Direct Equity Team: A Note from Bishopsgate
MELROSE UPDATE
“They [investors] think growth or something new is important, neither of those in themselves matter to us. The most important thing to us is high barriers to entry.” – Sir Chris Hohn, TCI Fund Management.
Barriers to entry, or “moats” to quote Warren Buffett, are what protect a company’s profits from new entrants to their marketplace. We believe some of the strongest barriers to entry stem from industries with intense regulation, stringent safety standards, large capital requirements, and proprietary knowledge of complex systems.
Melrose is the parent company of GKN Aerospace, a Tier 1 component supplier to the aircraft engine manufacturing industry. The industry is one of the best examples of barriers to entry, evidenced by the fact that no new entrants have entered the marketplace for more than 50 years.
The story of GKN began with the founding of the Dowlais Ironworks in 1759 in South Wales. During the Napoleonic Wars, Dowlais Ironworks supplied cannonballs to the British army, and it was instrumental in the industrial revolution in Britain. Almost 270 years after its founding, the business spans 12 countries. It employs more than 16,000 people to build immensely complex aircraft engine components and airframes in the Civil and Defence sectors.
To compete with GKN from scratch, the first hurdle is to achieve certification from global aviation regulators like the FAA or EASA. This in itself will take five to ten years. Once you can show you have parts that are deemed credible enough to safely transport hundreds of people in the air, you then must compete with (OEMs) such as Rolls-Royce, Pratt & Whitney, and GE Aerospace for decades. They have completed hundreds of projects together across various designs. The built-up R&D, design improvements, lessons learned are all difficult to recreate overnight. The revenue royalty that engine manufactures earn is from engine flight hours. The revenue they generate is correlated one for one with the number of hours that engine flies for. Any additional down time for maintenance and repairs impacts all the suppliers/OEMs who worked on that particular engine. This means there is not only a safety risk of working with a new supplier, but a hefty financial risk too. Royalty contracts are structured this way because the manufacture of an aircraft engine is very capital intensive. Suppliers need deep pockets and experience for the design and build phases. Importantly, OEM partners must be confident those pockets are deep enough to complete their projects.
The airline industry itself is generally considered to be cyclical, and long-term profit growth has been minimal. This is despite the backdrop of growth in passenger flight time which has typically been ahead of global GDP in recent decades. The airline industry remains low margin and low growth because the marketplace is so competitive: there are no barriers to entry, and so there is no pricing power. Passenger flight time is a function of population growth, expansion of the global middle class, tourism, and globalisation. These are factors that are expected to continue the long-term increase in the number of flying hours, and in turn drive demand for already supply constrained aircraft engines.
In the design and build phase of an engine, Tier 1 component suppliers and OEMs buy into a risk and revenue sharing partnership in proportion to the cash amount invested. Companies like Melrose typically have a 5% share in the partnership from the components they have provided. Engines are then sold to the airline at minimal profit, sometimes even at a small loss; the benefit comes from the aftermarket royalty. The airline agrees to a maintenance contract where the partnership is paid a royalty based on the engine’s airtime rather than paying per shop visit for repairs. The risk for the partnership members is that they bear the cost of each repair trip, so they are incentivised for engine longevity. The airline benefits as they have a predictable maintenance cost line rather than infrequent, expensive bills that are difficult to plan for.
Melrose has a unique position in these partnerships. It produces more components, such as engine cases, which receive low levels of wear and tear rather than rotational equipment that need more frequent replacing. This means that when the engines do visit the repair shop, Melrose will have less work to do than others in the partnership. This allows them to earn 32% operating margins in their engines segment.
The barriers to entry in this industry means investors can benefit from the long-term growth trend in airtime without suffering the volatility of a typical airline company. Additionally, maintenance contracts are decades long, so the level of demand is more predictable and they are high margin.
The OEMs trade on high price to earnings multiples: Rolls-Royce 39x, Safran 34x, and GE Aerospace 47x. Because the barriers to entry are so high, they have instrumental pricing power, and the contracts are long-term. The shares of Melrose trade on just 12x earnings. 20% of Melrose’s operating profit comes from its airframes segment, which we believe overshadows the business and weighs on the rating. The airframes segment generates sales per transaction and is reliant on new aircraft orders, which makes the segment more cyclically exposed. Even if we value the airframes segment at 0, we are getting the engines segment for just 15x earnings. This is less than half what any of the OEMs it partners with trade on.
Melrose has historically operated a private equity style model of buying average businesses, improving them, and later selling them for a profit. They are now solely focused on running GKN Aerospace for the long-term. This makes historical financial analysis of the parent company a challenge, but it also creates an opportunity to own what we believe to be an exceptionally high quality, misunderstood business.
This article was prepared by Tom Waters, one of our Investment Managers.
