Breaking down the Melrose founders’ final huge rating | Invesloan.com

Melrose Industries is known as a wealth-creation machine. So when the engineering company’s co-founders exited this year with the lion’s share of a £330mn payout, complaints were muted. But how much of it was earned?

Simon Peckham and Christopher Miller stepped down from the Melrose board in March alongside long-standing finance director Geoff Martin. The men had spent the previous two decades transforming an Aim-quoted cash shell into a FTSE 100 constituent. Their reputations as turnaround specialists came from five major acquisitions, culminating in a £8.1bn hostile takeover of GKN in 2018.

Management took its rewards along the way, including a controversial £167mn long-term incentive plan (LTIP) bonus in 2017, but so did shareholders. Between 2004 and 2017, the stock delivered a near 3,000 per cent total return — adding more than £4bn in market value. Melrose is often held up as an example of how to make private equity-style returns work in public markets.

But while the long-run performance means Melrose can rely on steadfast support from sections of its investor base, the value creation story appears to have weakened. Share price performance since the GKN deal is no better than the market average. Cash flow has been boosted by selling invoices, which some in the industry call financial engineering and the outsized awards handed to its founders came after moving the goalposts.

Unexpected turbulence

To buy an aerospace engineer two years before a global pandemic halted air travel might be seen as bad luck.

That’s how it was presented to investors. The 2017 LTIP Melrose put in place before launching the GKN takeover had a maturity date of May 31, 2020, when peak Covid fear had halved the stock. It expired worthless. Melrose’s 2020 annual report discusses at length how the incentive plan was “on track to generate a reward before the impact of Covid-19”, and how misfortune meant its management was among the lowest paid in the FTSE.

Any sympathy might be undercut by the fact that, even before Covid, Melrose was failing to hit performance targets. The 2019 annual report puts year-end value on the LTIP of zero. To reach the minimum payout threshold the board had to add another £381mn in market value and even then the awards were “unlikely to be significant”, it said.

Nevertheless, the hard-luck story helped convince Melrose shareholders to approve a new LTIP on similar terms in January 2021. The follow-on scheme was backdated to a starting point of May 2020 and kept the same threshold. That required the company to increase its “initial invested capital” — effectively market capitalisation adjusted for corporate actions — by 7.5 per cent over the span of the LTIP before it started to pay out.

Melrose also added a ratchet mechanism to account for “an earlier-than-expected aerospace market recovery, which means that executive directors will not be rewarded for windfall gains”.

By Melrose’s measure, its invested capital value over the following four years rose from around £3.5bn to £8bn. “The aerospace business has benefited most significantly from the self-help improvement action driven by Melrose and this is what ultimately led to the £4bn of value created for shareholders,” the company told FTAV.

But estimating the actual value Melrose has created for shareholders is complicated by the spin-off of GKN’s auto-parts division, Dowlais, in April 2023 and the return to shareholders of a £1.2bn special dividend and buybacks in the previous two years.

Alongside the auto-parts demerger, Melrose pushed back the maturity date on the 2020 share scheme by 12 months to May 2024. Estimates given in the annual reports show the LTIP had been underwater at the end of 2022 but had moved into profit by the end of 2023.

Had the scheme vested in May 2023 as originally planned it would have had a gross value of less than £60mn, according to FTAV calculations, rather than the £330mn jackpot it delivered a year later.

A late rally was enough to prove the strategy and earn the maximum payout, even though value creation in the five years since the completion of the GKN deal in March 2018 has been negligible:

Measured by share price alone, Melrose’s recovery from Covid lows was no more rapid than industry peers and its performance since has been lacklustre. It’s the worst performer in the large-cap European aerospace and defence sector and has only just kept pace with the FTSE 100 over the period:

What about the ratchet mechanism? How tough was it really?

Melrose directors had promised not to make windfall gains from a post-Covid aerospace market recovery alone. The method used was to increase the LTIP’s starting point valuation, so they had a higher hurdle to clear before reaching payout threshold.

Here’s an illustration of how the scheme worked. Click on each bar for a fuller description:

And here’s the formula used for calculating the aerospace adjustment:

It looks complicated but is fairly simple to apply. The initial capital level would rise if aerospace sales (“2022AS”) returned to 85 per cent of the 2019 level by 2022. “M” is the net margin, “PE” is the price-to earnings ratio and “GTR” is the effective group tax rate. The idea was to put an estimated market value on sales that were returning.

But, thanks to the “multiply by 0.5” sum that’s tagged on to the end of the formula, only half this market value metric carries through to the LTIP’s starting point. Melrose said at the time that its board “considers that adjusting for only half of the sales improvement is appropriate as management should have an incentive to improve sales”.

As a result, the size of the aerospace adjustment was not commensurate to sales growth. The LTIP was all-but-guaranteed to be in the money long before the stock had reclaimed its pre-pandemic valuation.

As the chart below shows, if aerospace sales had recovered in full by 2022 it would have increased invested capital measure by just 6 per cent. A 10 per cent sales improvement beyond the full recovery base adds 10 per cent to the LTIP’s starting point, a 20 per cent improvement adds 14 per cent, a 30 per cent improvement adds 17 per cent, and so on.

To put it another way, Melrose had a market value of £11.5bn immediately before the pandemic. The incentive package agreed in early 2021 used a starting market value of £7.13bn (per the 2023 Dowlais shareholder circular) but in the event of sales recovering in full by end-2022 this hurdle increased to just £7.55bn.

