[See our pre spin comments in the previous writeup on Melrose….this one is a standalone aero writeup]
Summary: Now that Melrose Aerospace has separated from the auto business, we believe investors can focus on underlying earnings potential of the aero asset. We believe that both the multiple and earnings for the aerospace business are too low and that the coming months could see a considerable increase in earnings expectations and corresponding multiple expansion. We see a base case 30-50% IRR over the next 2 years.
Please see prior comments section of old Melrose writeup for our spinoff summary and why the SOTP should be higher than the pre spin structure.
Our thesis is as follows:
1) Melrose trades at a significant discount to peers -> CMD coming up on May 17th should rectify that issue as business is further explained
2) Aerospace EBITDA will significantly outperform expectations in 2023 - 2026
Thesis 1) Melrose trades at a significant discount to peers -> CMD coming up on May 17th should rectify that issue as business is further explained
Peer aero businesses with similar margin structures trade at 10-12x EBITDA – today the aero business is implicitly valued at 6.5x ’24E consensus EBITDA
MTU Aero is the best in class peer with similar margins; trades at 12.2x 2023 EBITDA
Safran (an admittedly higher quality business with slower EBITDA growth) trades at 13.7x 2023 EBITDA
Why doesn’t Melrose’s share price already reflect a fair multiple for the aerospace business?
Most investors don’t believe (as we do) that Melrose will grow EBITDA at a ~25-30% CAGR b/w 2023 and 2026 (see next thesis point)
Melrose’s aerospace business isn’t well understood -> investors don’t fully appreciate how much of the business is related to engines and how much is related to structures
Also, some investors comp Melrose ‘structures’ business to Spirit aero which is not the right comparison
What is Melrose/GKN aerospace?
Today we believe that ~70% of the business is related to engines (primarily related to the Pratt/Whitney GTF) and 30% is related to structures
We will get into the GTF and value of the engines business below in the 2nd thesis point
What is the structures business and why is it different than Spirit and other US peers?
Our diligence suggests that the Melrose aerospace business is far superior to the Spirit business
A) Melrose owns all its IP vs. Spirit owns very little of the IP
B) Because of the IP ownership, Spirit has no pricing power w/ Boeing; our diligence with experts at Boeing and Airbus suggests that Melrose/GKN aerospace has significant pricing power given the IP ownership
C) Spirit is tied to the 737 max which is losing considerable share; Melrose/GKN aerospace is tied to Airbus and the NEO which is gaining considerable share
We believe that the quality of this business relative to Spirit will be explained at the CMD on May 17th
Thesis 2) Aerospace EBITDA will significantly outperform expectations in 2023 – 2026 and CAGR at ~30%
We are dislocated on EBITDA by ~20% per annum including in 2023 relative to the street primarily because of our view on “RRSPs” which are revenue sharing agreements related to engine parts that GKN produces for OEMs (primarily Airbus)
GKN is paid a royalty based on total annual engine program revenue
Melrose has alluded to RRSPs in its investor presentation, but not quantified the impact on the P/L
We have done several VAR calls and other diligence that have helped us triangulate the impact of the RRSPs on the P/L
We believe the ramp on RRSPs is faster, and more profitable than expected by anyone else which will result in significantly higher than expected EBITDA/EBIT growth
Our diligence suggests revenue sharing agreements ramp materially in 2023 and accelerate in 2024 at 90%+ EBITDA margins
Why are the RRSPs so attractive?
First, the RRSPs will most likely come in at very high margins, much higher than similar agreements that peers like MTU have
The engine parts that Melrose/GKN makes has no forward looking work once it is delivered (i.e. no maintenance requirements); margins should be 90%+ (this is a key insight)
This also means that Melrose can recognize the PV of future cash flows sooner than expected given they have no obligations to their customers once the part is delivered
Investors are underestimating the benefit from these RRSPs –one sellsiders says “we don’t even want to take them into our valuation”
Second the GTF ramp is not being properly considered by the sellside
The GTF is an engine that Pratt/Whitney makes and that GKN is a supplier into
The ramp for the GTF is extraordinary given its ties to the NEO and how quickly the NEO is growing/taking share from Boeing
Using a relatively simple ramp for future GTF engines and announcements provides significant evidence that the RSPs are much higher than expected by the street
You can piece together GTF deliveries using public information
Our estimates suggest that Melrose EBITDA will CAGR b/w 25-30% b/w 2022 and 2026E, faster than any other aerospace player out there
We believe by the end of the year, GKN Aero will be worth more than all of Melrose today at a 10.5x EBITDA multiple
We can also do a SOTP valuation à we are doing this to frame the downside case if investors value the structures business similarly to Spirit (which they shouldn’t)
Note that the split of MTU (Melrose’s best comp) is 60% engines, 40% MRO (with MRO being a business w/ similar margins to structures)
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.