A deep dive on Melrose, a company with secured cashflows until the 2050.

Melrose is a pure aerospace play that, due to its unusual history, trades at an unjustified discount, given its visibility into future cash flows and its inclusion in a long-term trend empirically supported since the very creation and commercialization of the airplane.

Melrose has two revenue segments: Engines and Structures. Engines accounts for 75% of EBIT with 50% of revenues, and Structures accounts for 25% of EBIT with the other 50% of revenues.

Before going deeper into Melrose, it is worth clarifying the moat that all participants in the aerospace industry enjoy. Once a part is certified as a component of an aircraft or engine, especially, as we will see later, highly advanced and critical parts, substitution is nearly impossible and definitively impractical, because certifying that a replacement part will perform identically requires putting it through the same tests and demonstrating equivalence to the original. And as you will appreciate, in aircraft and engine iteration cycles that span 30 years, there is simply no interest on the part of Airbus, Boeing, or the engine OEMs in recertifying key components.

So, moving into engines, for context: civil engines, excluding state participants, has been an oligopoly for over 50 years with no new entrants. Not only that, but engine life cycles tend to be close to 30 years. It is worth highlighting that 85% of profits come from the "aftermarket," while the remaining 15% comes from "OE" or original equipment. To explain briefly (the rest is covered in greater detail in the writeup below): aircraft parts suppliers, in part because they sell through Boeing and Airbus, sell the original part at the lowest possible price, often at cost or below cost, and then in the aftermarket, since only they can provide support or replace the part (this is more complex, given the existence of PMAs, but for our purposes in engines it holds true), that is where they capture the majority of their margins.

In engines, the majority of profit comes from two sources: RRSPs (Risk and Reward Sharing Partnerships) and commercial agreements. The more interesting part is the RRSP, where Melrose holds participation in the aftermarket profit of engines, covering a total of 60% of flying hours. That is, Melrose, as a key supplier and key technology partner, was able to invest in the development of engines in order to receive a share of their cash flows throughout their entire service life. But beyond that, it is skewed toward the future, because across the two "generations", older engines and more modern ones (which will eventually replace the older ones), Melrose holds a larger participation in the modern fleet (GEnx, Trent XWB, P&W GTF Family); in other words, it holds a royalty on flying hours.

And to complement this portfolio, through commercial partnerships Melrose is a supplier to 90% of engines, including the LEAP, where it holds no RRSP, the GE9X (not yet at market), the GE90, and others. What does this mean? The engines segment accounts for 75% of Melrose's EBIT, and within it, these two categories, supplier agreements and RRSPs, make up 80% of engines revenue. The result is a portfolio of growing, secured cash flows through the 2040s, with visibility extending to 2050. Not bad.

The other segment, referred to as "Structures" or "Airframes", follows the same logic, except that instead of supplying the highly profitable engines and their aftermarket, it supplies the airframers directly. Content here is purely OE (Airbus and Boeing, though predominantly Airbus), both civil and military; margins are significantly lower and aftermarket is virtually non existent. That said, it is worth noting that Melrose is not a supplier of commodity or low-value parts, rather, it codeveloped wing technology jointly with Airbus and is part of the new development consortium, as well as supplying other critical structural components such as empennages, wiring, and windows.

On the tailwinds side, this segment deserves more attention than engines. In defence, the tailwind is self-evident. On the civil side, it is worth highlighting that both Airbus and Boeing face a structural post-COVID order backlog because of a delivery deficit and are actively ramping up production; the aircraft with the shortest backlog still carries roughly six years of orders at current production rates.

The whole if anyone is interested, including risks, valuations, and a broader picture of the aerospace industry, in greater detail is here: https://substack.com/home/post/p-198942601

Happy to get your feedback/pushback!