Investor Days, or Capital Market Days, are useful presentations for investors to get updated on a company’s strategy. Last month, industrials company Melrose Industries (LSE:MRO, Financial) held an Investor Day to go through the turnaround at its GKN PLC aerospace business. It was an eye-opening presentation that demonstrated the embedded value within the segment as strategies are in place to boost margins.
Melrose's turnarounds
While Melrose might be classified as an industrials business, it’s really a publicly listed private equity business. Its motto is “buy, improve, sell." It buys underperforming engineering businesses, restructures them and sells them for (hopefully) a large profit. Melrose was floated on London’s junior market, AIM, in 2003 and now sits comfortably within the FTSE 100.
It has done four such turnarounds to date, each time getting bigger in size. The first was the 427 million British pound ($506 million) purchase of McKechnie and Dynacast from private equity firm Cinven. The one before GKN PLC was the £2.2 billion buyout of Nortek in 2016, which it just this year finished divesting. Each time, it has doubled the return on its investment, usually within three to five years.
The GKN deal
The £8.3 billion acquisition of GKN in 2018 made Melrose the owner of a prestigious engineering firm with a history going all the way back to the industrial revolution. GKN gave Melrose exposure to three major business segments: aerospace, automotive and powder metallurgy.
The acquisition suffered from terrible luck in its timing. GKN's two main businesses – automotive and aeronautical engineering – were hit hard by the pandemic and recent supply chain disruptions. Last year, the company’s revenues of £6.88 billion were 37% down on those made two years earlier and its pre-tax loss grew to £618 million after taking over £450 million in amortization for intangible assets and reporting £269 million in restructuring costs.
In the company’s largest division, automotive, which was the source of 47% of total 2021 revenues, Melrose is taking actions to cut costs, closing GKN plants in Germany, Korea and America last year and starting the closure of a factory in Birmingham, U.K. In aerospace, which made up 37% of 2021 revenues, Melrose has started reducing the number of sites to 33 by the end of 2023, from 51 previously.
All this is a rationalization of the business, to get utilization up and focus on the components customers want most. This will lead to higher margins (and ultimately a higher valuation in the eventual sale of GKN).
Last month, Melrose CEO Simon Peckham predicted that if GKN can reach its 2019 level of revenue and make its targeted margin, then group profits should triple. Last year's adjusted operated profit was £375 million.
In its May trading statement, Melrose said like-for-like sales for its Automotive and Powder Metallurgy segments in the first four months of the year were down by 4% on the same period last year. This was because of the continuing shortages of semiconductors, and sales were “significantly below” what consumer demand otherwise would be.
Luckily, Melrose is well placed for the renewable energy transition. The automotive segment produces drive systems for conventional and electric vehicles, and 50% of last year’s £5 billion orderbook was for either battery operated or full hybrid vehicles. It has strong market penetration too, as its components are found in seven of the top 10 electric vehicle platforms around most of the world (excluding China).
Site closures contributed to about £60 million of savings last year, which drove a doubling of adjusted operating margins to 4.6%. Melrose thinks it can grow this to 10%, although this will depend on a recovery of the automotive sector.
In aerospace, the company makes a wide range of parts for planes across three subgroups: Engines, Civil and Defence. Customers include Airbus (XPAR:AIR, Financial), Boeing (BA, Financial), Rolls-Royce (LSE:RR., Financial) and GE (GE, Financial). The rebound in demand for air travel is a huge positive. The International Air Transport Association in June said it expected a doubling of passenger traffic this year, to 82.4% of 2019 levels. The Covid-driven downturn had masked the progress GKN aerospace had made thanks to Melrose’s improvement drives, chief financial officer Geoffrey Martin said at the firm’s June Investor Day.
Melrose used the event to guide operating margin targets for the aerospace segment higher to 14%, from 12% before. Aerospace’s adjusted operating margin in 2021 grew four percentage points to 4.4%. Melrose thinks it can deliver another 4% improvement with operational and cost improvements. Another 6% could be attained as the overall market rebounds to pre-pandemic levels.
The company forecast compound revenue growth of 7% for GKN Aerospace through 2030, highlighting that the segment has the highest potential equity return of all the GKN businesses.
CEO Peckham said that most of the difficult operational changes in GKN’s transformation were already complete or progressing well. Although returns from the GKN deal would take a bit longer than the typical four to six years Melrose typically executes turnarounds in, Peckham believes Melrose will maintain its record of doubling shareholder returns on its deals.
Valueing the business
Given GKN cost £8.3 billion, a doubling of value would mean selling GKN for over £16 billion. Melrose itself is only valued at £6.4 billion currently. This implies well over 100% upside potential if Melrose can maintain its track record.
Given that GKN’s businesses are improving, the Melrose valuation looks cheap in my opinion. Melrose has already repaid the £3.4 billion of net debt incurred at the time of the GKN acquisition. At year end, net debt excluding lease liabilities stood at £950 million, or 1.3 times adjusted Ebitda for Melrose. The laser focus on costs has seen working capital reduced to 3% of revenue, from 5% at the time of the acquisition.
Financial strength is slightly weak with an Altman Z-Score of 1.5, but its Piotroski F-Score is decent at 6 out of 9.
Aerospace head David Paja told investors that one business unit making up 20% of aerospace revenue has a net present value of £5 billion. This suggests Melrose is very confident there is more value in the business than the stock market gives it credit for. The presentation and slides are well worth going through to understand GKN Aerospace in more detail; you can find the full presentation on the company's website.
CEO Peckham believes Melrose will soon be “able to look to the next opportunity." If Melrose usually spins out its turnaround in five years, and we give the company an extra year or two due to the pandemic, then the GKN units could be started to be sold off in 2024.
Track record
Since Melrose came into being, it has given back £5.5 billion in cash to shareholders. Total shareholder returns since May 2005 – when it made its first acquisition – have reached 1,700%, while the FTSE 100 returned about 175% over the same timeframe.
Melrose has returned 19% on an annualized basis. However, its returns are lumpy, as it harvests businesses in the early stages of an investment and looks to recoup big profits on divestment. This explains why it has shown only one pre-tax profit in the last seven years, but when it eventually monetizes its GKN position, we might see 2016-like returns when its stock went up over 250% on the back of monetizing its last great turnaround.
