Melrose reported revenue growth of 14% over the four months to 31 October.
Revenue growth was driven by its Engines division, which saw a 28% uplift due to strong demand for equipment sales and aftermarket services. Structures revenue grew by 5%, with performance improving since the half-year mark, helped by strong Defence demand.
Underlying operating profit was “significantly higher” than the prior year, and in line with group expectations.
Full-year guidance has been reiterated, pointing to revenue and underlying operating profit of £3.5bn and £635mn at the midpoints of its target range. Free cash flow is expected to exceed £100mn.
The shares were broadly flat in early trading.
Our view
Melrose’s performance has picked up since the half-year mark, with trade agreements removing some tariff-related uncertainty. Its Engines segment continues to be the key driver of performance, and with a strong demand outlook, full-year guidance looks well within reach.
Melrose is a pure-play, aerospace business. Its Structures division, which deals with building the body and wings of planes, has seen performance improve recently thanks to growing demand on the Defence side. The ongoing restructuring programme, contract re-pricings, and new commercial agreements mean there’s room for more improvement in the near-to-medium term.
Truth be told, we view Structures as one of the least attractive areas of commercial aerospace. It tends to have generally weak pricing power, and the supply chains involved in building these structures can make for a logistical nightmare, often leading to production delays.
We wouldn’t be opposed to Melrose offloading this part of the business, but there doesn’t seem to be too many potential buyers knocking about at this stage. In the meantime, it’s likely to keep weighing on group growth.
The Engines business is the better asset. It has Risk and Revenue Sharing Partnerships (RRSPs) with engine makers - 17 out of 19 of which are in the cash-generation phase. The RRSPs require Melrose to contribute an agreed percentage of the total annual engine costs, and in exchange, it receives the same percentage of total annual engine revenue. Considering the long lifetime of an engine model (typically 30+ years), it means Melrose can continue to benefit from ongoing cash flows for decades after engine delivery.
Profitability in the Engines division continues to impress. Operating margins are moving higher, and further improvements are expected. While this sounds attractive, it relies on trimming fixed costs, improving productivity, and resolving issues with unprofitable contracts. By no means a straightforward set of tasks.
Some issues are also outside of Melrose’s control. Unfavourable exchange rates were blamed for a downgrade to full-year guidance back in August. And with supply chain issues likely to remain a challenge for the industry, we can’t rule out further setbacks in the future.
Melrose’s looks attractive based on traditional valuation metrics. But remember, ‘cash is king’ and Melrose has been unable to produce positive free cash flows in the last three years it’s operated as a standalone company. That’s set to change this year, but until it develops a track record of delivering, we think other names in the sector look better placed to benefit from industry-wide tailwinds.
Environmental, social and governance (ESG) risk
The aerospace and defence sector is high-risk in terms of ESG. Product governance and business ethics are key risk drivers. Carbon emissions from products and services, data privacy and security and labour relations are also contributors to ESG risk.
According to Sustainalytics, Melrose’s management of ESG risk is strong.
It has board-level oversight of ESG issues and a very strong environmental policy. A part of executive remuneration is explicitly linked to sustainability performance targets, and there is a robust whistleblower policy in place. However, business is cyclical, depending highly on economic changes, which can lead to periodic layoffs.
Melrose key facts
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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by LSEG. 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.
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