedules expected to continue to recover, albeit only returning to pre-pandemic levels in 2025.

Exhibit 1: Civil airliner delivery expectations Boeing and Airbus (number of aircraft)

Source: Boeing, Airbus

FY25 management guidance is starting to look conservative. Management has previously set margin targets for the Engines (28%) and Structures (9%) divisions. Depending on growth rates, we estimate that this equates to an overall margin of c 16.8%. The operating margin was 6.3% in 2022. Management is guiding to 12% in FY23 and 15% in FY24, suggesting a pathway at the very least in line with these FY25 targets.

Management has provided no further guidance for the recent GE Aerospace contract. At the original equipment level, revenue is only likely to come through in FY25/26; the additional RRSP revenue will be later but will obviously be positive for Melrose’s cash flows and valuation.

Forecast changes

Exhibit 2 highlights the changes we have made following management’s new guidance.

Exhibit 2: Changes to forecasts

£m

2023e

2024e

Old

New

Change

Old

New

Change

Revenues

3,410

3,372

(1.1%)

3,605

3,657

1.4%

EBITDA

505

544

7.8%

638

688

7.7%

EBITDA margin

14.8%

16.1%

1.3%

17.7%

18.8%

6.2%

Aerospace operating profit

380

409

7.7%

501

543

8.3%

Aerospace operating margin

11.1%

12.1%

1.0%

13.9%

14.8%

0.9%

Normalised operating profit

350

379

8.4%

476

518

8.7%

Normalised operating profit margin

10.3%

11.2%

1.0%

13.2%

14.2%

0.9%

Normalised PBT

288

317

10.2%

415

441

6.1%

Normalised basic EPS (p)

16.8

18.6

10.4%

24.9

27.0

8.3%

Dividend per share (p)

4.2

4.2

0.0%

6.3

6.3

0.0%

Net debt/(cash)

720

687

4.5%

1,023

1,139

(11.3%)

Source: Edison Investment Research

Exhibit 3 highlights the changes made to our forecasts since the demerger of Dowlais automotive group.

Exhibit 3: Changes to Edison EPS forecasts since demerger (p/share)

Source: Edison Investment Research

Valuation

Our valuation methodology is unchanged from our re-initiation note, post the demerger. We split the valuation into two parts: the RRSPs and the main Aerospace manufacturing operations in Structures and Engines.

Engine RRSPs

Exhibit 4 provides a summary of our discounted cash flow or NPV of the RRSPs cash flows relative to discount rates. Our 7.6% WACC is consistent with leverage of 2.0x EBITDA (we note that the FY23 forecast is 1.3x but will rise through the share buyback programme).

Exhibit 4: RRSP valuation

 

Cost of debt

WACC

Melrose cost of equity

Discount rate (%)

5.5

7.6

9.2

NPV (£bn)

7.2

5.3

4.2

Source: Edison Investment Research

Exhibit 5 provides a valuation for the group’s non-RRSP activities using a quoted peer group of aerospace component suppliers.

Exhibit 5: Aerospace ex-RRSPs valuation

 

Currency

Share price

Market cap

EV/EBIT (x)

EV/EBITDA (x)

 

Local

£m

2023

2024

2025

2023

2024

2025

FACC

EUR

6.3

246

27.1

15.3

11.3

8.7

6.9

5.9

Magellan

CAD

7.4

248

7.7

5.3

5.3

5.8

4.4

3.5

MTU

EUR

213

9,815

15.2

13.8

12.1

10.9

10.0

9.0

Safran

EUR

146

52,280

20.2

16.0

13.2

14.5

12.1

10.4

Senior

GBp

175.6

740

19.4

14.6

11.2

9.1

7.8

6.7

Spirit

USD

21.0

1,760

-29.5

11.7

6.7

18.3

6.3

4.8

Triumph

USD

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)

253

270

463

403

430

633

Melrose ex-RRSPs valuation (£m)

3,844

3,329

4,534

4,421

3,407

4,297

Source: Refinitiv, Edison Investment Research. Note: Prices as at 16 November.

