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Melrose - disruption to continue into second half

Nicholas Hyett, Equity Analyst | 22 July 2020 | A A A
Melrose - disruption to continue into second half

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Melrose Industries plc Ordinary 48/7p

Sell: 0.00 | Buy: 0.00 | Change -168.45 (-100.00%)
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Revenue fell 27% in the first half, reflecting a rapid decline from mid-March in both aerospace and automotive. The group was loss-making in the second quarter overall, but returned to breakeven in June and is on course for a small underlying profit in the half.

Aerospace revenues are not expected to recover in the second half and the group will not be paying a dividend.

The shares fell 15.9% following the announcement.

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Our view

Melrose wasn't in peak condition before the coronavirus outbreak struck.

Buying GKN involved taking on considerable debts, not to mention a sizeable pension deficit. While the new management team made impressive early progress in improving margins, there hasn't been time to sell off the smaller Powder Metallurgy business and shore up the balance sheet.

Against that backdrop the near complete closure of Automotive and Powder Metallurgy and reduction in activity in Aerospace is unwelcome news.

So far the group's been able to hold on to sufficient cash through the crisis to actually trim debt levels a little. But a long a term downturn in aerospace suggests lower profits in future years and that could mean all available cash is directed towards debt reduction for some years to come. We suspect it will be some time before the dividend returns to anything like the levels it once was.

Fortunately Melrose has access to substantial short term liquidity through its banks. Those lenders have also agreed to suspend rules governing how much the group can borrow relative to cash profits for the next year. That should help it weather the immediate storm, even if it does emerge weaker.

The recovery is unlikely to be smooth though, even after the immediate crisis has passed.

It looks increasingly like we're facing a sharp economic downturn this year. That's bad news for car sales, one of Melrose's key end markets, and will also make disposals of the Powder Metallurgy and smaller Nortek businesses more challenging.

More worrying is the group's pessimistic outlook for long term demand in aerospace, which accounted for some 37% of underlying operating profits last year. While exposure to defence markets will provide some shelter for the division, the long term outlook for commercial aerospace is pretty bleak. British Airways owner IAG reckons passenger demand won't return to 2019 levels until 2023. Less passengers means less planes, and less planes means less demand for Melrose's products.

Given the uncertainty in Melrose's end markets, and a balance sheet that's someway off being as healthy as we'd like, we're inclined to watch the current turbulence from the sidelines.

Melrose key facts

  • Price/Earnings ratio: 19.2
  • 5 year average Price/Earnings ratio: 18.8
  • Prospective yield: 1.5%

We've introduced this section in response to recent survey feedback.

Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Trading Update

Aerospace revenues fell 18% in the half, with full year sales now expected to be 25-30% lower than 2019. The group plans to make a substantial reduction in costs in the division, improving performance next year even if revenues remain subdued.

Both Automotive and Powder Metallurgy saw factories shut during the half, with sales down 36%. However, conditions have improved more recently, with China actually ahead of last year, the US within 10% and European demand improving. Melrose warned it was too early to say if these trends would continue.

Nortek sales were down just 7% year-on-year. Technology aimed at improving air and water usage in data centres is gaining traction and expected to generate $100m of sales this year. The group will return to assessing the strategic options for Nortek in early 2021.

Melrose generated free cash flow of £200m in the first half, resulting in a modest £90m decline in net debt. As a result bank headroom has increased to £1.1bn, with a further £300m of cash on hand.

Management think there's room for a further £150m reduction in inventories this year and has identified £100m of further cost savings.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.