Description

Historical Operating Margin Improvement at Melrose’s Prior Acquisitions

As detailed in the preceding chart, the last four assets that Melrose acquired generated an average 50% improvement in underlying operating margins. Nortek, the industrial asset owned by Melrose, shows operating margins 44% in excess of the pre-Melrose level with more to come in 2019.  Shareholder returns have proven equally impressive as the last three completed deals generated IRRs in excess of 30%.

Current Situation

In early 2018 Melrose offered to acquire GKN, an industrial conglomerate based in the UK.  After the offer was rebuffed Melrose launched a hostile bid for GKN and appealed directly to GKN shareholders by highlighting its stellar track record and the numerous missteps made by GKN’s management. Following three months of direct appeals to GKN shareholders, Melrose emerged victorious with a supportive shareholder vote.  Melrose closed the GKN acquisition in mid-April 2018.

 GKN Overview

GKN is an industrial conglomerate consisting of three businesses: Aerospace, Driveline/Auto and Powder Met. Below are summaries of each business.

Aerospace: ~37% of revenue, consists primarily of aero structures and engine structures

GKN’s business focuses more on wide body airplanes than narrow body. The business is nicely diversified by customer and much more levered to Airbus than Boeing. Content per plane on the 737 max is ~300k/plane and currently generates close to zero profit.

Products are split broadly into three categories:

Aerostructures (49% of sales):

Structures includes a mix of civil and military work on wings, fuselages, empennages and nacelles, with just over half based in North America. In 2001, GKN purchased Boeing’s St. Louis plant, taking over structures work on the F-18, F-22 and C-17, and setting the company up to work on the F-35 fighter jet. More military and civil work is done in the US in GKN’s Alabama facility (Blackhawk, CH-53, Boeing 787), while the Sumner facility in Washington is close to a Boeing factory and works on civil products including 737 MAX winglets. In Europe, GKN’s main site at Filton provides parts for every major Airbus program. The purchase of Fokker in 2015 also increased GKN’s European structures business with facilities in the Netherlands.

Engine structures (37% of sales):

The bulk of GKN’s engine business is from the acquisition of Volvo Aero in 2012. The business mostly involves engine parts in the colder, front-end of the engine (fan blades and casings) as well as compressor parts and rear turbine exhaust structures. The business includes work on key civil engines (V2500, CFM-56, GTF, Trent XWB) as well as a range of military products.

Other (14% of sales):

The remaining Aerospace revenues consist of wiring (Fokker Elmo),transparencies (cockpits and windows), and landing gear.

Auto / Driveline: ~48% of revenue, consists primarily of aero structures and engine structures

GKN Driveline is the global leader in automotive driveshafts (used to transfer power from the engine to the wheels). It has 53 manufacturing sites with 40% of sales in Europe and 32% in North America. Automotive OEMs are the key customers (Fiat Chrysler and VW  account for 13% and 11% of sales, respectively). The company has dominant market share globally. It is the #1 player in driveline (47% market share), #1 in all wheel drive (30% market share) and #1 in e-drive systems (14% market share).

Products are split broadly into three categories:

Constant Velocity Joints (64% of sales):

This is the most common and straightforward offering, comprising two side-shafts which transfer power from the engine in a standard, two-wheel drive vehicle. GKN is the clear market leader in CVJs).

All-Wheel Drive (33% of sales):

For 4-wheel drive vehicles. This involves four side shafts to transfer  power to each wheel as well as connected prop  shafts to transfer power down the vehicle. GKN is also the market leader in all-wheel drive solutions.

eDrive (3% of sales):

eDrive represents an increasingly important product as more vehicles become3.hybrid or fully electric, with the company focusing on the higher value end of the market (full hybrids and battery electric vehicles). GKN has won just under 40% of programs bid for, and has over300,000 eDrive powered vehicles currently on the road, suggesting a relatively similar market share as its legacy products.

Powder Metallurgy: ~15% of revenue, consists primarily of aero structures and engine structures

Powder Metallurgy generated c.£1.1bn of sales in 2017, of which the automotive industry accounted for c.67% and general industry was 16%. The customer base is much more fragmented than the other GKN divisions; its largest customers are automotive OEMs and industrial suppliers and the business are split as follows:

GKN Sinter Metals (85% of sales):

The world leader in producing ‘sintered’ components. Sintering consists of compressing metal powder into the required shape and then heating it at an elevated temperature to form metallurgical integrity. This process avoids almost all scrap metal and waste, and can also reduce costs. Most sales are into the automotive industry used in parts including pump systems, shock absorbers, and drivetrain components.

