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10 Mar 17. Meggitt ready to boost returns. Over recent years engineer Meggitt (MGGT) has invested heavily to entrench more products in key civil aerospace programmes. Spending has hit record levels, but should start to come down over the coming years. This will give the company the chance to focus on improving operating efficiency and cash generation while benefiting from aftersales work linked to its increased market penetration. Given that the shares currently trade near a five-year low based on a multiple of sales (a useful metric for trying to identify recovery situations), we see plenty of potential upside should management succeed in its ambition to lift margins by between 200 and 250 basis points by 2021 while releasing £200m of excess cash. The company should be helped along the way by weak sterling, as well as the potential for a rising oil price to improve trading at its troubled energy division (7 per cent of revenue) and a Trump-induced rise in defence spending to benefit the military division (35 per cent of revenue).
Meggitt has been working on repairing its reputation since it warned on profits in October 2015. Its problems, in the main, were linked to an industry-wide retirement of large jets which hit the group’s aftermarket business. Although this dynamic is still in evidence, the influence of the customer services and support (CSS) division, formed in the aftermath of the profit warning, is being felt in the civil aftermarket, with organic revenue growth of 5.4 per cent versus market growth of 3.5 per cent.
The value on offer from a potential turnaround has attracted activist interest. Last year, Elliott Advisors, a hedge fund formed by Paul Singer, took a 5.2 per cent stake and started courting institutional shareholders with a view to breaking up the group. But Mr Singer’s overtures fell on deaf ears, and the fund has reportedly started selling down its stake. The news will have been welcomed by Sir Nigel Rudd, who was appointed in 2015 with a view to reviving the engineer’s fortunes. Sir Nigel has brought in former Rolls-Royce veteran Tony Wood as chief operating officer to accelerate that process, and the latest figures suggest that the group is making headway.
Shares in Meggitt recorded a double-digit hike after the group revealed a one-fifth rise in reported revenue, albeit largely as a consequence of favourable foreign currency movements and the acquisition of the advanced composites business of Cobham (COB) and EDAC in late 2015. Reported earnings were held in check by a £66m mark-to-market write-down of financial instruments. All in all, though, the results point to ongoing operational progress.
However, the big gains could be yet to come as the company focuses on improving margins (underlying operating margins were 19.1 per cent last year) and cash generation.
The with net debt equivalent to 2.1 times cash profit, Meggitt is well inside its target of 2.5 times. That said, debt is not the only noteworthy balance sheet risk. The company has a £415m pension deficit and “programme participation cost” intangible assets of £333.5m, which chiefly relate to losses on providing cut-price kit in anticipation of generating more aftermarket work further down the line. Still, new product introduction costs should peak next year while research and development spending should have already peaked. What’s more, the recent rise in bond yields could push down the level of the deficit.
IC VIEW: We feel Meggitt has an opportunity to improve its business’s performance along with investors’ perception of the business’s quality. A get-together with City-types organised for 26 May should give management an opportunity to highlight the potential benefits of the 2