Description

Melrose Industries

We recommend buying shares of Melrose Industries, PLC (LSE:MRO or MLPSF). We estimate the intrinsic value at £3 - £3.5 per share or more.

Melrose Industries is a UK-based publicly traded private equity business. Historically, the firm has achieved excellent returns, compounding their share price north of 20% per year since going public in 2005. MRO buys a qualitatively good but poorly managed industrial firm, improves it through management changes, cost cutting, strategy pivots, and better capital allocation decisions, and then sells the business at MOICs ranging from 2.3 – 3x, usually over roughly 4 year periods.

HTC2012 also has a great writeup on Melrose from April 2019, with lots of good scuttlebutt on margins and competitive position. Please take a look at that writeup as well if considering an investment in MRO.

We believe MRO is underestimated by the market due to their (1) exposure to commercial aerospace end markets, (2) manufacturing base in general, and higher costs imposed by COVID on industrial businesses, and (3) general malaise towards UK stocks.

Melrose has a high quality, stable, highly incentivized management team with a history of value creation, insider ownership, and profit redistribution. The firm buys, improves, and sells industrial assets, distributes profit to shareholders and does it all over again. The firm’s approach is differentiated by the fact they do this with one asset at a time (though there may be some overlap between the old asset when they start to buy the new one).

We like MRO’s narrow focus. It de-risks execution, as the management operates in its niche circle of competence. It has done four of these transactions since 2003. MRO’s management is highly incentivized to succeed, and its interests align with shareholders. They get 7.5% of the value they create, after shareholders receive a 5% annual return. That is the main reason why we bought the stock.

Most of their value creation comes from margin expansion rather than revenue acceleration. By improving the cost structure and management of the operations they purchase, MRO achieves a low risk, high reward path to shareholder value. Once margins have been expanded, the market rewards the business with a higher multiple. MRO breaks down their return drivers as follows[1]:

GKN: Aerospace, Automotive, and Powder Metallurgy

Acquired in 2018, Melrose’s main focus for turnaround and improvement is GKN, a very respectable British industrial firm and the largest of MRO’s purchases so far, with 8 billion British pounds of sales.

GKN has three segments: auto parts (45% of sales), aerospace (40%) and powder metallurgy (15%). Let’s look at GKN Aero first.

In its aerospace business GKN makes aerostructures and engine parts that go into civilian (Airbus and Boeing) and military planes (about a quarter of the business). Usually there is a lot to like about the aerospace business. The barriers to entry are incredibly high. A plane is as safe as the smallest part that goes into it. Once a supplier gets engineered into a plane, it rarely gets replaced – the risk is too high. 

Aero accounts for almost half of GKN’s 9.8% profit margin in 2019[2]. They’re a tier 1 supplier in the commercial aerospace market.

Before the pandemic, global travel demand was growing a few points above global GDP. By buying MRO, one is making a calculated bet that once the global economy opens up, the aerospace segment, and the rest of the company, will return to its pre-COVID normal. This virus, just like a flu, may never go away, but we’ll learn to manage it. 

More information on their Aero business is below.[3]

GKN Automotive makes driveshafts and all-wheel drive programs for ICE, hybrid and electric vehicles (driveshafts are components that transfer power from the engine to the wheels). Ninety percent (90%) of the world’s auto OEMs rely on GKN Auto for these components; it is a dominant player with factories located strategically close to automakers. This segment did £2.8b in revenue in 2020 and was about 41% of operating profit in 2019.  Here’s their revenue breakdown for Auto[4]:

GKN’s Powder Metallurgy segments makes industrial powders of various types that can be cast to precise specification and hardened into a variety of high integrity shapes and structures for industrial purposes. The segment did £900m in 2020 and was about 13% of 2019 operating profit. Powder Met provides a lot of optionality in 3D printing and hydrogen storage. 

