GKN Takes Up Arms Against the Hedge Fund View of the World

(Bloomberg Gadfly) -- A hostile takeover bid can improve a company by imposing cultural revolution. But it may not need to succeed to do so. Shareholders in GKN Plc are already getting the benefits of Melrose Industries Plc's assault and the offer is still being fought over. The U.K. engineering group has come up with a defense that's worth supporting.

Both sides have seemingly similar visions for the poorly performing maker of car and aircraft parts. GKN says it can lift operating margins from 7.4 percent to at least 10.5 percent; Melrose eyes at least 10 percent. Bidder and target both see GKN's powder metallurgy business as something to sell -- GKN now, Melrose later.

GKN would at some point split the remaining automotive and aerospace component businesses. Melrose would presumably sell them off separately as part of its exit plan. GKN is creating distinct operational and management structures immediately and would explore formal separation -- for example a demerger -- further out.

Shareholders have been focused on management credibility. There's no clear winner on this score.

Melrose has a proven record of making money for shareholders -- and its own bosses -- by buying businesses, turning them around and selling them. By contrast, the appointment of Anne Stevens as boss of GKN was driven by events, after the CEO designate left with a profit warning and Melrose pounced.

But getting the job for want of a better alternative doesn't mean Stevens can't deliver as well as Melrose. Her diagnosis of GKN's ailments -- the pursuit of growth over returns -- is right. The solution, in the form of focused capital allocation and clear management incentives, is convincing.

GKN now has a mostly new management team. The plan set out on Wednesday included 340 million pounds of audited financial benefits, against operating profit of 774 million pounds for 2017.

The real choice comes down to the terms of Melrose's offer and investors' investment horizon.

The Melrose terms aren't better than GKN's new strategy. GKN had an enterprise value of 6.5 billion pounds ($9 billion) before Melrose pounced. Suppose both sides could improve that by 25 percent to 8.1 billion pounds (a conservative assumption given the envisaged margin improvement). Deduct current net debt and GKN would be worth 7.2 billion pounds.

Now consider a merged Melrose-GKN. Add Melrose's undisturbed enterprise value to that of an upscaled GKN and the combined company would be worth 12.9 billion pounds, with an equity value of 10.1 billion pounds. GKN shareholders are being offered a 57 percent share of this plus 1.4 billion pounds -- about 7.2 billion pounds as well.

But if GKN's improvement goes further, the economics tilt in favor of independence -- as GKN shareholders would keep 100 percent of the upside.

Taking Melrose's offer also means abandoning GKN's longer term upside from R&D projects that take decades to deliver, in favor of a "buy-improve-sell" model that could be done and dusted well within 10 years.

None of this guarantees GKN's success. The prevalence of Melrose shareholders and short-term hedge funds on its register plays to the bidder's advantage. And a raised bid would change the calculations.

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

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

©2018 Bloomberg L.P.

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