The decision to spin out automotive engineer Dowlais (DWL) from Melrose Industries (MRO) seems to have paid off in the short term, with investors making a net gain of around 9 per cent.
Melrose shares had finished the previous day at 162p a share, valuing the company at around £6.57bn. The separation involved a three-for-one consolidation of Melrose shares (implying a new price of around 486p), with shareholders then granted one Dowlais share for each Melrose share. Although Dowlais shares fell by 21 per cent in first day's trading, to 117p, Melrose shares settled at 413p, implying market capitalisations of £1.63bn and £5.59bn, respectively. Dowlais rebounded slightly on Friday morning to 125p.
The gain was made despite index-related selling pressures. Compiler MSCI confirmed on Monday that both Melrose and Dowlais would be deleted from the MSCI World index at Thursday’s close and move into the Small Cap index instead. And although Melrose remains large enough to be part of the FTSE 100 index, Dowlais will find itself a part of the FTSE 250.
“It goes without saying that there’s more money tracking large cap (indices) than small cap, so there’s a big net sell,” said Alastair Mankin, vice president at investment bank TD Cowen.
Estimates vary, but this translates to index-linked funds selling around 50mn-60mn shares in both Melrose and Dowlais, or around 4 per cent of the total of each. However, TD Cowen said that that a mix of pent-up demand from investors for the pure-play Melrose business, banks agreeing to buy shares in bulk at auction and purchases by index arbitragers who had shorted shares and needed to settle trades all translated into a strong first-day close.
The demerger effectively splits the GKN business Melrose bought for £8.1bn in 2018. Melrose has retained the aerospace engineering arm, while the new Dowlais business comprises GKN’s automotive and powder metallurgy arms, as well as a fledgling hydrogen business.
The divergence in market capitalisation is a reflection of investors' views of the two firms' future prospects. Although Dowlais is the larger in revenue terms, Melrose is viewed as offering better growth potential, particularly given the recovery in air travel as engine maintenance contracts are linked to flying hours.
Prior to the split, RBC Capital Markets analysts valued Melrose’s equity at £4.8bn, which was derived from an enterprise value of 16-times earnings, or £5.3bn, minus the £480mn of group debt it is assuming. Using a similar methodology, albeit a lower earnings multiple of between 6-times and 7-times and higher assumed debt of £850mn, it valued Dowlais at £2.9bn. Ratings agency Moody's said there would be no change to the Ba1 rating (just below investment grade) of £130mn of GKN Holdings bonds for which Melrose will assume responsibility. The bonds are due to mature in 2032.
Louis Knight, an analyst at Third Bridge, said it is likely that the aerospace arm will be sold off in the near future.
"Our experts say the initial agreement within Melrose was to keep the aerospace business for at least for five years, and that timeframe will expire later this year."
We remain bullish on Melrose given the huge cash flows (estimated at £18.5bn last summer) it expects to generate from engine contracts until 2060.
Although the Dowlais case may seem less convincing, it has some key strengths. Its components are used by 90 per cent of the world's car makers in around 50 per cent of models and its drive systems are deployed in both combustion engine and electric vehicles. Systems for the latter are much more expensive and Dowlais has proprietary technology but it faces a potential challenge in car makers bringing this work in-house, Knight said.
UBS analysts estimate the company can grow its adjusted operating margin from around 7 per cent this year to 11.6 per cent by the end of 2025. Their base case valuation for Dowlais works out at 200p a share. RBC analysts's equity valuation implies a price of 208p.
This year could well prove to be a rough one, with the demerger itself likely to have been a distraction. Trading could also remain volatile, with potential for more “near term shareholder rotation” from long-term Melrose holders who now find themselves owning a listed automotive business, RBC analysts warned.
For those prepared to sit it out, though, the discount that Dowlais shares currently trade at provides a decent buying opportunity for a well-regarded engineering group.
Early index-related selling pressures should also now be complete. Compiler MSCI confirmed ahead of the split that both Melrose and Dowlais would be deleted from the MSCI World index and move into the Small Cap index instead. And although Melrose remains large enough to be part of the FTSE 100 index, Dowlais will find itself a part of the FTSE 250.
“It goes without saying that there’s more money tracking large cap (indices) than small cap, so there’s a big net sell,” said Alastair Mankin, vice president at investment bank TD Cowen.
Estimates vary, but this translates to index-linked funds selling around 50mn-60mn shares in both Melrose and Dowlais, or around 4 per cent of the total of each.