Nortek Air Management

Nortek Air Management is a remnant of the previous company MRO owned and subsequently sold. Broadly speaking, Nortek is an HVAC business doing about £1.2 b in revenue and £190m in operating profit. In June 2021, Melrose announced the sale of Nortek to Madison Industries for £2.62b; £100m will go to a pension allocation and the rest of the capital will return to MRO investors across the capital stack. MRO has announced that £730m will be coming back to shareholders via a special dividend of 15 pence per share. The balance should go towards deleveraging.

Other Industrial

MRO owns some other much smaller industrial businesses that we won’t discuss here. Revenue was about £630m in 2020 and operating profit was £86m in 2019.

Analyzing Melrose – Quality, Growth, Valuation

We utilize a simple framework to assess a business’ investment potential: quality, growth, and valuation. Valuation comes last as it is an output that is largely dependent on the previous two. We’ll primarily focus on GKN’s automotive and aerospace businesses as that is the bulk of revenue and operating profits.

Quality

We break quality into three parts: management, business, and balance sheet.

Melrose has excellent management. They have a demonstrated track record of knowing what to do and doing it; this is then reflected in the performance of MRO shares.

See table below for an overview of their “buy, improve, sell” process in prior deals:

Their 2020 Annual Report also details their process of margin improvement over time.[5]

Despite one of their co-founders, David Roper, retiring earlier this year, the firm is still in great hands with co-founder Simon Peckham at the helm. And a variety of experienced and well-incentivized managers underneath him.

Assessing the business quality of GKN Aero and Auto is a somewhat more complex task. Both are tier 1 suppliers in their industries, but this doesn’t necessarily mean great returns are headed our way as owners or to any future owners. The automotive and aerospace industry supply chains are both heavily consolidated and specialized, a complex ecosystem of manufacturing and (re)assembling parts across multiple companies, aggregating up into the large, relatively few in number, OEMs that sell to commercial customers.

GKN Aero and the Dynamics of the Aerospace Supplier Industry

Like the tier 1 automotive supplier industry, aerospace suppliers tend to become hyper specialized in one or several aircraft components, resulting in oligopolistic, or even monopolistic, market structures for some components. Others can become more commodified, but the trend in the industry is consolidation and specialization, enabling good returns to companies that successfully occupy a niche within the industry.

Pricing dynamics will vary within the industry as a function of what part or component is being sold. GKN Aero makes aerostructures/airframes (the shell of the aircraft, two thirds of their revenue) and engines (one third of their revenue). Aerostructures are mostly a one-off revenue model, in which one structure is sold to customers with essentially no aftermarket/servicing revenue. This in in contrast to engines, which are a more standard razor-and-blades model. Engines earn good margins in themselves, however, so GKN is not entirely dependent on higher margin aftermarkets to make the business model work. GKN Aero is a tier 1 airframes supplier to the industry.

Another important dynamic to consider regarding aerostructure manufacturing is whether the products are wide body or narrow body. Wide body airplanes are larger, and intended for long hauls between countries or continents. Narrow body aircraft are intended for shorter flights. Given COVID, long haul flight miles and revenue passenger kilometers (RPKs) are both down and likely to stay down for some time, given that even with reopening most people will likely fly closer to home or in their country or region.

According to Melrose IR, historically about 30% of GKN Aero revenue has been from wide body planes and 15% from narrow body. However, in 2021 these figures reversed (currently 30% narrow, 15% wide), with that differential accelerating next year.

Another important consideration for the Aero business is that on a normalized basis, almost one quarter of their revenue comes from defense (with the contraction in revenues from COVID, this number is now north of 50%). Defense is a critical line item, particularly today with rising geopolitical tension and an increased tendency for countries to go it alone on defense. Defense suppliers compete against a budget more than they do each other; this is particularly true when OEMs are specialized, as they tend to be in the defense space.

A roster of GKN Aero’s biggest customers is below. Keep in mind defense revenue here is a greater than normal share due to civil aerospace recent underperformance as a result of the pandemic.

The moat source in GKN Aero will largely come from switching costs. By being a safe provider of critical components to aircraft OEMs such as Boeing and Airbus, there is little incentive for their customers to switch unless there are major problems (which haven’t materialized under MRO’s ownership).

