The rally in European aerospace and defence stocks has one notable laggard today:
Wee! And it all looked so promising at the open. Full-year 2024 results from FTSE 100-listed Melrose beat expectations and came with a five-years-out target for £600mn of free cashflow, which is about 20 per cent higher than the consensus.
As usual with Melrose, however, there’s a rather complicated mismatch between reported profit and cash.
Melrose posted an adjusted operating profit for its engines business of £422mn, but this included a “£274mn of total variable consideration” from Risk and Revenue Sharing Partnerships. The 2025 guidance includes another “variable consideration” of between £320mn and £360mn. By 2029 the VC rises to £500mn.
These are non-cash items, as we have discussed previously, and are a big part of the £544mn of adjustments that turned last year’s £4mn statutory loss into an operating profit.
Melrose said the 2024 variable consideration was “in line with our expectations”, but its guidance for future years was very much not in line with market expectations. The number had been expected to go down, not up.
The way Melrose amortises profit on long-term engine contracts has long been a bugbear for the market. The stock having crashed 30 per cent over the 12 months to last October on worries around cashflow, Melrose hosted an accountancy teach-in and published a booklet, though it seems to no longer be online. (Update: link’s working now.)
Here’s the relevant bit:
[A]t the point we deliver our engine component we are required by IFRS 15 to record a proportion of future aftermarket income called variable consideration. This is due to a combination of specific contractual rights and the nature of our components in these partnerships, which typically last the lifetime of the engine.
The variable consideration, which is currently around a quarter of our overall RRSP revenue, effectively recognises or pulls forward a percentage of our future contractually entitled aftermarket income and treats it as revenue at the point of delivery of our components. In order to pull forward the aftermarket income, a rigorous assessment of future revenues and costs is made. This assessment draws upon OEM inputs and other market data for items such as expected fleet size, flight hours and cycles, frequency of shop visits and the expected profitability over the life of an engine.
Importantly, IFRS 15 requires us to ensure that any revenue pulled forward must be highly probable to not reverse at a later stage. As a consequence, any revenue pulled forward is risk adjusted and currently we record only 10% to 30% of available aftermarket income over the life of the engine, despite having substantially completed our work at the manufacturing stage. Our risk assessment considers a wide range of programme risks including the length of an engine’s life, potential programme cost pressures, and the cost of any additional development work. These assumptions are reassessed annually and, where appropriate, the prudence is unwound, resulting in a “catch up” addition to variable consideration being recognised.
Variable consideration creates a mismatch between profit and cash, since the cash is typically received at the point of the shop visit that takes place routinely, but often several years after a percentage of the revenue and profit is recorded. This mismatch is most acute whilst two of our 19 RRSP contracts remain cash negative and the gap is expected to be at its largest in absolute terms in 2024. Variable consideration leads to an increase in the unbilled work done asset in the Melrose Group balance sheet and this asset is expected to continue to increase as OEM deliveries grow, and the programmes mature, ahead of the rate of amortisation.
Sure, fine. But note the guidance in bold (our addition) where Melrose said it would only book “10 per cent to 30 per cent of available aftermarket income” over the engine’s life. From that, investors and analysts assumed the 2029 variable consideration would fall to about £350mn.
However, according to JPMorgan, the most important bit of the October teach-in wasn’t the up-to-30 per cent guidance, it was the word “currently”:
After speaking to management, we understand that ‘currently’ was meant to refer to the near-term (i.e. 2024-26). Thereafter, as new engine programmes mature and the risk profile drops, Melrose expects to pull forward over 30% of the future aftermarket each year. For example, to achieve VC of £500m in 2029, we estimate the pull forward is c36%.
What this means is, while 2029 expectations can move higher (as much as any analyst was looking that far ahead) the bigger than expected pull-forward of yet-to-be-earned aftermarket income is likely to make cashflow forecasts for 2025, 2026, 2027 and 2028 move lower.
It’s this kind of thing that makes Melrose a recurring feature on this blog.
Further reading:
— The great Melrose cashflow conundrum (FTAV)
— Breaking down the Melrose founders’ last big score (FTAV)