Melrose Industries PLC (LON:MRO) gives an “Improved” and final offer for GKN plc
On March 12th, 2018, Melrose Industries announced their final offer for GKN plc. The offer comes on improved terms: shareholders will receive £1.4 billion in cash (or £0.81 per GKN’s share) and the rest in shares and will own 60% of the combined company.
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Melrose thinks that going vabanque with this final offer and putting a pressure on GKN shareholders will force them into a panic mode that will lead them to accept the offer. It remains to be seen what would be the final outcome of this battle, but one thing is clear: if the offer will not be accepted, it will be Melrose Industries’ shareholders who will remain to hold the bag. The only thing that justifies company’s current valuation and market capitalization is a possible future acquisition. I believe this is the reason why Melrose decided to proceed with this hostile and aggressive offer in the first place. Their only currency is their share price, and as Melrose’s valuation is much higher than that of GKN’s it is not clear who in his right mind would accept the dilutive offer only for the opportunity to change management. It might be too high a price to pay for this and GKN shareholders understand it perfectly well.
Proposed transaction with Dana Inc
I believe the criticism outlined by Melrose today regarding proposed combination with Dana Inc is not justified. In fact, the opposite might be true: it seems that GKN’s management and the board started to move and work actively for the benefit of their shareholders. I think they deserve some credit here because despite a quick move to reach a deal with Dana Inc they were able to secure rather attractive and reasonable terms for their shareholders. At the same time, it seems that the merger of two companies is a great win for Dana Inc shareholders as well.
The terms of the transaction leave the shares of the combined company conservatively valued at almost the same EV/EBITDA multiple of x6 (assuming synergies, as outlined in company’s presentation) while doubling the EBITDA and at least doubling or possibly tripling free cash flow. Dana Inc had a free cash flow of $266 million last year and adding $200 million in synergies and $161 million from GKN (rough estimate) would bring total free cash flow to $627 million. Subtracting an estimated $102 million of new interest expenses would leave a free cash flow of $525 million. This would provide a 7% free cash flow yield based on the new market cap of $7,547 million ($27.14 per share closing price of Dana’s stock and 278 million of shares outstanding after the transaction with GKN).
Just a stabilization and revaluation of the EV/EBITDA multiple to x8.5 would provide a three-year price target of $49.17 per share or an upside of 81.2%. GKN shareholders will own approximately 48% of the combined company. Needless to say, if things turn out right, the larger company can probably achieve much higher synergies and cost savings than $235 million specified in company’s presentation and press release of the transaction.
From Numbers to Narrative
In my recently published book Story Investing I discuss how to be creative in the investment research process and come up with great investment ideas. One of the highlights of the approach is the proposal to identify important, dramatic turning points. Just as in any good story or movie there are important turning points, there are such inflection points in company’s history. After such turning point is identified, one can develop both a historical perspective as well as future narrative around this event. It seems that GKN plc and its shareholders are exactly at such turning point right now.
All the problems and concerns voiced by both Melrose and GKN such as pension liabilities will remain and will not disappear by themselves disregarding what course shareholders of GKN will decide to take – be it an acquisition by Melrose or merger of the division with Dana. GKN’s management will and still is facing a hard task of turning the company around. But one thing is clear in my view: under no circumstances, shareholders should become “hostages” to an overvalued share price of the acquirer. In choosing between dilutive merger with an “empty” management company whose equity is valued much higher compared to GKN’s and between merger with a strategic industry player shareholders of GKN should prefer the latter option.
By Alex Gavrish, Etalon Capital; author of "Story Investing"