Hoeganaes (15% of sales):

Hoeganaes is the second-largest manufacturer of metal powder globally. These atomised metal powders are used in the sintering process by GKN Sinter Metals and other powder metallurgy companies.

Note that Melrose also still owns Nortek (prior acquisition) which consist of Air Management (HVAC), Security, and Ergonomic assets. Given this business is less material to the story, have already seen  big margin improvement, and will be disposed of in late 2019 or early 2020 we won’t go into detail on these businesses but are happy to answer any questions in the Q&A.

Investment Thesis

We have been an investor in Melrose for the better part of the last decade and have never seen as attractive an opportunity to invest in Melrose as right now. We believe that an investment today in Melrose will generate a base case return of 50% over the next 18 months.

Thesis Point 1: GKN is a collection of high-quality businesses that has been historically mismanaged

After studying GKN we concluded that it consists of high quality but badly mismanaged assets. We conducted over 20 calls related to the quality of GKN’s assets and technology with customers, competitors, and former GKN employees. These conversations illustrated that GKN’s products are deeply entrenched with customers, its technology is second to none, and that GKN operates with leading market share in most product categories. Feedback related to the quality of the company’s offering was overwhelmingly positive. Despite this, GKN’s financial performance has been lackluster for years.

In researching GKN we met with its former management team and studied their history. We discovered shocking levels of operational mismanagement, missed targets, and wasted capital, which in aggregate resulted in a lack of margin improvement and weak free cash flow generation over many years.  As shown in the following exhibit, GKN’s margins in the aerospace business fell from 11.2% in 2011 to 8.5% in 2017. This occurred during a period in which revenue grew and management targeted ~13% margins.  Our internal benchmarking suggested that GKN should be achieving roughly 13-14% margins in its aerospace business today. 

Aerospace Adj. EBIT Margin (GKN)

GKN’s auto margins also didn’t improve between 2011 and 2017, despite the Company posting solid organic growth during the period and promising its shareholders it would improve margins to 10%. In fact, margins flat-lined and the amount of cash generated from the auto business fell by nearly 25% as capital invested failed to generate a sufficient uplift in margin.

Auto Adj. EBIT Margin (GKN)

As a result of this lack of operating leverage, GKN’s share price languished relative to its peers, the index and Melrose. During one of the longest upward trending aerospace and auto cycles in the last 50 years, GKN underperformed its index by roughly 3x since October 2003 as illustrated in the following chart.

Thesis 2: Margin improvement at GKN will likely be higher and achieved faster than the market expects, significantly enhancing the IRR of the investment

Our research suggests that Melrose will not only be able to achieve significant margin improvement, but will be able to do so more quickly than expected by the market. Via in depth conversations with over 15 former employees and conversations with several industry experts, we independently determined three primary causes of GKN’s margin underperformance.  First, GKN’s incentive structure is set to compensate managers for revenue growth rather than profit or cash generation. This has led to perverse behavior including a) wasteful capital spend in order to drive low value added projects and b) contracts with customers that generate negative profit but significant revenue. In our conversations with Melrose management, they have indicated that managers will be incentivized based on profit and cash flow going forward.  Second, benchmarking has indicated that GKN’s employee base is far too large relative to its revenue base (see below). We believe that Melrose has the opportunity to rationalize the workforce by roughly 20% over the next year, generating significant savings rapidly. Our research suggests that the workforce is already being rationalized faster than we expected and will likely lead to near-term margin improvement in 2018.

Third, our research has indicated that a significant portion of GKN’s sales base in North America is loss making (particularly in the Aerospace business). We believe that consolidating loss-making facilities and letting unprofitable contracts roll off will generate nearly 200bps of margin expansion over the next two years. Our research has uncovered that closing one particularly large loss-making contract in the North American aerospace business could alone generate 100bps of margin.

While most analysts on the sellside believe that Melrose will achieve ~11% margins by 2022, we believe that run-rate margins will be 11% by the end of FY 2019 (see below). In comparing the GKN acquisition to prior Melrose acquisitions including Nortek and FKI, it is strikingly similar. While larger in size, nearly all the margin improvement initiatives are in management’s control and aren’t dependent on improvements in revenue. In addition, most of the major initiatives related to cost (labor rationalization, U.S. aero footprint reduction) have already begun and should be complete by the end of 2018 based on our channel checks. As a result, we believe the market is underestimating how quickly margins will improve.