Combining these two valuations provides an overall valuation for the group. Note that the valuation does not take into account of the management incentive plan, which matures in May 2024. We estimate that full payout would reduce the valuation by c 20p share. There is further potential upside from the buyback, which we estimate at 5p a share. Our new valuation of 643p increases by 2.3% and is now 5.7% higher than our re-initiation note in May.

Exhibit 6: Overall valuation, £m

Old

New

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

3,740

3,960

RRSPs DCF valuation

5,300

5,300

Melrose net debt on demerger/year end

(553)

(687)

Melrose equity valuation

8,487

8,573

Number of shares in issue (m)

1,351

1,335

Value per Melrose share (p)

628

642

Source: Edison Investment Research

Exhibit 7: Financial summary

£m

2022

2023e

2024e

2025e

Year to December

IFRS

IFRS

IFRS

IFRS

INCOME STATEMENT

Revenue

 

2,957

3,372

3,657

4,150

EBITDA

 

292

544

688

848

Operating profit (before amort. and excepts.)

147

379

518

673

Amortisation of acquired intangibles

(260)

(300)

(300)

(300)

Exceptionals

(157)

(200)

(50)

(10)

Reported operating profit

(270)

(121)

168

363

Net Interest

(85)

(62)

(77)

(84)

Profit Before Tax (norm)

 

62

317

441

589

Profit Before Tax (reported)

 

(355)

(183)

91

279

Reported tax

99

0

0

0

Profit After Tax (norm)

48

251

348

466

Profit After Tax (reported)

(256)

(183)

91

279

Minority interests

(5)

0

0

0

Discontinued operations

(80)

0

0

0

Net income (normalised)

43

251

348

466

Net income (reported)

(341)

(183)

91

279

Average Number of Shares Outstanding (m)

1,406

1,348

1,290

1,250

EPS - normalised (p)

 

4.1

18.6

27.0

37.2

EPS - normalised fully diluted (p)

 

4.1

17.9

25.9

35.7

EPS - basic reported (p)

 

(18.6)

(13.6)

7.0

22.3

Dividend (p)

2.33

4.20

6.30

9.31

Revenue growth (%)

8.5

17.5

12.9

13.2

EBITDA Margin (%)

9.9

16.1

18.8

20.4

Aerospace Operating Margin (%)

6.3

12.1

14.8

16.8

Normalised Operating Margin (%)

5.0

11.2

14.2

16.2

BALANCE SHEET

Fixed Assets

 

11,114

5,381

5,124

4,867

Intangible Assets

6,882

3,498

3,198

2,898

Tangible Assets

2,599

811

854

897

Investments & other

1,633

1,072

1,072

1,072

Current Assets

 

2,873

1,538

1,630

1,731

Stocks

1,025

573

610

650

Debtors

1,426

857

912

972

Cash & cash equivalents

355

85

85

85

Other

67

23

23

23

Current Liabilities

 

2,978

1,576

1,638

1,706

Creditors

2,347

1,260

1,342

1,430

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

1,638

1,321

817

Long term borrowings

1,433

709

1,161

1,073

Other long term liabilities

2,408

929

160

(256)

Net Assets

 

7,168

3,704

3,795

4,074

Minority interests

39

0

0

0

Shareholders' equity

 

7,129

3,704

3,795

4,074

CASH FLOW

Operating Cash Flow

292

544

688

848

Working capital

(148)

(74)

(109)

(99)

Exceptional & other

(83)

(180)

(210)

(150)

Tax

(8)

(73)

(95)

(124)

Net operating cash flow

 

53

217

267

476

Capex

(31)

(190)

(213)

(219)

Acquisitions/disposals

(7)

0

0

0

Net interest

(82)

(72)

(75)

(78)

Equity financing

0

(125)

(375)

0

Dividends

(77)

(20)

(63)

(91)

Other

Net Cash Flow

(144)

(190)

(452)

87

Opening net debt/(cash)

 

343

487

687

1,139

Closing net debt/(cash)

 

487

687

1,139

1,051

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).

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.

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

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).

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.

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

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