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Melrose - some signs of improvement

Nicholas Hyett, Equity Analyst | 3 September 2020 | A A A
Melrose - some signs of improvement

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No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Melrose Industries plc Ordinary 48/7p

Sell: 0.00 | Buy: 0.00 | Change -168.45 (-100.00%)
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Melrose reported underlying revenues in the first half of £4.4bn, down 25.8% year-on-year. That reflects a particularly tough half in Automotive and Powder Metallurgy, while aerospace sales (although falling) benefitted from a good result in defence. Underlying operating profits fell 89.6% to £56m - reflecting the group's high fixed cost base.

Recent trading has been at the higher end of management expectations across Automotive, Powder Metallurgy and Nortek.

The board will not be recommending a half year dividend.

The shares rose 8.6% in early trading.

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Our view

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

Buying GKN involved taking on considerable debts, not to mention a sizeable pension deficit. While the Melrose 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 was always going to stress the business.

So far the group's been able to boost its cash position by running down inventory and collecting extra cash from customers. That's actually seen it trim debt levels a little. But a long and sustained downturn in aerospace suggests lower profits in future years and will unfortunately lead to significant redundancies.

Redundancies mean upfront cash costs, and lower sales mean reduced cash inflows. With working capital improvements difficult to repeat indefinitely, we suspect the vast majority of available cash will be directed towards debt reduction for some years to come. In that case it will take years for the dividend to return 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.

While sales have been stronger in the last couple of months than management, or we, had expected, we worry that the road to recovery is unlikely to be smooth. Pent up demand provided a boost immediately after lockdowns ended, but a longer term economic downturn looks likely. 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 pessimistic outlook for long term demand in aerospace, which accounted for some 37% of underlying operating profits last year. Exposure to defence markets will provide some shelter for the division, but 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 at the earliest. Fewer passengers means fewer planes, and fewer planes means less demand for Melrose's products.

It's hard to overstate the hurdles ahead. However, the good news is managing industrial businesses through difficult market conditions is what the Melrose management team do best. With some financial headroom to play with, that provides some reassurance in the longer term.

Melrose key facts

  • Price/Book ratio: 0.7
  • 10 year average Price/Book ratio: 0.9
  • Prospective yield over the next 12 months: 1.8%

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 Results

Aerospace saw underlying sales fall 18% in the half to $1.6bn, with a modest £54m profit. That reflects a strong first 3 months of the year, followed by severe disruption caused by the coronavirus outbreak. The group expects full year sales to fall by 25-30%. This weakness was concentrated in the Civil Airframe and Engines businesses, with Defence continuing to grow year-on-year.

The Aerospace division is focused on cost reduction going forwards, with the aim of improving performance in 2021 without relying on a return to sales growth. The division expects a significant reduction in the worldwide workforce in the second half.

The Automotive business reported a 37% decline in sales at constant currency to £2.5bn, and an operating loss of £64m. That reflects lockdown in China, Europe and North America. However, early signs are that the recovery is coming faster than expected, with China ahead of last year and the US only modestly behind. Cost control remains a central focus.

Exposure to the automotive market meant Powder Metallurgy sales fell 32% in the half to £396m, with an operating loss of £3m. Once again cost control remains the priority, although there are some signs of improving market conditions.

Nortek sales were broadly stable year-on-year and actually rose 13% in July and August. The division reported revenues£550m and underlying operating profits of £71m. The new delivery of the new StatePoint cooling systems for data centres is on track and expected to boost the order pipeline going forwards. The division remains subject to a strategic review.

Melrose reported free cash flow in the half of £118m, or £213m excluding restructuring spend (compared to £85m and £269m respectively a year ago). That reflects a significant decline in working capital, as the group ran down inventory and reduced the amount owed by customers. The group also trimmed capital expenditure during the year.

Positive free cash flow and the cancellation of the dividend meant net debt fell £93m to £3.4bn, giving the group financial headroom of £1.2m and a further £300m of cash on hand.

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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.