RTX - Melrose - A Top-Tier Aerospace Engine Business Mitigates The Risk Of A Radical Change In Strategy

2023-08-22 18:04:54 ET

Summary

• Melrose Industries has shifted its strategy to focus on its GKN Aerospace business, spinning off all other operations and swearing off meaningful M&A in the future.
• The company's GKN Aerospace business consists of Engines and Structures, with Engines expected to contribute a significant portion of profit and free cash flow growth in the future.
• Melrose's Engines business holds impressive content across a range of programs, and 90% of civil aircraft have some Melrose/GKN Aerospace content.
• An ongoing recovery in narrowbody production, an upcoming recovery in widebody production, and future aftermarket sales can support a strong FCF outlook and a share price at least 15% higher than today's price.

Credit where due - in a world where many management teams will stubbornly stick to legacy operating philosophies and structures no matter how circumstances have changed, Melrose Industries ( MLSPF ) (MRO.L) has shown that it is absolutely willing to shift its strategy as circumstances dictate. Once basically a public-traded private equity group with a stated strategy of "Buy, Improve, Sell", Melrose has radically changed this approach, choosing instead to focus on its GKN Aerospace business, spinning off other operations as Dowlais (DWL.L) and all but swearing off meaningful M&A for the foreseeable future.

To paraphrase Mark Twain, Melrose is putting all of its eggs in a single basket (aerospace) and choosing to watch that basket very carefully. Given the quality of this business (particularly compared to the assets sent off with Dowlais), I think this is a sound strategy and I think the business is set to benefit from years of air travel growth. The shares have already done quite well over the last year and I do have some concerns that aerospace is yesterday's hot space, but the valuation doesn't look unreasonable next to management targets that I think are reasonable if not somewhat conservative.

Meet The New Melrose

As I said in the open, Melrose management has opted to depart dramatically from its former operating strategy of serial acquisition, improvement, and divestment. Management has chosen instead to focus on the growth and operational potential of its high-quality engine business and its aerospace structures business (not a bad business, but not on the same tier as the engine business).

The GKN Aerospace business consists of Engines and Structures, with the former expected to contribute about 40% of revenue in 2023, 45% in 2025, and likely more than half in 2028 and beyond (quite possibly well more than half by 2030). The Engines business manufactures components like engine casings, turbine blades, nacelles, pylons, shafts, and mounting structures for aerospace engine OEMs like General Electric (GE), Rolls-Royce (RYCEY), RTX 's ( RTX ) Pratt & Whitney, and Safran (SAFRY). So significant is Melrose in this market that about 90% of civil aircraft in operation have meaningful content onboard and about 50% of global flight hours come from two engine programs (the CFM56 and V2500) where the company has major content.

The Structures business is less dominant relative to its competitors, but the company is nevertheless a major player in components like cockpit/cabin windows, canopies, fuselage components, primary wing structures, empennage, and electrical distribution systems. I believe Melrose is a top-three player in electrical distribution, empennage, and wing structures, but not as strong in areas like windows, doors, and landing gear.

Around 70% of the company's revenue comes from civil aerospace with the remainder coming from defense, and the company has long-standing relationships with multiple defense suppliers and operators like the Swedish Air Force. As is typical with aerospace engine companies, aftermarket sales are a massive source of long-term cash flow, as companies usually accept low margins on initial sales in exchange for decades of lucrative repair and maintenance sales.

To that end, more than half of the company's revenue comes from long-term risk and revenue-sharing partnerships (or RRSPs), and 17 of the company's 19 current RRSPs are already cash-positive. Melrose also has a meaningful and growing repair business (particularly fan blade repair) that management is looking to leverage in the coming years.

The Aerospace Story Is A Familiar, And Fairly Simple, One

I've talked about my basic views on the aerospace sector in articles on companies like Curtiss-Wright (CW), Hexcel (HXL), and Woodward ( WWD ) over the last year, but I'll summarize the major gist here. I'm expecting suppliers to continue to benefit from recovering narrowbody jet production for several more years, with widebody production also starting to contribute more meaningfully in 2024 and beyond. Longer term, I look for continued to grow in air travel (particularly in Asia), as well as technology-driven value-added opportunities in areas like fuel efficiency and emissions.

