Civil aerospace woes push engineering groups into the red

The collapse in international travel due to Covid-19 has hit not just the airlines, but reverberated down the entire civil aerospace supply chain. Amid lower demand for components for new planes and aftermarket services, engineering group Meggitt (MGGT) saw revenue from its civil aerospace activities plummet by more than two-fifths in 2020, to £726m.

Lower sales volumes, particularly for higher margin aftermarket services, translated to the group’s underlying operating profit dropping by 53 per cent to £191m. On a statutory basis, Meggitt swung to a £297m operating loss, versus a £325m profit a year earlier, weighed down by over £400m of exceptional charges. These relate to asset impairments and writedowns in response to the civil aerospace downturn.

Despite the tough conditions, the group did remain free cash flow positive and has reduced its net debt by 15 per cent to £773m, aided by the sale of the Training Systems business. Still, having not paid an interim dividend in 2020, there is no final payout either.

Looking ahead, the rollout of Covid-19 vaccines should enable international travel restrictions to be lifted, although Meggitt expects that the recovery will be weighted towards the second half of this year. Assuming no further disruptions from the pandemic, the group believes that its 2021 revenue will be broadly in line with 2020, while underlying operating profit should increase.

Melrose also flies into the red

Engineering conglomerate Melrose (MRO) is a little more downbeat on the prospects of the civil aerospace market – it does not anticipate a meaningful recovery this year. Despite higher defence sales, aerospace revenue declined by 27 per cent in 2020, and it is restructuring the business to match current levels of demand.

Reflecting the civil aerospace downturn, the buyout and turnaround specialist saw its adjusted operating profit plunge by almost 70 per cent to £340m. Much like Meggitt, hefty exceptional charges pushed it to a statutory operating loss of £338m, down from a £318m profit in 2019.

In response to the Covid crisis, Melrose increased its focus on cash generation. As a result, adjusted free cash flow – which excludes restructuring costs – rose by 6 per cent to £628m, while net debt (excluding lease liabilities) has come down by more than a tenth to £2.9bn. This has allowed the group to reintroduce what vice chairman David Roper calls “a gesture of a dividend” at 0.75p per share. The balance sheet should be further aided by the disposal of air conditioning business Nortek Air Management, which has now been put up for sale. Investec estimates it is worth around £2.5bn.

Automotive recovery picks up speed

Despite the pressures in civil aerospace, Melrose’s trading in the second half of the year was at top end of the management’s expectations thanks to a recovery in its automotive and powder metallurgy divisions. Excluding aerospace, revenue grew by 2 per cent in the second half, with 9 per cent growth in the fourth quarter.

The GKN automotive and powder metallurgy businesses were facing a slowdown in the car industry heading into 2020, which was exacerbated by the pandemic. The slump in vehicle production also hit the likes of Vesuvius (VSVS) which sells castings that are used by foundries to make high-volume automotive components. The group’s foundry revenue fell by a fifth in 2020, to £413m, and when combined with the decline in global steel production, Vesuvius’ adjusted operating profit contracted by over two-fifths to £101m.  

The car industry’s woes have also weighed on Morgan Advanced Materials (MGAM), which booked a £36m impairment on its thermal ceramics business in 2020, as well as registering £29m of impairment losses in its technical ceramics division in response to the aerospace downturn. But, following a recovery in orders between November and January, the group is pointing to “modest” organic revenue growth in 2021. Meanwhile, Vesuvius is guiding to a “meaningful improvement” in financial performance this year.

A long haul back

While there is the longer-term structural shift to electric vehicles, in the short-term, the automotive industry is being held back by the global shortage of semiconductors. Meanwhile, the civil aerospace sector is facing the prospect of a multi-year downturn. The International Air Transport Association (IATA) does not expect global air traffic to rebound to pre-pandemic levels until 2024, and there will be a further lag in the recovery of new aircraft production.

Still, Meggitt will benefit from the resilience of its defence business, as well as the fact that more than 70 per cent of revenue is derived from sole-source contracts. Melrose’s strong cash generation should help it endure the tough times – and potentially enable further acquisitions – and its restructuring efforts should translate to improved margins. Hold on both counts.

Last IC Views: Meggitt: Hold, 282p, 08 Sep 2020; Melrose: Hold, 99p, 22 Jul 2020