Does Not Compute

A Tempting Buyout Target?

A private equity bid for GKN looks a long shot.
Chris Ratcliffe/Bloomberg
MELROSE INDUSTRIES PLC
-4.80
At Closing, June 15th
235.70 GBp
CARLYLE GROUP/THE
-0.25
At Closing, June 15th
22.55 USD

GKN Plc looks a tempting target for private equity. But it will be hard for the embattled U.K. engineer to lure a buyout firm into an auction against putative bidder Melrose Industries Plc.

Merger Bump

Melrose's proposed offer for GKN has taken the shares back to levels last seen four years ago

Source: Bloomberg

The attractions of GKN to a financial sponsor are the same as those to Melrose. It's a business that has long been poorly run, with profitability below what Melrose and even its own management think is achievable. It could also be broken up and sold off in parts, each transaction offering the chance to make a turn. GKN is already planning to split itself in two; Melrose's plan involves some less radical asset sales.

What's more, GKN seems to have a strong balance sheet. Net debt is expected to end 2017 at 846 million pounds ($1.2 billion), or 0.8 times Ebitda, Bloomberg data show. That suggests scope for a buyout firm to use borrowed money to fund a deal. Melrose's 7 billion-pound takeover proposal includes a plan to increase debt and pay out 1.4 billion pounds to GKN shareholders, lifting the enlarged group's leverage to 2.5 times Ebitda.

It's not surprising, then, that Carlyle is considering an offer, according to the Sunday Times.

The big obstacle is the target's U.K. pension deficit of 1.1 billion pounds. The plan's trustees would rightly demand more annual top-ups into the retirement program to compensate for the increased risk of a more heavily geared balance sheet. That would lower the returns for the private equity owner.

There are other difficulties. Private equity would want full ownership; Melrose would give GKN shareholders a share in the enlarged company, allowing them to benefit from whatever performance boost follows. Institutional investors may be wary of selling to a private equity firm for fear of being embarrassed later on if the new owner makes great returns -- a feeling they have suffered before.

To overcome all this, a buyout firm would need to make a knock-out offer. In that scenario, Melrose's share price would suffer, weakening the value of its proposal. There's a snag: a price that's too high for Melrose would probably also be too high for private equity.

Melrose can certainly afford to pay more. A 10 percent bump on its starting figure would lift the value of its proposed bid to about 445 pence a share, giving it a more credible 37 percent premium to GKN's undisturbed share price. That would cost 7.7 billion pounds, or 8.5 billion pounds including assumed net debt.

Margin For Improvement

GKN's operating margins have been stubbornly below the aspired 10 percent level

Source: Bloomberg

If Melrose can drive operating margins to 10 percent, operating profit net of tax would be roughly 880 million on the 11 billion pounds of revenue forecast for 2020. That would be equivalent to a 10 percent return, comfortably exceeding GKN's own cost of capital.

Melrose can afford to be more generous. Finding an all-cash bidder that would force it to be so is another matter.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Chris Hughes in London at chughes89@bloomberg.net

    To contact the editor responsible for this story:
    Edward Evans at eevans3@bloomberg.net

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