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Melrose - demerger completes

Melrose has completed the demerger of its Automotive, Powder Metallurgy and Hydrogen Businesses into a new company called Dowlais.

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Melrose has completed the demerger of its Automotive, Powder Metallurgy and Hydrogen Businesses into a new company called Dowlais.

Just prior to the demerger, Melrose undertook a three for one consolidation of existing shares. This was to ensure that no outstanding fractional amount new Melrose shares were left over after the demerger.

Dowlais has become a separate, publicly listed company. For every post-consolidation Melrose share owned, shareholders will receive one Dowlais share.

Melrose's focus will now be on the continued development of the Aerospace business which Melrose CEO, Simon Peckham, believes has "the opportunity to clearly establish itself as a leading focussed aerospace business" over the next few years.

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Our view

The completion of the Dowlais demerger marks the start of a new chapter for Melrose. The two businesses have become separate, publicly listed companies. Melrose has retained ownership of its Aerospace business, and shareholders now have shares in both companies.

Investors holding Dowlais shares will undoubtedly be curious about the outlook. We think the Automotive and Powder Metallurgy businesses have market-leading positions, alongside a now leaner cost base. There are also structural growth drivers to consider, such as legislation and the electric vehicle transition, which Dowlais looks to benefit from. With pre-demerger underlying revenue of £5.2bn and operating profit of around £332m, the current valuation of around £1.7bn doesn't look too demanding to us.

The separation means Melrose is now purely an aerospace play - giving it the potential to attract a valuation reflective of a high-quality aerospace business in an improving market backdrop.

In 2022, full-year underlying revenue rose 16.3% to £3.0bn, thanks to a recovery in air travel. Flying hours in the US and Europe have returned to pre-pandemic levels, and the easing of restrictions in China also provides the industry with a welcomed boost.

The group's Engines segment has multiple Revenue and Risk Sharing Partnerships (RRSPs) with engine makers - 17 out of 19 of which are now 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, it means Melrose continues to benefit from ongoing cash flows for decades after engine delivery.

Airlines are now looking to upgrade their aging fleets after several years of covid-related underinvestment. That's resulted in an order backlog of more than 12,000 aircraft, meaning we see potential for revenue to continue growing at double-digit rates for the next couple years.

Underlying operating profit soared 51% to £186m last year, while the margin also improved from 4.4% to 6.3%. Management's already set itself the ambitious target of getting this margin above 14%, which if achieved, is expected to approximately treble last year's profit. While this sounds attractive, it relies on trimming fixed costs by reducing headcount and global footprint, as well as resolving issues with unprofitable contracts. By no means a straightforward set of tasks.

Then there's the bigger picture. While there's been a steady uptick in air travel over the past couple years, the potential for a recession hangs heavy over the market. Historically, aerospace has not been a particularly great place to hide when the economy enters a down cycle. And while supply chain disruptions have moderated, they're likely to remain a thorn in the side throughout this year.

Since the demerger, the historic price/earnings ratio is no longer reflective of Melrose's current operations. The new, streamlined Melrose trades at 13.6 times expected earnings, which is towards the lower end when compared to peers. There's room for upside, with an improving market backdrop and a management team that's now able to focus solely on one division, rather than juggling several. But bear in mind, there's still plenty of operational challenges for Melrose to navigate, so potential investors should be prepared for volatility.

Melrose key facts

All ratios are sourced from Refinitiv. 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.

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 Refinitiv. 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 disclosure for more information.

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Written by
Aarin Chiekrie
Aarin Chiekrie
Equity Analyst

Aarin is a member of the Equity Research team. Alongside our other analysts, he provides regular research and analysis on individual companies and wider sectors. Having a keen interest in global economics, he knows how macro-events can impact individual companies.

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Article history
Published: 21st April 2023