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Regular readers will know of our interest in Melrose Industries, the FTSE 100-listed industrial turnaround vehicle that became an aerospace parts company. Our previous reporting centres on the possibility that Melrose founders banked oversized exit rewards after juicing performance in unsustainable ways, particularly around future cash flow.
The idea seems to be catching on. UBS analysts today downgraded Melrose to “sell” from “buy” after taking deep dive into its revenue and risk sharing partnership portfolio (RRSP), where it books income from after-market programmes with engine makers including Rolls-Royce and General Electric. The long-term value of RRSP contracts is what supports Melrose’s claim that it is sitting on a £22bn “cash mountain”, and underpins the majority of its public market value.
Melrose told investors at half-year results earlier this month that the portfolio had a net present value of around £5.7bn. UBS, having conducted its own modelling, arrives at a figure of just £2.8bn. Much of the difference, it says, is the gap between profit and likely cash generation.
“We stick 100 per cent with what we’ve reported to the financial community,” a Melrose spokesperson told Bloomberg. “We have been consistent about the quantum and development in terms of timing for the last three years and fully transparent as to the calculation methodology, with our assessment based on industry-recognised forecasts.”
Jet engine contracts are fiendishly complicated, with each sale involving decades of after-market revenues that can be a multiple of the original price. Rolls-Royce’s share price re-rating following its appointment of CEO Tufan Erginbilgiç is thanks partly to its clearly explained accounting around long-term service agreements, which had been the focus of regular sellside attacks.
Melrose sits below Rolls in the aerospace supply chain. It is what’s called a risk-and-revenue sharing partner, meaning engine makers pay for the parts it supplies at a pre-agreed rate based on how quickly they’re likely to need replaced. Since aerospace manufacturers make little or no margin on the original sale, generally speaking, these long-term service agreements are essential to their profitability.
But according to UBS, many of the parts Melrose supplies under RRSP contracts “are either expected to last the [20 year] life of the engine, or are at least not planned to be replaced during the first 8–12 years of the engine.” Hardware like engine mounts and turbine cases are big and don’t rotate, so are unlikely to wear out, say the analysts. Things that are likely to wear out, such as fan blades and propeller shafts, are mostly sold or repaired outside RRSP contracts, it says.
Melrose recognises certain contracted RRSP revenues as soon as the part is delivered to the customer, rather than over the six- to 10-year life of the after-market contract, “as is normal for other after-market players,” UBS says. These upfront-booked after-market revenues are termed unbilled work.
Unbilled work for Melrose totalled £173mn in 2023, up from £45mn in 2019, with the line accounting for a quarter of its RRSP revenues. What results is a positive and increasing net contract asset on the Melrose balance sheet, which is the opposite direction of travel to its aerospace peers, UBS says:
UBS takes the Melrose customer list and builds its own long-term cashflow model using the probable engine repair and replacement rates. Its forecast for cash from RRSP contracts is higher than the one provided by GKN, before it was bought by Melrose in 2018, but is still well below current management guidance:
Melrose appears to be taking an optimistic view of extended programmes and engine lives, even though under its ownership “RRSP shares on engines have not changed materially,” says UBS.
Pratt & Whitney’s recall of GTF engines last September at an expected cost of $6-7bn brought home the risks of this approach. GTF partners including MTU have booked charges to reflect the shared costs but Melrose has not, saying its assumptions were already sufficiently conservative, a policy UBS called “surprising”.
The UBS team also uses a lower discount rate to Melrose management, at 7.5 per cent rather than 9 per cent, which it says is more in line with peer methodology. It also deducts tax from the headline present value and includes a terminal value for next-generation engine programs, neither of which are in Melrose’s headline figure. Here’s its chart showing the bridge between the two valuations:
Because Melrose used to be a capital goods conglomerate, it might be that investors and sellside analysts paid too much attention to profit metrics. Aerospace companies have much more complicated customer relationships so are more commonly valued on free cashflow. This re-evaluation process has only just begun, says UBS, which set its share price target at £4 based on peer valuation metrics.
The stock closed not far above that level today, but it’s a brave bet to say it can’t go lower still:
Further reading
— Breaking down the Melrose founders’ last big score (FTAV)