Melrose Industries, formerly known as a buyout group and now a key player in the aerospace sector, has encountered a sharp decline in its share prices. Last week, the FTSE 100 company experienced a drop of up to 7% after UBS analysts indicated that the valuation of its jet-engine division could be nearly half of the figure suggested by the company’s management.

While Melrose has contested the methodology used by UBS, claiming inaccuracies in their analysis, the downgrade has had a substantial negative impact, bringing the company’s year-to-date stock drop to 14%.

Understanding Melrose’s Revenue Model

Initially focused on turnaround strategies, Melrose adopted a business model centered on acquiring manufacturing companies, improving their operations, and subsequently selling them for profit. Between 2005 and 2015, Melrose achieved an impressive total shareholder return of 437%, significantly outperforming the FTSE 100’s 101% return, according to data from FactSet.

The company gained significant attention in 2018 with its hostile takeover of GKN, marking its transition towards becoming an aerospace manufacturer. This restructuring involved cutting approximately 1,000 jobs, laying off more employees during the pandemic, and spinning off its automobile-related business into a separate entity known as Dowlais.

Today, Melrose specializes solely in aerospace manufacturing and acts as a “revenue and risk-sharing partner” (RRSP) for various engine portfolios, including models from Pratt & Whitney, Rolls-Royce, and General Electric. In this capacity, Melrose contributes to engine production while also benefiting from ongoing aftermarket profits derived from support services.

Reasons Behind the Decline in Melrose Shares

The recent downgrade from UBS, changing its rating from “buy” to “sell,” primarily stems from a lower valuation of Melrose’s RRSP portfolio. UBS estimates its worth at £2.8 billion, which contrasts sharply with Melrose’s own estimate of £5.7 billion.

UBS’s valuation approach employs distinct assumptions regarding discount rates, cash flow estimates, taxes, and timing, which has led them to believe that the long-term value of RRSP contracts is critical for supporting Melrose’s assertion of holding a £22 billion “cash mountain,” a claim that UBS argues is largely driving its market valuation.

Concerns Surrounding Melrose’s RRSP Contracts

Melrose’s operational model hinges on generating substantial aftermarket revenues that exceed initial sales prices. Manufacturers typically operate with minimal margins on their first sales, making sustained service agreements vital for profitability.

While Melrose acknowledges the inherent uncertainties in forecasting revenues and costs related to these RRSP contracts, UBS contends that the company is overly optimistic regarding the duration and value of its contracts, as the components they supply may require less maintenance compared to competitors.

UBS developed their cash flow model using conservative estimates of engine repair and replacement rates, resulting in a cash flow estimate that is £670 million lower than Melrose’s projections. Additionally, UBS has employed a more industry-consistent discount rate of 9%, compared to Melrose’s 7.5%. Furthermore, they subtracted tax from their RRSP valuation while incorporating terminal values for upcoming engine models.

Implications for Melrose’s Executive Compensation

Melrose’s executives have historically received substantial remuneration, particularly through the Melrose employee share plan (MESP), which resulted in nearly £300 million for the top 20 executives before May 2023. This compensation was largely based on achieving targets related to share price performance and profit growth.

The introduction of a new performance share plan (PSP) now includes metrics for cash flow, which is noteworthy given UBS’s skepticism regarding Melrose’s cash flow projections.

Outlook for Melrose Shareholders

The downgrade by UBS is likely to cast a shadow over the company’s shares; however, this situation is not unprecedented within the aerospace industry. Similar concerns have impacted companies like Rolls-Royce in the past, where improved clarity on accounting practices led to a reassessment of share value.

UBS has set a target stock price of 400p, which is 16% below the company’s trading level prior to this report. Nevertheless, many analysts still rate Melrose as a “buy” or “overweight,” with an average target price of 635p—about one-third higher than the most recent trading price.

Despite recent challenges, Melrose has reported positive operational outcomes, with a 62% increase in operating profit to £247 million and a rise in its operating profit margin to 14.9%. Management has also disclosed an additional £250 million share buyback, building on an ongoing £500 million repurchase initiative.

While analysts have pointed out concerns regarding Melrose’s rising net debt, which surged from £553 million to £976 million, this figure is projected to decrease to 1.8 by 2025 and further to 1.3 in 2026, according to Peel Hunt forecasts.

A representative for Melrose stated, “We fully stand by what we have reported to the financial community. Over the last three years, we have maintained consistency in our assessments regarding timing and quantitative evaluations while being transparent about our calculation methodologies, grounded in industry-recognized forecasts.”

Assessment: Hold

The ongoing concerns related to RRSP valuations continue to impact Melrose’s stock performance.