GKN Auto and the Automotive Supplier Industry

Like aerospace, automotive suppliers tend to become specialized in one or several niches within the supply chain. The best players can carve out a differentiated, remunerative specialty, enabling higher returns over time as their customers face switching costs and competitors have trouble replicating their assets and customer relationships.

Unlike the aerospace industry, the razor-and-blades model is less prominent in auto suppliers. This industry tends to operate with pre-negotiated step downs in price/revenue to the supplier over time as a given product is delivered over the life of a contract. Critics of the industry will say this is evidence of a lack of pricing power; however we believe that the switching costs and mission-critical nature of the product leads to a kind of recurring revenue dynamic in which while contracts lose value over time, they are constantly being renewed, and existing suppliers are hard to displace. Additionally, price stepdowns at GKN Auto are less severe than they might be at competitors or other comparable businesses, given their market leadership in driveshaft/AWD.

GKN also has the capacity to innovate, thereby providing a differentiated and better, higher margin product. Their driveshaft business is a leader in the field, and present in almost 50% of cars on the road globally. Furthermore, they are ahead of the curve on electrification. While 90% of their vehicles are ICE and just 1% are fully electric (battery-powered electric vehicles, or BEV), they expect this mix to shift to 15% full EV, 45% ICE and the balance some form of hybrid by 2025. The electrification of the auto industry should be a net positive to this business. 

More detail on GKN Automotive’s market penetration can be found below:

We believe GKN Automotive is a differentiated, high quality business with a moat from switching costs and asset specificity. Their drive shafts and AWD technologies are embedded in a huge number of cars, giving them credibility with OEMs. Unless there is a large manufacturing or technical issue (something we see as very unlikely under Melrose ownership), we expect this market leadership to continue.

GKN Powder Metallurgy

While GKN Powder Met is a leader in its field, we view this as a less salient segment and as such it demands less attention analytically. Powder Met is the largest single provider in an otherwise fragmented market, with 17% share. Like Auto and Aero, it has a global manufacturing footprint close to customers. There is upside optionality here with exposure to 3D printing, though we don’t underwrite the growth or margin profile as such. 

Balance Sheet

As a whole, Melrose Industries has an excellent balance sheet. As of the end of 2020, net debt as a percentage of total assets was 17%. Let’s take a look at their maturity profile as well.

The next maturities Melrose has are 450m GBP due in September 2022, as well as about 1.3b the following January (2023).

We’d make a couple points here.

1. Melorse already has more than 300m GBP of cash on its balance sheet, prior to the Nortek sale.

2. We estimate Nortek sale proceeds will be broken down roughly as follows:

a. Pension contribution: 100m

b. Special Dividend: 700m

c.  Debt Paydown/Cash on the balance sheet: 1.79b.

This forward cash balance gives them substantial headroom to pay down their debt and/or knock out all near term maturities, including paying down all or some of their revolver.

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Big picture, we see GKN as a leading supplier to automotive and both commercial and defense aerospace OEMs. Both businesses are handling pivots to highly likely future states well (narrow body aircraft in commercial aero, electric vehicles in auto). Melrose management is excellent, and making improvements in both on cost, which should benefit substantially in a COVID recovery.

Let’s now turn to the other two elements of our investment framework, Growth and Value.

Growth

After a revenue rebound from a COVID recovery scenario, or even a partial reopening in Europe and elsewhere, we expect medium to long term growth in GKN’s revenue to track (1) global increases in demand for short and long haul flight travel, (2) growth in defense budgets, and (3) growth in demand for cars. The net effect of this is growth should roughly track GDP changes over time, low to mid-single digits.

Valuation

An investment in MRO is not, in our view, a bet on high secular growth rates or a play on capturing a large TAM. Melrose’s core modus operandi is to buy fundamentally good, but under-managed assets, replace the business managers, extract costs and thereby drive margin improvements, which in turn highlights the fundamental asset quality to the market, resulting in a higher multiple. Turned around businesses are sold for cash to buyers at good prices, and the cash is redistributed to shareholders via large special dividends.

