Melrose grinds through the gears at GKN

Its £8.3bn takeover of GKN in 2018 managed the rare feat of uniting both the unions and the Daily Mail, both of which felt that it would be an unsuitable owner for a storied engineering group with a history dating back to the industrial revolution.

Unite, the UK’s biggest trade union by membership, argued the deal risked GKN being “sold off piecemeal”, with jobs being axed and technology shipped abroad. The Mail, meanwhile, ran a ‘Save GKN’ campaign, labelling Melrose “asset strippers”.

The company’s view of how it operates is unsurprisingly more sober, summing up its approach in three words: buy, improve, sell. It acquires underperforming engineering groups, turns them around and sells them off.

Melrose was floated on Aim in 2003 by executive vice-chairman Christopher Mills, chief executive Simon Peckham and ex-chief executive David Roper, who retired two years ago. The trio previously worked together at mini-conglomerate Wassall, which was sold to private equity giant KKR in 2000.

It has done four turnarounds to date – each bigger than the last. The first was the £427mn purchase of McKechnie and Dynacast from private equity firm Cinven, and the last before GKN was the £2.2bn buyout of Nortek in 2016. In each case it has doubled the return on its initial outlay, usually within three to five years.

Since inception, it has handed about £5.5bn in cash back to shareholders and total shareholder returns since May 2005 – the date of its first acquisition – have reached 1,706 per cent, compared with the 174 per cent earned by the FTSE 100 over the same period.

Its annualised average return has been around 19 per cent, but payouts tend to be lumpy, as it loses money in the early stages of an investment only to recoup big gains once disposals are made. It has only made one pre-tax profit during the past seven years.

This lumpiness is reflected in directors’ bonuses, which have been a source of contention among shareholders in the past. Although its last long term incentive plan (LTIP) lapsed in 2020 given the prevailing market conditions, the previous one for its 2017 financial year led to payouts of almost £42mn to each of its four directors. Shareholders rebelled, with almost a quarter voting against the group’s remuneration report.

The next LTIP bonuses are not due to vest until the end of 2023. If directors are entitled to another big payout by then, shareholders may be more accommodating if it means the GKN deal is finally delivering results.

Melrose’s acquisition was disastrously timed. GKN's two main markets – automotive and aeronautical engineering – have been hammered by the pandemic and supply chain disruption. In 2021, the company’s sales of £6.88bn were 37 per cent lower than two years earlier and its pre-tax loss widened to £618mn after booking more than £450mn in intangible asset amortisations and £269mn of restructuring costs.

Counting the cost

The amount spent on restructuring show the union’s concerns weren’t entirely without merit.

In automotive, the company’s largest division and source of 47 per cent of total 2021 sales, Melrose closed GKN plants in Germany, South Korea and the US last year and began the shutdown of a plant in Birmingham employing around 500 staff. In aerospace, which made up 37 per cent of revenue, the company is in the process of reducing the number of sites by more than a third to 33 by the end of next year, from 51 previously.

The prize, as ever, is higher margins. Last month, Peckham said that if GKN gets back to 2019 levels of revenue and achieves its stated margin targets –  “and we have never failed to do to that to date” – group profits should treble. Last year's adjusted operated profit stood at £375mn.

Its two core markets are taking time to recover, though.

In its most recent trading update, Melrose reported that like-for-like sales at its automotive and powder metallurgy arms in the first four months of the year trailed the same period in 2021 by 4 per cent. It blamed the ongoing shortage in semiconductors, saying sales were “significantly below” underlying consumer demand levels.

The automotive business makes drive systems for both conventional and electric-powered vehicles. Half of the £5bn of orders won last year were for either battery operated or full hybrid vehicles, and its components are used in seven of the top 10 electric car platforms outside China.

The site closures were part of a programme that delivered about £60mn of savings last year, which contributed towards a doubling of adjusted operating margins to 4.6 per cent. Melrose's target is to grow this to 10 per cent, which depends on a recovery of the automotive sector. Although new car registrations in the UK fell by 12 per cent in the first six months of 2022, as pandemic restrictions in China further hampered chip supply, analysts at Fitch Ratings see signs that this could improve as demand eases.

In aerospace, the chaos that has engulfed understaffed airports in recent months attests to the rebound in demand for air travel. The International Air Transport Association (Iata) last month forecast a doubling of passenger traffic this year, to 82.4 per cent of last year’s levels. A recovery to pre-pandemic levels is expected by 2024, with long-term annual growth between 2019 and 2040 forecast to average 3.3 per cent.

This bodes well for Melrose, whose aerospace arm makes everything from lightweight structures for single aisle planes built by Airbus (FR:AIR) and Boeing (US:BA), as well as engine parts for the likes of Rolls-Royce (RR.) and GE (US:GE).

The decline in the aerospace market has also masked how much GKN Aero has responded to Melrose’s improvement model, chief financial officer Geoffrey Martin told investors at its capital markets day.

The company used the event to upgrade its operating margin target for the aerospace business to 14 per cent, from 12 per cent previously. The division's adjusted operating margin last year grew by four percentage points to 4.4 per cent, and the company expects to be able to deliver a further four percentage points through operational and efficiency improvements. A further six percentage points will appear once the market recovers to pre-pandemic levels, it argued.

Melrose forecasts compound revenue growth of 7 per cent for GKN Aero by 2030, saying the division has “the highest potential equity return of all the GKN businesses”.

Engines for growth

Peckham argued that most of the risky operational challenges in GKN’s transformation are already complete or well under way. Although returns from this deal will take longer, given time “we believe that we will maintain this record” of doubling shareholder returns, he said.

This would mean returning over £16bn, which looks ambitious given that Melrose's market value has slipped to £6.4bn, or £2bn less than it paid for GKN four years ago.

Given the improving end markets, this valuation looks harsh. Melrose has repaid the £3.4bn of net debt incurred at the time of the GKN acquisition, save for cash returned to shareholders. At the end of last year, net debt excluding lease liabilities stood at £950mn, or 1.3 times adjusted cash profits. Its focus on costs means working capital has been reduced to 3 per cent of revenue, from 5 per cent at the time of the acquisition.

Aerospace head David Paja told the capital markets event that the cumulative value of future cash flows linked to aero engine programmes it is working on comes to £18.5bn over their lifespan which, if discounted back at a 7.5 per cent rate, has a net present value of £5bn. Of course, this is highly dependent on the assumptions used, but given these contracts make up less than 20 per cent of the aerospace division’s current sales, or 5 per cent of group sales, it suggests there is more value in the business than the current share price reflects.

Indeed, a consensus share price target of 200p suggests analysts believe the company is trading at a 30 per cent discount.

The market would probably like to see more evidence of GKN’s improvement before agreeing. Either way, Melrose does not intend to lose momentum. Peckham believes enough of the hard work at GKN has been done that once the summer is over, the turnaround group will be “able to look to the next opportunity” – equity markets permitting.