MLSPF - Melrose Performing Well As Margins Improve And Long-Cycle Projects Mature

2023-12-28 15:47:22 ET

Summary

• Melrose has continued to leverage a strong commercial aerospace cycle, with high-teens revenue growth and significant operating margin improvement through October of this year.
• RTX's issue with GTF engines will have a modest, and easily manageable, negative impact on Melrose.
• Strong growth in new aircraft production from 2022-2026 will drive exceptionally high-margin aftermarket revenue in future years, driving Engines margins above 30%.
• The company's strong financial performance, expanded partnerships, and positive outlook make it undervalued and poised for a total annualized return of over 10%.

Expectations were pretty robust for the aerospace industry in 2023, and orders have in fact come through, with 2023 industry-wide orders matching 2022 levels by the end of September. There have been some new challenges of late, including a product manufacturing issue at RTX ( RTX ) and a little weakness in global flight demand, but the overall outlook for the aerospace industry remains strong for at least the next three years.

All of that is good news for Melrose ( MLSPF ) (MRO.L) given its leverage to aircraft engines and global air traffic, as well as the maturation of multiyear supply agreements that are transitioning from less profitable launch phases and into much more lucrative aftermarket phases. On top of this, strong execution is helping drive ahead-of-schedule operating margin improvement, while the company's strong internal R&D and manufacturing capabilities are driving expanded commercial opportunities.

Up about 16% since my last update , Melrose has done well compared to many other aerospace peers, including General Electric ( GE ), MTU Aero Engines ( MTUAF ) ( MTUAY ) (MTX.DE), RTX, and Safran ( SAFRY ). With high single-digit long-term revenue growth potential and fast-improving margins, I believe Melrose is still undervalued and priced for a long-term total annualized return in excess of 10%.

Hurdling Higher Bars

Melrose's financial performance since my last article has been more than satisfactory, with a good mid-year update in September and a strong update on second-half results in mid-November.

First-half revenue rose 19% in constant currency, with balanced contributions between Engines (up 18%) and Structures (up 19%). Engine revenue was boosted by strong growth in the aftermarket business (up 46%), while Structures growth was driven by 24% growth in the civil aviation side of the business.

Adjusted operating income rose more than 160%, with Engines profits nearly doubling (up 94%) on strong growth in lucrative aftermarket revenue. While the Structures business isn't, and never will be, as profitable as Engines, the company did reverse a year-ago loss to a 2.5% margin in the first half of 2023.

November's update on the July-October period saw these trends continue.

Overall revenue rose 18% for that four-month period, with Engines revenue up 18% (Aftermarket up 24%) and Structures up 17%. Engines operating margin was "comfortably in excess" of 25% versus 23.5% in the first half of 2023, while Structures margin improved further to 4%.

With this strong performance, management raised guidance for 2023 and established a strong initial guide for FY'24 of GBP 3.5B to GBP 3.7B for revenue and 14%-plus for operating margin.

The GTF Issue Is Easily Manageable For Melrose

Earlier this year, RTX announced that they had discovered certain anomalies in high-pressure turbine disks for Pratt & Whitney GTF engines (the PW1100G engines) related to issues with powdered metals that RTX sourced internally from its HMI Metals division. This engine powers the Airbus ( EADSY ) A320neo plane, and over 600 engines will require off-wing remediation in workshops.

RTX initially estimated a $3.0B to $3.5B impact for its 51% share of the program, with Melrose management disclosing a proportionate potential impact of $240M to $280M (based on Melrose's 4% share in the GTF risk and revenue sharing partnership (or RRSP)). Importantly, these costs will be experienced over a somewhat extended time out through 2025.

Since then, RTX has disclosed additional issues involving rotors, hubs, and air seals, but I have not yet seen updated estimates of potential remediation costs.

With a 4% participation in the RRSP, this is unlikely to become all that material for Melrose, and it's certainly important to remember that none of the cited flaws are related to Melrose's components. Moreover, there could be some positive longer-term impacts for the company - with these latest issues with the GTF engine (a program that has had several other challenges), it seems plausible that operators could look to extend the life of legacy engines, leading to more life-extending shop visits and increased demand for aftermarket parts and services that are quite lucrative for Melrose.