MRO was in the early stages of turning around GKN when COVID hit in 2020. As such, we see a successful investment in Melrose as dependent upon three things happening:

1. Achieving their margin guidance or better in automotive.

2. Achieving their margin guidance or better in aerospace.

3. Successful sale or exit of both businesses, plus GKN Powder Met and the return of capital to shareholders.

Before we get started on valuation work, we want to note that we’ll use IFRS statutory revenue and adjusted operating profit margins to derive our margin profiles of MRO’s segments. We do this because (1) adjusted revenue includes that of equity accounted investments, which we want to exclude to be as close to real, “fully owned” revenue as possible and (2) adjusted operating profit gives a real sense of how the business is performing, excluding the impact of of acquired intangibles, impairment and restructuring charges. Note that because we do not deduct these items from earnings, there is also no need to add them back in the cash flow statement.[6]

Automotive

Automotive revenue and margins were both adversely impacted by COVID-19 and social distancing provisions. As shown below, in 2019, prior to the pandemic, GKN Auto almost achieved 9% margins:

In their full year 2020 earnings presentation, MRO management shared their belief that a 10% operating margin is achievable with a “clear pathway,” even without a full recovery.[7] We don’t know, but we suspect that Melrose management are being conservative here, and that margins could even expand a further 100 – 200 bps from there. A full recovery may be needed to achieve this, however.

Below are some comps for GKN Auto; notice the relatively wide dispersion of operating profit margins, despite all being automotive suppliers.[8] Recall that differentiated results here are a function of (1) product differentiation and niche occupation, and (2) good management. We think Melrose has both.

Aerospace

GKN Aerospace is significantly more troubled than automotive, with flights and RPKs still at a fraction of what they were pre-pandemic. Nevertheless, we are of the view that (1) the pivot to narrow body aerostructures, away from wide body, and (2) the increased exposure to defense will ultimately accrete to improved revenue and margin from here onward. Looking at the segment’s financial metrics, we can see the collapse in operating profit from COVID:

In their 2020 results presentation, Melrose confirmed (1) the dispersion of results between civil and defense subsegments (civil was down 40%; defense was up 8%)[9], and (2) that they see a pathway to 10% operating profit margins in the medium term, even without a full recovery.[10]

Once again, we are of the view that 10% may be on the lower end of what is achievable in the aerospace segment by this business and management team. Below are comps on the aero segment, civil and defense. Keep mind that more exposure to defense now should flow through to better margins. In any event, we believe that more operating profit pounds (GBP) are possible for MRO in the future in a variety of recovery scenarios. We are mindful that some of these will not be perfect comps, but we think they are useful to get a sense of what is achievable in the industry.

Despite the challenges in the segment, we believe commercial air travel will return sooner or later – it’s in our DNA as humans. When it does, GKN Aero will benefit, and we’ve got a good (if not exceptional) asset with a stellar management team while we wait.

Powder Metallurgy

Melrose management is guiding to an even better margin performance in Powder Met. First, let’s look at what they’ve done in this segment.

MRO thinks they can do a 14% operating profit margin in this segment; we believe them, and model the business as such in the medium term, post COVID.

Capital Allocation

Before we proceed to valuation, we wanted to share some important facts about what we see as MRO’s capital allocation prowess.

During what was basically a terrible year for Melrose and the entire automotive and air travel industry, MRO managed to generate record levels of free cash flow, nearly 630m GBP of it, coming in at 6% above 2019. We find this very impressive. This was achieved by cutting capex and strict working capital discipline. In our view, this highlights the extent to which management is able to apply expense and capital discipline during a time of profound challenge in the industry.

Melrose also utilized this cash generation to pay down debt. Net debt was reduced by 13% (around 400m GBP) as of the end of 2020 to 2.87b, amounting to 17% of total assets. Not your typical private equity approach to capital structure management.

