Morning Note: Market news and an update on aerospace company Melrose
Market News
Gold continued its recent upward march to $2,155 an ounce, scaling its highest levels on record as the dollar and Treasury yields weakened on hopes that the US Federal Reserve will start cutting interest rates soon amid growing economic gloom. The Beige Book Survey said the economy expanded slightly since the beginning of the year, while consumers showed more sensitivity to rising prices. US equity markets rose – S&P 500 (+0.5%), Nasdaq (+0.6%) – and the 10-year Treasury currently yields 4.11%
This morning in Asia, markets were generally lower: Nikkei 225 (-1.2); Hang Seng (-1.3%); Shanghai Composite (-0.4%). The yen climbed to a one-month high on speculation the BOJ will raise rates in March. Driving market chatter today: the acceleration in wage growth and remarks by board member Junko Nakagawa on Japan’s economy steadily making progress toward the BOJ’s 2% price target. Several government officials were also said to support a hike in the near term.
Sterling trades at $1.2740 and €1.1695, while the FTSE 100 is currently trading 0.3% lower at 7,658. Companies trading ex-dividend include HSBC (3.97%), Rio Tinto (4.02%), Standard Chartered (2.43%), and Berkeley Group (0.72%). Nationwide offered to buy Virgin Money for 218p a share and a proposed dividend of 2p, valuing the company at £2.9bn. Virgin is trading up 35% this morning.
Source: Bloomberg
Company News
Melrose has this morning released its 2023 results which were better than forecast. Guidance for 2024 was raised by 6% and the group highlighted that positive earnings momentum means the 2025 targets are ‘derisked’. The shares have been a strong performer, but despite the strong read-out, they have seen some profit taking 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 (and more than 70% as sole supplier). 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 strong 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). These targets are increasingly underpinned by the Engines outlook and mix, Civil ramp up, Defence portfolio improvements, and ongoing business improvements throughout the group.
By 2025, Engines is forecast to contribute over 70% of Melrose profit with over 85% of this being from the accretive and structurally growing aftermarket. The business has OEM-level capability and responsibility for selected engines which gives more technical and commercial advantages than normal for a Tier 1 supplier. Engines is a leading independent Tier 1 partner to all major engine OEMs with its lucrative and diverse Revenue and Risk Sharing Partnerships (RRSP) portfolio providing balance and resulting opportunities. Following the recent GE contract, future RRSP net cash inflow has grown by 10% to £22bn. Almost 50% of the Melrose engine fleet is aged between 6 and 15 years, the age range estimated to be the peak period of aftermarket demand.
In 2023, revenue was up 17% to £3.35bn, in the middle of the guidance range, and by 13% 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. Significant delivery of restructuring and repricing actions has been ahead of plan. Good operational progress was achieved with a 23% improvement in the cost of poor quality and a £40m reduction in arrears.
As a result, the adjusted operating margin increased from 6.3% to 12.5%, and was above the 12% guidance. Operating profit (pre-PLC costs) more than doubled to £420m. This was above the guidance range of £400m-£410m, which itself was raised twice during the year, and the consensus forecast of £407m. EPS rose from 4.1p to 18.7p, well ahead of the consensus of 17.4p, while a full-year dividend of 5p has been declared.
In Engines, revenue grew by 16% to £1.19bn, while margins rose from 15.7% to 26%, versus guidance of 25%. This strong performance was driven by good aftermarket trading, up 34%, and despite ongoing supply challenges. Growth was supported by strong end markets with increasing flying hours leading to an acceleration in shop visits and spare parts demand. The business is entering the lucrative aftermarket 'sweet spot' supporting an above market performance. OE revenue grew 3%, constrained by ongoing industry supply chain issues.
In Structures, revenue grew by 18% to £2.16bn, with the margin rising from 1.3% to 5.1%, versus guidance of 4%. The ramp-up in Civil OEM shipments resulted in 28% growth. Defence repricing and portfolio work progressed well with 42% of core work now sustainably priced. The group is increasingly confident of achieving the target of 85% of the portfolio being sustainably priced by 2025. The group made significant progress on restructuring and portfolio rationalisation with two non-core plants closed in 2023 and further exits underway. Overall, the division has positive momentum and is improving the quality of its earnings.
Melrose has a 4% programme share on the GTF PW1100G variant impacted by a rare condition in powder metal used to manufacture certain engine parts. The full potential cash impact to Melrose spread over the period to 2026 could be in the range of c.£200m if it was assumed that this is all a programme cost. However, Melrose has also highlighted that two ongoing industry consequences of the issue are likely, namely generally higher aftermarket pricing in a supply constrained industry and legacy engines potentially flying for longer – both will be beneficial to the company.
Melrose has a strong balance sheet with free cash flow ramping up sharply. End 2023 leverage was only 1.1x net debt to EBITDA, better than the 1.3x guidance, despite a share buyback cost of £93m. Financial strength is expected to drive attractive shareholder returns through a progressive dividend and 5%-10% buybacks p.a. as the spending on restructuring comes to an end. Because of higher confidence and strong operational progress, the company commenced a £500m share buyback programme (6% the market cap.) at the beginning of October to run for 12 months. There is potential for a sizeable cash return every year until the end of the decade. The company has reiterated that no material acquisitions will be made in the near term.
The group has raised its guidance for 2024 and is confident about unlocking significant further potential of the business going forward. Revenue is now expected to be between £3.6bn-£3.75bn (versus £3.5bn-£3.7bn previously), with growth tempered by headwinds from industry-wide supply chain issues, short-term destocking due to the phasing of commercial aircraft build rates, and the impact of planned exits and disposals in the Structures division.
Adjusted operating profit is now expected to be £550m-£570m, 6% above prior guidance, driven by ongoing operating margin improvement. The Engines margin is expected to reach 28% in 2024 (one year early) and is on track to exceed 30% post 2025, driven by strong aftermarket demand. Structures is targetting a margin of 9%. Overall, positive earnings momentum means the 2025 targets are ‘derisked’, with a target adjusted operating profit of £700m as the benefits of market growth and the full impact of the improvement plans flow through.
As expected, cash generation will be limited by ongoing restructuring in 2024 and previously announced GTF issues (see above). Increasing free cash flow is expected in 2025 and beyond, driven by RRSPs.
Given the evolution of Melrose from the 'Buy, Improve, Sell' model into a focused aerospace business, there have been several senior management changes, with its CEO and Finance Director standing down, and replaced by strong internal appointments, providing essential operating continuity.
Source: Bloomberg