The Cycle Is Still Healthy, And Opportunities Are Expanding

New aircraft orders will slow at some point, but for now, I believe the aerospace cycle is still a positive driver for Melrose. Year-to-date orders (through November) were up 47% at Airbus and 63% at Boeing ( BA ). Better still, high-value (to Melrose) widebody programs have been even stronger, with A350 orders of 159 versus 38 at this point in 2022 and 113 in 2019, and 787 orders of 284 versus 38 and 107, respectively. At this point, widebody production schedules are fully supported into 2026 and orders are still coming in.

Looking at near-term demand, air travel has continued to recover toward pre-COVID levels, but it would appear as though there has been some slowdown of late. November flight cycles were down 5% versus the same period in 2019, a modest deterioration from the down 3% level in August. Given a more challenging near-term economic outlook, I do see some modest risk to air travel demand (and thus aftermarket demand), but I don't think it's an especially material risk at this point.

Not only is Melrose executing well today and looking forward to significant leverage as new planes and engines built in 2022-2025 transition to aftermarket demand, but the company is also expanding its business relationships.

In early November of this year, the company announced an expanded partnership with GE for its GEnx, CF6, and GE90 engines (used primarily on the Boeing 777 and 787 and the Airbus A330), including 100% of GEnx, CF6, and GE90 fan cases and 50% of GE9x fan case assemblies. The deal also included expanded participation in GEnx RRSPs, which will mean increased aftermarket revenue down the line.

Melrose's management estimated a GBP 5B revenue impact over 30 years, but I think the value of the deal goes well beyond just the top-line impact. First, the expanded aftermarket opportunity will only help accelerate the margin improvement story here - a story that is driven in no small part by the transition from relatively low-margin launch/OEM business to high-margin aftermarket business that will extend well past the 2030s. Second, this deal was driven at least in part by GE's appreciation of Melrose's additive manufacturing capabilities and as additive manufacturing becomes more common in aerospace, I believe Melrose is well-placed to leverage years of investment and R&D in these capabilities.

The Outlook

Between a mid-October investor event focused on the Engines business and the November business update, it is clear that the company's operating margin improvement plan is ahead of schedule. Management is expecting the Engines business to reach operating margins in the high-20%s in 2025 and then exceed 30% after 2025, and it's worth noting that this is based in large part on the maturation of existing business (engines moving in their aftermarket phase) more so than winning new business.

With that, I do think there's at least a chance of consolidated adjusted operating margin hitting 15% in FY'24 and then moving to around 17% in FY'25. Likewise, I believe a 20%-plus EBITDA margin in FY'25 is quite likely.

I'm expecting long-term revenue growth in the 7% to 8% range as the company continues to benefit from its status as a partner-of-choice for larger engine manufacturers and as more customers turn to the benefits of additive manufacturing (including reduced weight and scrap cost). I do expect this aerospace order cycle to eventually come to an end, but efforts to create engines with improved fuel efficiency and emissions profiles could extend the OE phase. It's also well worth remembering that the engines built in this cycle create something like an annuity for Melrose as they transition to the maintenance/overhaul phase, and Melrose is continuing to build its repair business in regions like Asia.

Considering all of the above, I expect free cash flow margins to improve significantly in the coming years, with double-digit margins in around three years and potential into the high-teens. I don't expect the company to divert much of that cash flow to M&A (a select small tuck-in here or there, maybe, but nothing big), and I'd note that the company is already underway with a meaningful (GBP 500M) buyback program.

Between discounted cash flow and an EV/EBITDA approach (using a 13.5x forward multiple), I believe the shares are at least 10% undervalued now and likely to generate a long-term annualized total return in excess of 10%.

The Bottom Line

The biggest risk I see for Melrose shares is the "what have you done for me lately?" nature of institutional investors. The aerospace cycle is already well understood, and I believe the company's leverage to future high-margin aftermarket business is likewise no secret.

I do think there are opportunities to outperform on margin improvement and to win more expanded business agreements (like the GE announcement). Moreover, the market loves margin improvement stories, and Melrose is well-placed to deliver. I can't say it's a screaming buy at this point, but investors who still want exposure to aerospace could certainly do worse than Melrose.

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