The group also announced a 0.75 pence (0.0075 GBP) dividend, paid in May, and reduced the pension deficit to 100m GBP.

In June 2021, the group announced the disposal of a legacy business from a prior acquisition, Nortek Air Management, for 2.62b GBP, and a consummate return of capital to shareholders of 730m GBP, or 15 pence per share. The balance of proceeds will be used to reduce the pension deficit and pay down debt. This could reduce net debt considerably, potentially to close to 1b GBP.

All in all, the group managed to generate substantial cash and take the overall risk level within the company down considerably during what may amount to the worst crisis for the industry for many decades.

Valuation

Let’s now turn to valuation.

To conduct this analysis, we make the following assumptions:

1. 2019 is our base year for normalized operations. We’ll be anchoring to 2019 as a jumping off point, though the analysis will look forward. To this end, we model a revenue surge for Auto and Powder Met in 2021 after sharp declines in 2020. From there, each compounds at 3% per year.

2. Aero is modeled separately based on a variety of COVID recovery scenarios.

3. As such, defense will only be 21% of Aero revenue going forward, as it was in 2019.[11]

4. Most of their revenue in the aero segment happens in Europe (34%) and North America (61%). Rest of world is the balance (5%).

5. To properly underwrite the aero segment, we need to consider their exposure to domestic and international RPKs in their key markets, as well as look at different rebound scenarios in each. To accomplish this, we’ve assumed that pre-COVID North American RPKs were skewed 75% domestic, 25% international, and that the inverse (25% domestic/75% international) is the case in Europe. There is data from IATA, ICAO, and the US BTS that corroborate these high level figures.[12]

6. To derive pro-forma defense and rest of world aerospace revenue, we compounded 2019 revenue levels by 3% and 1% per year for 5 years, respectively.

7. To forecast base case margins, we assume Melrose will hit their operating profit margin guidance over the medium term. As a reminder, these are:

a. Aero: 10%

b. Auto: 10%

c.  Powder Met: 14%

8. The model doesn’t factor in lower interest payments resulting from debt pay down from the Nortek sale proceeds; rather it simply contemplates a normal, periodic paydown from free cash flow over time.

Using this as a baseline, we can model the following scenarios:

1. A collapse of international travel but a domestic rebound.

2. A collapse of both international and domestic travel (we’ll take down aero margin a lot here.

3. A rebound in domestic, and a slight decline in international travel.

4. A full travel recovery, plus growth from the 2019 base, along with expanded margins.

As such, the baseline assumptions look like this:

Here are the assumptions for travel in Scenario 1: International travel collapse, domestic rebound. We bring Europe domestic travel back to 80% of pre-pandemic levels due to smaller average country size, and the ability to drive in country.

Here’s how the P&L shakes out in Scenario 1. We get 0.12 pence/share of earnings, and apply a 17x multiple in this and every scenario. Why 17x? Historically, GKN traded at 21x LTM earnings, and 14x NTM earnings. We think the 14x NTM multiple makes sense, given the asset was high quality but mismanaged. Given the excellent management team at Melrose and long track record of capital return, we believe 17x is warranted and will use it in every scenario here. Scenario 1 results in a fair value north of 2 GBP / share, roughly a 23% premium to today’s price.

Our second Scenario contemplates a total collapse in air travel. To model this, we utilize the following assumptions. All travel has collapsed by 80% here, resulting in travel being 20% of 2019 levels.

Turning to the P&L for scenario 2 (all travel collapse), we get the following:

You can see that in this scenario, we take Aero margins down 50% to 500 bps. We contemplate that in this future, making airplane parts is not a desirable business to be in, despite the attractiveness of defense, which we see robust to a variety of adverse future scenarios.  In this case, we arrive at 8 pence per share of earnings, and 1.44 GBP per share of fair value; about a 15% downside from here.[13]

Scenario 3 is our base case, which contemplates a rebound in domestic travel and a slight decline (20% reduction, so not a collapse) in international travel. We underwrite this scenario using the following assumptions.

