Melrose’s underlying revenue rose 6% to £1.7bn in the first half. The Engines division grew at the fastest pace, up 11%, driven by strong aftermarket demand. Structures revenue grew 3%.
Underlying operating profit rose 29% to £310mn (£299mn expected), largely driven by sales growth and operational improvements, which saw the associated margin climb from 14.2% to 18.0%.
Underlying free cash outflows improved from £145mn to £54mn, helped by the increased profits and lower restructuring costs. Net debt increased from £1.3bn to £1.4bn.
Full-year guidance has been downgraded, with revenue now expected to land between £3.4-3.8bn (previously: £3.6-3.7bn). Underlying operating profit guidance is now £650-690mn (previously: £620-650mn), excluding around £30mn of corporate costs. This guidance excludes any impact from tariffs.
An interim dividend of 2.4p per share has been announced, up 20%. £91mn of current £250mn buyback has been completed.
The shares rose 6.8% in early trading.
Our view
Melrose had a mixed first half, with lacklustre revenue growth in its Structures business and another set of guidance downgrades. But an impressive performance from its Engines division was enough to distract markets, and the shares moved higher on the day.
Melrose is a pure-play, aerospace business. Its Structures division, which deals with building the body and wings of planes, took some shine off performance as some customers ran down their inventories. The ongoing restructuring programme, contract re-pricings, and new commercial agreements should help, and mean there’s room for 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 are being blamed for a downgrade to full-year guidance. And with supply chain issues likely to remain a challenge for the industry, we can’t rule out further setbacks.
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 nearly three years it’s operated as a standalone company. 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
All ratios are sourced from LSEG Datastream, based on previous day’s closing values. 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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