Melrose: in it for the long term

Those wanting proof of Melrose’s track record need only look at its c-suite’s latest pay packet. In May 2017, its top four directors were handed £160m-worth of shares as part of a share-price-linked incentive plan. That may seem obscene – and indeed a sizeable bloc of shareholders baulked at the executives’ remuneration at the annual meeting – but it at least shows that management interests are aligned with ordinary investors'. In the five years covered by the plan, Melrose bought metering firm Elster for £1.8bn and sold it for £3.3bn, tripled its money on several smaller businesses, and returned the proceeds to investors through a series of special dividends. By the group’s calculation, it has created £3.6bn in shareholder value since being incorporated in 2003 when it had a £13m market capitalisation.

For the next five years, the focus will be on GKN, which Melrose snapped up after a string of profit warnings from the UK-based aerospace and driveline specialist with a leadership vacuum and a depressed share price. Melrose sees the UK stalwart as a group of “world-leading, but currently underdeveloped businesses”, and believes it can lift trading margins from around 7 per cent to over 10 per cent by 2022, a commitment renewed in last week’s half-year results. Should the targets be hit for GKN, Melrose’s top four directors could land £285m. For this to happen, investors’ holdings would have to appreciate substantially, too.

So what’s the story thus far? At the half-year stage, GKN’s financial contribution was limited to 73 days of trading, but included all acquisition costs – not just stamp duty and Melrose’s professional fees, but the £129m GKN spent defending the takeover. And while ownership is nascent, each GKN division – aerospace, automotive and powder metallurgy – is now operating on a standalone basis. Melrose has also promised to plug GKN’s legacy pension deficit, and invest in projects including a new aerospace technology centre in the UK and an engine repair facility in Malaysia. Most encouragingly, perhaps, a hampered due diligence process appears not to have missed any corporate or operating “black holes”.

Still, the deal has caused a surge in net debt, from £572m at the end of 2017 to £3.4bn at the end of June this year, meaning Melrose needs to improve GKN’s profitability fast.

As you’d expect, the group already has a plan. In aerospace, losses in North America are narrowing, while the broader market outlook remains positive, and initiatives have been launched to tackle weak pricing, onerous contracts and procurement issues. In automotive, management has kick-started focused price increases, global cost base reductions and investment in the eDrive business, all in the face of global headwinds. And in powder metallurgy, the one part of GKN that was performing well, Melrose thinks it can push margins from 10.4 to 14 per cent, and begin a sale process this year. Added to this, divisional managers across the group have had their “incentive arrangements realigned”.

For aerospace, which on a pro-forma basis contributed 22 per cent of Melrose’s operating profit in the first half, Numis believes operating margins can double to 14 per cent. That would match the current profitability of ventilation and security business Nortek, which Melrose bought for £2.2bn in 2016. Since then its margins have climbed six percentage points thanks to central cost savings, better returns on capital and cuts to low-margin sales.