The Scenario 3 P&L shakes out as follows:

A 17x multiple on 13 pence per share of earnings renders a fair value of 2.26 per share, 33% above today’s price.

Scenario 4 looks at a full travel recovery, 20% above 2019 levels, as well as an additional 200bps of margin potential in each of their 3 GKN segments. Here are the core inputs:

And the P&L, which comes to EPS of 0.18 per share and a fair value north of 3 GBP per share. From here, that’s an intrinsic value 82% above today’s price. Although this is a bull case, our conviction that travel will return at some point and that MRO management will continue to make improvements at GKN are quite high.

We believe MRO has a considerable margin of safety and a pathway to achieving at least a 50% return from here. But wait, there’s more – dividends.

Dividends

A key feature of Melrose as an investment is dividends. Management sells turned-around businesses at good multiples and returns the capital to shareholders. This has already happened multiples times in their history, most recently with Nortek.  The Nortek dividend will be 15 pence per share, roughly equal to one year of normalized earnings, an almost 9% return on today’s price. More dividends will come in time with the sale of GKN,[14] and we anticipate a 50% dividend payout ratio of normal earnings, rendering 2.5 pence per share to 7.5 pence per share per year, depending on how the recovery goes. We think these could add another .15 to .215 pence per share of value to Melrose’s intrinsic value.

Contemplating an Exit Multiple for GKN

At what multiple might Melrose management be able to sell GKN? To analyze this question, we consider a sale on an EV/EBITDA basis.

GKN’s historical average EV to TTM EBITDA was a shade above 7, prior to the acquisition by Melrose. However, we think they can do substantially better selling a more efficient and well-managed GKN, rendering a premium multiple of 10X EBITDA (recall they’ve done this historically).

In that scenario, we believe the intrinsic value per share shakes out as follows:

Conclusion

Adding it all up, we think an optimistic but still very realistic outcome is that MRO is worth about 3.4 GBP / share or more, a double from here, with in our opinion very limited downside. Should travel, EV demand, growth in automotive demand in developed or emerging markets, and/or margins surprise to the upside, there may be additional value that MRO management will likely capture.

[1] MRO 2020 Annual Report page 9.

[2] We are utilizing 2020 revenue figures so you can get a sense of the size and mix of the business; 2019 operating profits are utilized here to reflect normalized operating margin and earnings; though we expect 2019 operating margins can likely be improved upon.

[3] MRO 2020 Annual Report page 15.

[4] MRO 2020 Annual Report page 19.

[5] Page 7.

[6] We do deduct cash restructuring charges along with pension contributions in our free cash flow calculation.

[7] MRO Full Year Results for the year ended December 31, 2020 page 23.

[8] Data from Capital IQ.

[9] MRO Full Year Results for the year ended December 31, 2020 page 19.

[10] MRO Full Year Results for the year ended December 31, 2020 page 19.

[11] Should defense constitute a larger portion of revenue than 21%, this could be a source of additional upside. 21% is a relatively conservative figure, giving MRO in this analysis a larger exposure to commercial air travel.

[12]For example see IATA June 2021: https://www.iata.org/en/iata-repository/publications/economic-reports/air-passenger-monthly-analysis---june-2021/; ICAO: https://www.icao.int/annual-report-2019/Pages/the-world-of-air-transport-in-2019.aspx; BTS: https://www.transtats.bts.gov/TRAFFIC/

[13] Margins may shake out considerably higher than 5% in this scenario, given that the Aero segment would predominantly be a defense business at that point.

[14] Given the relative disparity between the two main business lines and the fact that a conglomerate of GKN’s nature is relatively rare, we would not be surprised for two buyers to emerge. Both supplier ecosystems are relatively specialized for Auto and Aero, and each segment would make a nice standalone tuck in at any of the larger supplier firms. 

Catalyst

Finalization of Nortek sale, subsequent net debt paydown 

Post-COVID travel recovery

Sale of GKN