GKN v. Melrose

Hedge Fund Arbs Place Their Vote In $9 Billion Nail-Biter

GKN's standalone strategy looks more attractive than a Melrose takeover, but that might not be enough to win.
Photographer: Chris Ratcliffe/Bloomberg
MELROSE INDUSTRIES PLC
-1.20
At Closing, May 25th
240.80 GBp
DANA INC
-0.11
At Closing, May 25th
23.31 USD

GKN Plc's shareholders owe Melrose Industries Plc a debt of gratitude for its hostile bid. But that doesn't oblige them to accept a takeover offer from the industrial turnaround specialist that still looks too low compared to what the British engineer can achieve on its own.

Melrose's bid expires in a week. It comprises cash and shares worth 7.9 billion pounds ($9 billion), or 458 pence a share, based on its share price on Thursday. GKN is trading at 429 pence. The large spread suggests the market is divided over whether the assault will succeed.

Merger arbitrageurs and Melrose shareholders on GKN's register will want the bid to prevail. Melrose's offer provides an immediate gain, which might be amplified by any jump in its shares after a victory. By contrast, GKN's share price would dip if Melrose fails.

But taking a longer view, GKN's plan looks that bit more attractive.

On a fundamental analysis, the Melrose offer and the GKN strategy can get to the same value in different ways.

Melrose says it can lift GKN's operating margins above 10 percent. The business would then deserve a higher valuation multiple than before. On that basis, the enterprise value of GKN under Melrose ownership would arguably be at least 10 billion pounds.

Add Melrose at its pre-bid value, adjust for debt and GKN shareholders' 60 percent stake in the combination would be worth more than 7.2 billion pounds. Finally, add the cash from the offer and they have 8.6 billion pounds of value -- or over 500 pence a share.

GKN has set out a sum-of-the-parts calculation that's worth the same. This comprises: 2.6 billion pounds for the autos business following a merger with Dana Inc of the U.S.; 2.1 billion pounds for the powder metallurgy business that's up for sale; 5.2 billion pounds for the core aerospace business; and a deduction of roughly 1.2 billion pounds for net debt, pensions, central costs and separation expenses.

Lift Off

Melrose's takeover bid has shone a light on the value inside GKN

Source: Bloomberg, Gadfly calculations, Company statements

Those powder metallurgy proceeds look too high, while the autos valuation looks shy given it's based on a Dana share price that reflects uncertainty over whether its merger will proceed. These differences cancel each other out. The aerospace valuation seems fair if you assume GKN delivers on its targets and the unit trades on a peer multiple. 

Melrose argues that GKN's strategy would leave its shareholders with an aerospace business with chunky pension obligations relative to the business size, which could weigh on the valuation. But that suggestion looks overdone. The remaining GKN pension schemes have a plausible path to deficit elimination. Both sides have agreements with the trustees.

Still, it's true that Melrose's proposal is cleaner as investors get to keep a single, U.K.-quoted company with a primary London listing.

So what swings it for GKN? First, the deal with Dana is attractive and offers industrial synergies of which GKN investors share half. Second, if the improvement in aerospace is better than both sides are saying currently, GKN shareholders would keep all of it. Finally, the value creation under Melrose is open to doubt despite the bidder's very strong track record. Buying GKN would be much more ambitious than previous deals, and it would displease Airbus SE, one of GKN's main customers. Not a good start.

It's largely thanks to Melrose's competing interest that GKN got a good deal with Dana. Melrose has also given the target's management a kick to impose needed change. But GKN shareholders can reject the Melrose offer and still enjoy a benefit. If the British engineer doesn't deliver, another bid will surely come along.

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:
    James Boxell at jboxell@bloomberg.net

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