The effect is to create an approximately £4bn gap between the stock’s pre-Covid valuation and where management’s LTIP would be in the money. It’s a bit like a hedge fund manager claiming performance fees when their fund is 35 per cent below the high-water mark. But since shareholders voted to approve the LTIP, they only have themselves to blame.

Shareholders also agreed to a lower annual adjustment on top of the changes related to sales performance. In its 2019 annual report, Melrose proposed adding 6 per cent per year to the initial invested capital value, matching the previous scheme, then in 2021 cut the charge to 5 per cent “in light of likely inflation trends”.

The Dowlais demerger moved the goalposts once more, with Melrose rebasing initial invested capital to account for the spin-off. Dowlais was estimated to account for 53 per cent of group value, with 47 per cent on the remaining aerospace business.

The ratio chosen tied back to valuations given at the time of GKN’s takeover, but went against some investor perceptions that autos was being overvalued. Post-split share price performance has done nothing to change the perception: Dowlais dropped 40 per cent in the year following the demerger while Melrose rose more than 50 per cent.

Melrose told FTAV: “the core elements of the scheme have been constant throughout,” and that “any change reflects the demerger and aerospace pureplay strategy and was strongly supported by shareholders.”    

Not that shareholders had much choice. The vote to approve the Dowlais spin-off in 2023 came with LTIP adjustments as a rider. Everything was wrapped into a single resolution, leaving no way to protest against management’s pay without also voting to scrap the spin-off.

A person familiar with the company said the use of a single vote was deemed appropriate because the LTIP adjustment was entirely dependent on the demerger itself.

Flying on fumes?

GKN could barely break even though the pandemic and the Melrose share price suffered, lagging peers. Its recovery since has been helped by a run of beat-and-raise earnings releases.

Having bought GKN to cut what it saw as unnecessary costs, Melrose followed through on the promise:

The target given at 2021 results was to get operating margins back to the long-run average of 12 per cent. It raised guidance to 14 per cent at an investor day in June 2022, then to 17-18 per cent at a capital markets event in May 2023.

Giving a view on whether these targets are realistic is beyond the scope of this post. Sellside analysts are confident, for what that’s worth, with 12 buy ratings and no sells among the 15 brokerages to cover the stock. But a divisional rejig following the Dowlais demerger has made like-for-like comparisons tricky, and what happens under new management is anyone’s guess.

Investors already seem jittery, with the stock slipping to a six-month low this week in reaction to a profit warning from Airbus, a GKN customer, which blamed persistent supply chain disruptions.

Cash generation will be an important metric for gauging whether Melrose has been over-earning under the previous board, since their exits coincided with an increasing impatience with customers. Here’s the Working Capital section on page 215 of the 2023 annual report (high-res here):

What this refers to is collecting cash upfront by selling accounts receivable to a third party at a discount, also known as factoring.

Among the big aerospace parts makers, invoice factoring is used sparingly. Safran has all-but phased out factoring and Rolls-Royce says it doesn’t factor at all. (“This is about sustainable cash flow growth of the company rather than doing some kind of engineering,” Rolls CEO Tufan Erginbilgic told analysts in February.)

For Melrose ex Dowlais, factored receivables went from £138mn in 2022 to £268mn in 2023. The company reported a 2023 adjusted free cash inflow from continuing (meaning aerospace) businesses of £113mn, versus a £35mn outflow the previous year.

In that context, for a newly refocused company with no immediate cash flow needs, a £130mn year-on-year increase in factored receivables seems a lot.

Melrose said it applied “rigorous financial discipline”, and that factoring “is used commonly across the sector” to free up working capital and accelerate decision-making.

A person familiar with the company said the increase in factored receivables between 2022 and 2023 was a planned strategy that was based on new facilities becoming available.

Layover for refuelling

Melrose told FTAV by email: “Management’s view is that these matters were voted on — with overwhelming shareholder support — many years ago. The LTIP concluded after a £4bn increase in shareholder value over the period and management is focused on growing the pure play aerospace business while the founder directors have all left the business.”

Indeed they have. Shortly after exiting, ex-CEO Simon Peckham and ex-vice-chair Christopher “Jock” Miller took 16 per cent apiece of the £330mn bonus pot, for payouts each worth about £53mn before tax. Ex-finance director Geoff Martin took 14 per cent of the scheme, worth £46mn.

Former vice-chair David Roper was given 5 per cent, worth £15mn. He had previously been excluded from the 2020 LTIP, having been due to retire in May 2020, but was added back after delaying his departure by 12 months.

Just under half of the pot’s gross value was paid directly to HM Revenue & Customs to cover participants’ tax liabilities.

New CEO Peter Dilnot, formerly chief operating officer, qualified for a 12 per cent share of the pot. Since he is still on the board, slightly more than half of the reward was in nil-cost options that vest over the next two years. Everyone else got shares with very few strings attached, as MainFT reported:

Under the scheme, the three departed executives have to hold on to shares worth three times their final salaries, roughly £1.5mn each. They are allowed to sell the rest at any time. 

With money banked, the new plan is to raise more money. Sky’s Mark Kleinman reported:

The founders of Melrose Industries, one of Britain’s most prolific and lucrative investment groups, are preparing to list a new vehicle in London next month as they hunt a new wave of takeover targets.

Sky News has learnt that Simon Peckham is spearheading the launch of Rosebank Industries, with talks under way to raise more than £40m from institutional investors.

For prospective investors, Rosebank ought to be an easy sell. The founders’ knack for creating value from nothing speaks for itself — even though Melrose shareholders have reason to feel that rewards more recently have not been equitably shared.

Further reading
— Waning of the Melrose model is the end of an era for London (FT)