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GKN closing the value gap

Buying Volvo Aero makes GKN look more like an aerospace company - but its shares are trading on lowly multiples that are more appropriate for a pure play automotive business
September 20, 2012

Keen readers of the financial pages will know that GKN has the automobiles & parts sector largely to itself. Yet GKN's purchase of Volvo's aerospace division in July is a game-changer that increases its already substantial footprint within the resilient aerospace sector - indeed, making lightweight composite wing parts for Airbus and Boeing generated sales of £770m in the six months to end-June. In fact, the shares have jumped about 30 per cent since the deal was announced yet, when compared to aerospace peers, they remain undemandingly rated.

IC TIP: Buy at 237p
Tip style
Growth
Risk rating
Medium
Timescale
Long Term
Bull points
  • Volvo Aero deal boosts aerospace business
  • Reasonable dividend yield
  • Shares cheap when compared to aerospace peers
  • Outperforming global auto market
Bear points
  • Soft European auto market
  • Military aerospace sales in decline

Bought for much less than expected - £633m - Volvo gives GKN a complementary lightweight engine components business. It also means that civil aerospace - which grew sales 16 per cent at the first-half stage - will contribute more than two-thirds of divisional sales next year. Overall, higher-margin aerospace work should generate around 40 per cent of group trading profit, too - about £270m - and, with both Airbus and Boeing scrambling to fill a record backlog of orders, that should hit £295m in 2014. Last year it was just £166m. That easily offsets the decline in demand for US military aircraft like the C-17 transporter and F-15 and F-18 fighter jets.

Volvo also adds much more work on propulsion systems used on every one of Airbus' and Boeing's civil aircraft programmes and on almost every engine choice. That inevitably increases the amount of revenue generated per plane, which could increase further as new jets like Boeing's 787 and fuel-efficient narrow body planes ramp up production. It should also generate lucrative high margin aftermarket work.

True, Volvo's operating profit margin - 5.2 per cent in 2011 - falls short of GKN's high standards, yet integration should be rapid and management believes cost savings and operational improvements will get that up to its divisional target of 11-13 per cent next year. That sounds plausible - in February, chief executive Nigel Stein introduced tougher margin targets, just a month after taking the wheel, and is making good progress.

GKN (GKN)

ORD PRICE:237pMARKET VALUE:£3.86bn
TOUCH:236-237p12-MONTH HIGH/LOW:242p153p
DIVIDEND YIELD:3.3%PE RATIO:8
NET ASSET VALUE:75pNET DEBT:37%

Year to 31 DecTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20094.22-54.0-3.20nil
20105.0834519.65.0
20115.7535118.06.0
2012*7.0248324.27.2
2013*7.8760128.57.9
% change+12+24+18+10

Normal market size: 12,500

Matched bargain trading

Beta:1.6

*JPMorgan Cazenove estimates (sales not comparable with historic figures).

Still, a sharp slowdown in car production among European volume manufacturers has caused concern and the highly cyclical automotive industry generated 59 per cent of sales last year. But GKN has a well-established habit of outperforming global car production. In fact, first-half organic sales at the core Driveline division rose 9 per cent and trading profit jumped even more to £121m. GKN beat the market in North America and China, and in Europe, too, where more resilient premium brands such as BMW and Audi account for 40 per cent of sales. Increasing demand for sintered components also delivered significant gains for the Powder Metallurgy (PM) unit. Industry forecasts point to further declines in global light vehicle production, so PM sales will probably slow.

There could also be some read across from BAE's planned tie-up with EADS. That move may pave the way for "value creation across unloved, deep value stocks weighted down by pension liabilities," believes Oliver Wynn-James, analyst at broker Panmure Gordon - he sees GKN in that category. "This opens up a multitude of possibilities for companies like GKN, which could combine large operating businesses with strategic peers, and then service the pension issues at a removed level." Ideas for unleashing value in this way include flipping the aerospace business into another venture, or even selling it and settling the £926m pension deficit, which currently absorbs cash flow. All brave stuff - although possibly a distant prospect.

In the meantime - and despite the rerating since the Volvo deal - GKN's shares trade on under nine times JP Morgan Cazenove's 2012 estimate of adjusted earnings of 26.6p, and that falls to under eight times based on 2013's adjusted forecast earnings. That, however, is near the bottom end of the historic valuation range and represents a substantial discount to the share price rating of aerospace peers such as Senior and Meggitt - their shares trade on 13 times forecast end-2012 earnings. The broker also estimates that the shares are worth 280p after applying conservative mid-cycle share price multiples, and 290p on a sum-of-the parts basis. Meanwhile, a prospective yield of over 3 per cent looks good - the average yield in the aerospace sector is just above 2 per cent.