Market news and another strong set of results from Melrose.

Market News

A stronger-than-expected US ISM report raised concern about more Fed tightening – the 10-year Treasury yield moved up to 4.28% – and pushed equity markets lower last night in the US – S&P 500 (-0.7%); Nasdaq (-1.1%) – and in Asia this morning: Nikkei 225 (-0.8%); Hang Seng (-1.4%); Shanghai Composite (-1.1%). The FTSE 100 is currently trading 0.5% lower at 7,390.

Some believe another Fed hike would be “dangerous” for US consumers if the central bank tightens at a time when inflation is already slowing, JPMorgan’s David Kelly warned. That’s supported by an analysis by two Chicago Fed economists, who said the 5.25 percentage points of rate hikes over the past 18 months may be enough to tame inflation by mid-2024 and avoid a recession.

The usage of the Fed’s overnight reverse repo facility edged back from the lowest level in more than a year yesterday amid signs that demand for Treasury bills was waning. Higher bill issuance is going to continue to test the market’s appetite for the shortest dated Treasuries, BMO said.

The yen steadied, with NAB forecasting Japan wouldn’t intervene until the currency approached 150 against the dollar. Sterling trades at $1.2474 and €1.1644. Brent Crude remained well supported at $90.40 a barrel, while gold drifted to $1,918 an ounce.

China’s export slump eased somewhat in August, adding to early signals the worst may be over for some parts of the economy. Overseas shipments fell 8.8% in dollar terms from a year earlier, while imports contracted 7.3%, both better than estimates. That left a trade surplus of $68bn.

German industrial production dropped 2.1% year on year in July, in line with expectations. Bloomberg Economics said the dip implies a notable drag on third-quarter economic activity.

Source: Bloomberg

Company News

Melrose has this morning released first-half results, which were better than expected, and raised its full-year profit guidance. The company has also announced it will commence its share buyback programme earlier than planned and that its well-regarded CEO is to leave in March 2024. In response, the shares have been marked up by 8% in early trading.

Melrose is a tier one aerospace technology supplier with established positions on all the world’s high-volume aircraft. Its products are on-board c.90% of civil aircraft on the market today (wide and narrow body) and the company generates 95% of its revenue from industry-leading positions. Revenue is split 70% civil, 30% defence, and is generated from two divisions: Engines and Structures.

R&D excellence and long-standing relationships create high barriers to entry and mean the company is well positioned for the next generation of technology, particularly that enabling zero emission flight – additive manufacturing, composite structures, and electric and hydrogen propulsion.

The civil industry is enjoying a rapid market recovery from the Covid-19 lows and is expected to enjoy long-term structural growth as airlines upgrade their ageing fleets after years of underinvestment. Defence is also growing given the escalation of geopolitical tension as NATO countries work to meet commitments to spend 2% of GDP.

A strong management team has an excellent long-term track record of delivery. For 2025, the company is targetting revenue of £4.0bn (CAGR of 11% between 2023 and 2025) and an operating margin of 17%-18% (i.e., operating profit CAGR of 41% between 2023 and 2025). Growth will be driven by structural market growth, aftermarket contribution from engines, and further business improvements.

In the first half of 2023, revenue was up 19% to £1,633m and by 15% including businesses being exited. Inflationary pressure and global supply chains continue to provide some challenges which are expected to continue into 2024, but the business continues to manage these and has been able to fully offset all additional costs. As a result, the adjusted operating margin has increased substantially to 10.7%, up 5.8 percentage points on the prior year and 3.2 percentage points on the second half of 2022. Restructuring projects are proceeding to plan and should be largely complete in the next six months. The repricing is progressing well combined with improved quality and arrears reduction. Adjusted operating profit rose by more than 2.5x to £175m (or £159m including central costs).

By division, Engines generated revenue growth of 19%, with adjusted operating profit nearly doubling and adjusted operating margin up to 24.5%. Aftermarket growth of 46% was driven by recovering flying hours and the group entering the lucrative aftermarket 'sweet spot' allowing an above market performance.

Structures revenue grew by 18% (or 13% including businesses being exited), with adjusted operating margin reaching 2.5% in the first half versus loss-making in the first half of 2022. The ramp-up of the civil business generated 24% growth. Defence repricing and portfolio work accelerated with around 25% of the renegotiations planned by 2025 being successfully concluded in the last few months.

The group has a strong balance sheet, with net debt falling to £553m, in line with expectations, and leverage to 1.5x net debt to EBITDA. The target is to reduce leverage to 1.0x by the end of 2023. The group has previous said free cash flow is expected to increase by 7x between 2023 and 2025, including requirements to fund growth and complete the restructuring. This is expected to drive attractive shareholder returns through a progressive dividend – and interim payment of 1.5p has been declared this morning – and 5%-10% buybacks p.a. as the spending on restructuring comes to an end. However, because of higher confidence and strong progress, the company is commencing early its share buyback programme, at the beginning of October 2023, starting with a £500m programme over the following 12 months. This equates to 7x the current market cap., and leaves the group well placed to continue thereafter keeping leverage comfortably within previous guidance of 1x gearing.

The group has upgraded its full-year guidance for adjusted operating profit by 8% to between £375m and £385m with a higher Engines margin than previously guided. PLC costs are still expected to reduce to £30m. Revenue is still expected to be between £3.35bn and £3.45bn. The company has not adjusted its 2025 guidance, but this clearly underpins the achievement of those targets. A new Engines margin – above 30% post 2025 – compares to the 2025 target of 28%.

The company has also announced several senior management changes, with its CEO and Finance Director both standing down in March 2024. Both will be replaced by internal appointments, providing essential operating continuity. The news doesn’t come as a surprise given the group’s move away from its old ‘Buy, Improve, Sell’ strategy to one focused purely on aerospace.

Overall, this is yet another positive update and once again highlights the strong operational credentials of the management team.

Source: Bloomberg