ii view: Melrose flags impact of auto chip shortage

Better trading for aerospace is now being countered by automotive challenges. We assess prospects. 

Third-quarter trading update to 30 September 2021

Chief executive Simon Peckham said:

“All internal management actions are on track, and many are ahead of plan.  We are very pleased with the internal progress being made.  Tightened supply of semi-conductors to the automotive industry are frustrating and difficult to plan for, but whilst they affect current trading, they don't impact long-term value, particularly as cash is well controlled and debt reduced.  

“We have made our businesses better, more flexible and resilient to deal with near term headwinds, and all our businesses are on track to achieve their margin targets assuming partial end market recoveries.”

ii round-up:

Business turnaround specialist Melrose (LSE:MRO), owner of the GKN aerospace and automotive businesses, today warned about prospects given ongoing semiconductor supply issues hitting the broader auto industry. 

Monthly auto component customer cancellations had risen from 1% in the first quarter to a current rate of around 20% to 25%. But aerospace demand had improved, with sales up 16% in the quarter to the end of September compared to the same period in 2020. 

Melrose shares fell by more than 2% in UK trading, although remain up by over 70% since pandemic market lows bck in March 2020. Shares for automotive catalytic converter maker Johnson Matthey (LSE:JMAT) are up 40% over that time, while aircraft engine maker Rolls-Royce (LSE:RR.) is up by close to a quarter. 

Melrose flagged strong underlying demand from auto customers with near-term schedules from the industry being above 2019 pre-Covid levels. But the timing and duration of current supply constraints is uncertain. Similar challenges for its auto-related powder metallurgy business are also being seen. 

However, management is confident that the scale of the impact on profitability from any sales fall is in line with previous guidance. Good progress on restructuring continues to be made, while both auto and metallurgy are on track to achieve their margin targets once supply constraints are resolved.

The contents of the update are no surprise given a series of warnings from automotive suppliers due to semiconductor shortages. 

ii view:

Melrose seeks to buy good manufacturing businesses, improve their performance over a three to five-year investment horizon, then sell a more profitable and better cash generating asset to a new owner and return cash to shareholders and other key stakeholders. Melrose, and including the previously announced £729 million return, has now returned over £5 billion of cash to shareholders since it was established in late 2003. 

For investors, pandemic issues affecting its aerospace business are now being replaced by supply constraint challenges for both automotive and powder metallurgy. Outlook uncertainty across the business remains, with management having to work even harder to make additional restructuring on top of its original turnaround plan at GKN. 

But restructuring action across the business continues to be pursued and the pension funding deficit for GKN, acquired in 2018, has significantly reduced. The first-half pre-tax loss reduced to £151 million from £585 million in 2020, with all businesses achieving an improvement in adjusted operating profit margin compared to full-year 2020. An estimated share price to net asset value per share of 1.1 times also sits below a three-year average of 1.5 times, suggesting the shares are not overpriced. In all, despite bumps in the road, strategy remains sensible and investors will appreciate management's long track record of success.

Positives: 

• A track record of previous acquisitions and value enhancing sales
• Reduced net debt

Negatives:

• Ongoing trading challenges for both automotive and aerospace businesses
• Its strategy can create conflict with governments and trade unions

The average rating of stock market analysts:

Strong buy