GKN: defending hostility
Although GKN might not be a household name for all, it is a member of FTSE100 index and currently the target of £7.4bn hostile bid from Melrose Industries – the largest hostile battle since Kraft and Cadbury.
GKN is a British engineering group involved in the design and manufacturing process of the components for aircrafts, automobiles, and industrial machinery. With £8.82bn in revenues for 2016, the company enjoyed a healthy 22% growth rate, following by a period of stagnation between 2012-2015. The company is expected to record another rise in revenues with the consensus around £10bn for 2017. Its profits however, have trailed the revenue growth and reached £242m in 2016. GKN’s products include aircraft engines, wings or electric driveline technologies for BMW or Porsche. The latter are manufactured under GKN Driveline, the biggest segment of the group with 44% of the total revenues.
Its suitor, Melrose Industries is an investment vehicle and turnaround specialist in the manufacturing industry. Its business model is simply “Buy-Improve-Sell”, as one can read on their corporate website. The company is similar to private equity houses, as it cuts costs, repairs balance sheets and changes the strategy of its portfolio companies in order to sell at a premium. So far, Melrose has invested in companies more than 3 times smaller than GKN such as with its very successful acquisition of Elster for £1.9bn on which it achieved a 33% Internal Rate of Return.
The main reason behind Melrose’s proposal is GKN’s management underperformance. In two of its most important segments, aerospace and driveline, GKN has missed its target trading margins by 2.5 and 0.7 percentage points respectively. The results are unsatisfactory in the light of more than £3bn spent on capital and acquisitions since 2011. Moreover, GKN has raised two profit warnings in 2017 as well as experienced discrepancies in its inventory in the US. Melrose has already proposed a restructuring plan, which will lead to margins improvement and thus higher earnings for shareholders. Their actions will be focused around HQ restructuring as well as a cultural change from a sales-focused to profitability-oriented mind-set. Furthermore, Melrose plans to strap GKN of non-core businesses from the Aerospace and Driveline segments. Powder Metallurgy segment is also projected to be sold in the medium term. In its presentation, Melrose claims that outlined disposals will lead to “substantial capital returns to shareholders”.
With respect to the financials, the proposal gives GKN an enterprise value of £9.5bn, yielding EV/EBITDA 2017 multiple of 8.4x. The offer is essentially 405p per share, which represents a 24 % premium over the undisturbed share price on the 5th of January - the last day prior the approach. The terms of consideration include 20% cash and 80% in Melrose shares. The cash portion of this pay-out is ensured by new debt, for which Melrose has already obtained commitments.
The transaction resembles 1980s corporate raids actions as Melrose decided to go hostile – proposing its offer publicly to shareholders just days after the GKN’s management had rejected them. It is undoubtedly rare to move hostile nowadays, as most bidders attempt to gain management’s support before launching a formal offer. As one might have expected, the board of GKN has called the bid opportunistic and stated that it significantly undervalues the company. Moreover, it has taken an immediate action and appointed a new CEO, Anne Stevens as well as proposed a restructuring plan including a company split. Although management would like shareholders to quickly reject the bid, this is unlikely to occur. GKN’s largest shareholders, including activist investor Vulcan Value Partners and Elliott Management, voiced support for engaging with Melrose. Yet crucially, since both Melrose management and the recently appointed GKN’s CEO lack shareholders trust, the chances are anything but clear.
On top of quite a low premium there is an issue around GKN pension funds in the case of a company split as proposed by Melrose. The eventual split might put retirement plans at risk and necessitate additional funding. Although pension plan trustees cannot block the deal, the pension regulator might demand a cash injection if company does divide in two. Moreover, the company’s pension deficit has almost tripled since 2006, discouraging takeover attempts. In response to those concerns, Melrose has emphasised its excellent track record of managing pension schemes and willingness to meet GKN’s pension plan trustees.
The process is not yet over. One can either expect a revised higher bid from Melrose or another suitor’s appearance in the upcoming weeks.