In the Engines business, major programs like the A320neo and 737 Max should provide years of new-build opportunity followed by decades of maintenance and repair aftermarket revenue opportunities. Beyond that, Melrose is already working closely with RTX and CFM (a partnership between GE and Safran) on their next-generation engine platforms, which should launch in the early-to-mid 2030s if timelines stay on schedule. The more important takeaway here is that there is no evidence that Melrose's Engines business is losing share or market position to other suppliers and the company will have decades of future revenue, profits, and cash flow to look forward to from engines produced and sold from 2023 through 2030 and beyond.

I'd also note longer-term opportunities from the company's additive fabrication capabilities. Melrose has been working on these capabilities for a long time and is now launching products that combine welding and additive manufacturing in unique ways to produce components that are lighter and more cost-effective; a new fan case mount ring for the A220 has launched in 2023 that reduces titanium scrap by 70%.

The Structures business is less dynamic and honestly less exciting. The company does have JVs with COMAC and AVIC that give it some interesting additional leverage to the Asian aerospace market, and there are still opportunities here to benefit from operational improvement (site consolidation, automation, improved manufacturing flow) and volume leverage. There are some technology-driven opportunities in areas like wing structures, but this isn't the exciting part of the business.

The Outlook

Management has set out some impressive targets for the new Melrose.

Management has guided to GBP 3.4B in revenue for 2023 and GBP 4.0B in 2025 and this management team has a generally good track record of under-promising relative to what it can actually accomplish. Given my expectations for aircraft build-rates over the next decade, I'm expecting better than 7% long-term revenue growth here, and there could be upside if opportunities like the repair business exceed my expectations.

More impressive still is the leverage potential. Management is looking for adjusted operating income and adjusted EBITDA to grow from GBP 350M and GBP 505M in 2023, respectively (implying margins of 10.3% and 14.9%), to GBP 700M and GBP 870M in 2025 (margins of 17.5% and 21.8%).

The Engines business will drive much of this (with margins forecast to improve from 22% to 28%), with much of that coming simply from increased volumes as build-rates improve, but some also coming from self-improvement (including improved production flow, strategic insourcing, and automation). Still, Structures is expected to improve from 3% adjusted operating margins in 2023 to 9% in 2025. Beyond that, management believes that GBP 1B in EBITDA is achievable "in the next few years", with long-term free cash flow margins in the high-teens to possibly over 20%.

With the cash flow those estimates will generate, management believes they can buy back 5% to 10% of the company's market cap each year as well as increase the dividend. In a marked shift from the past, M&A is NOT on the docket - management stated definitively that the era of serial M&A under the "Buy, Improve, Sell" strategy is "permanently over". What's more, the company isn't all that interested in aerospace M&A either - namely because they don't want to dilute the impact of the exceptionally lucrative engines business and there's not much out there that would be additive.

I can't really disagree with that view. I could make an argument that the company could use its previously successful Buy, Improve, Sell strategy to acquire a company like Hexcel and generate good returns from it, but I can't say that would be a better use of capital than just running the Engines business at peak efficiency and returning that capital to shareholders. Maybe the opportunity to do a select strategic tuck-in will emerge along the way, but I don't expect anything big.

The Bottom Line

There are still some threats and risks to consider. While 2023 is off to a better start than management expected (the company's May trading update said sales and margins were "well ahead" of expectations for the first four months of the year), there are still ongoing challenges with sourcing castings, forgings, and certain components like connectors (arguably good for companies like Eaton (ETN)). Moreover, with the Chinese economy looking shaky, the recovery path for commercial aerospace may not be as smooth as everyone hopes.

Net-net, though, I come away from Melrose seeing more value than I expected to find. If the company can leverage its strong position in aerospace engines to drive around 7% long-term revenue growth and low-to-mid-teens FCF margins, I believe the shares are priced for a long-term annualized total return in the double-digits, and I likewise see 15% to 25% upside over the next 12 months on approaches like margin/return-driven EV/EBITDA.

I do have some concerns that the aerospace recovery theme is yesterday's news and that investors will look to lock in good profits from existing positions in Melrose, but it's hard for me to argue with the revenue and margin potential of this newly-restructured business and the value that years of improving free cash flow can produce for shareholders.

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