GKN Adj. EBIT Margin Bridge

Thesis 3: We believe the impact of auto and aerospace tariffs on GKN’s business is much smaller than the market believes it is

We believe the opportunity to invest in Melrose exists because of fear surrounding potential auto tariffs on EU autos by the Trump administration. There is significant concern that GKN’s products could be taxed and that OEM customers could shift to alternative, locally based substitutes to avoid the resulting mark-ups. We believe that this concern is unfounded.  Our research with former GKN employees and conversations with management suggest that over 90% of GKN products are produced locally and wouldn’t be subject to tariffs. In addition, given GKN is the sole source provider for many of its products, if tariffs were imposed on GKN products OEMs would have little choice but to pay a higher price for the part.

A different concern surrounds the impact of potential large new auto tariffs on the end demand for autos. While this concern is reasonable, we are heartened by the fact that management has cushion to operate with via the cost initiatives outlined above. We believe that Melrose could grow margins and profits significantly even if sales were to decline. Additionally, auto production today is a very different business than it was 20 years ago. Local production of autos has become ubiquitous as a result of globalization. If auto tariffs are imposed, OEMs will likely shift production to local plants to soften the impact of the tariffs.  This will likely result in much less of an impact on global auto sales than it could have in past eras, although undoubtedly the demand for autos would decline.

In conclusion, we believe that Melrose will likely liquidate most of its non-GKN assets later this year and in early 2020, leaving GKN as its primary holding. Using a conservative sum-of-the-parts analysis and assuming our margin targets are accurate, we believe there is 50% upside in Melrose over the next 18 months making it the most attractive investment in our portfolio.

Results so Far:

Keep in mind that Melrose had only owned GKN for a few months before reporting its FY 2018 results and so the run-rate impact of their actions haven’t flowed through the P/L yet. Margins were up 80bps YoY (after being down 10bps YoY under old management).

Huge improvements already in aerospace. The loss-making US aerostructures business was rationalized quickly and is now breakeven. The existing Aerospace business also improved YoY significantly.

Within Auto, margins were flat despite declining auto production, and most actions to rationalize sites and overhead were made in December and will flow through Q1 and the rest of 2019.

Nortek margins were down slightly, but that was primarily because of the loss of a customer that was one-time in nature.

Recent Invite Only Investor Day

Melrose recently posted an analyst day presentation on its website a few days ago. In addition, they conducted an analyst day in London that was not webcast but was only open to shareholders of significant size (we attended) and some sellside analysts. There were several datapoints from the investor day that confirmed our diligence.

Big picture, Melrose increased its EBIT margin targets for GKN from 11% to 12%. They also confirmed that they can get to that 12% without growing the revenue base at all. Note that the aerospace revenue base is expected to grow significantly over the next 3-4 years given all the new programs that GKN has been onboarded onto. The Company reiterated again and again that the margin improvement story is completely in their control (i.e. cost cutting, rationalizing plants/footprint, and removing loss making contracts). They also confirmed that nearly 10% of all revenue across GKN is loss making and will be wound down in a logical / rational fashion.

Aerospace

The takeaway on the aerospace business is that Melrose believes management can get to roughly 12% EBIT margins. They plan on doing this via the three cost buckets below.

Interestingly, this looks like an extremely conservative target to us. When you look at the 150m of net saving opportunity in this business, more than half of it comes from the US aerostructures business. This business represents roughly 17% of the revenue base. Yes that revenue base is unprofitable and should be achieving margins of 5-7% over the next three years, but it implies that the savings in the core is only 80m GBP. That seems unlikely given the number of employees per capita in the remaining business, the level of SG&A spend relative to competitors and the opportunities to get rid of loss making contracts. We believe that Aerospace is more likely to achieve a 13-14% margin target by 2022 vs. the 12% outlined by Melrose. Note that this business was at 12.5% margins in 2014 and peer margins have risen since then!

Auto

The takeaway on the auto business is that Melrose thinks it can take margins from 6.7% to ~10% by driving the savings from the below. This is roughly in line with our targets for the business. We believe that the Company will get there by late 2020 or early 2021 vs. consensus in 2022.

Sum of the Parts

Note the sum of the parts is much less theoretical than for most companies since Melrose always liquidates the assets. We believe that Nortek will be liquidated late 2019 or early 2020 and GKN will start to be liquidated in late 2021. We use a small premium to peer valuations given that these businesses will all be sold.

Note that the below valuation is on 2021 EBITDA and thus is a return achieved by the end of 2020, or ~18 months from now. Multiples reflect the purchase price net of tax.

Catalyst

Margin improvement at key GKN divisions will serve as the primary catalyst.

In addition, any disposal of assets (Nortek or otherwise) will catalyze value creation