GKN splutters to life

GKN is ploughing a lonely furrow as a British engineering company whose shares are still resident in the FTSE 250 index. Indeed, it is practically the only mass producer of car parts left in the UK. The group is the very epitome of a cyclical firm and its share price has fallen far from its highs of 2007. The boom years saddled it with a legacy of debt as it struggled to keep up with demand, while the credit crunch devastated orders and left production lines idle. But a £423m rights issue last summer and a deep restructuring has moved GKN off the critical list and into recovery mode.

An investment in GKN's equity has to contend with at least two practical risks. First, the dilutive effect of the rights issue could be repeated if the company needs more money; second, because of necessary dividend cuts, the shares offer little in the way of income. In order to offset this, investors might construct a combination of recovery play and income stock from GKN by splitting their investment between the company's shares and its bonds.

As we pointed out last week, GKN's 6.75 per cent 2019 bonds look like a good buying opportunity and offer a 6.5 per cent yield. Currently, their credit rating, according to Standard & Poors, is BB+. That does not quite make them a junk bond, but their status could be better. Indeed, GKN's bosses want to see the firm's debt regain investment-grade status by 2011. If that happened, then it would most likely ensure a decent rise in the market value of these bonds as various types of institutional investors chased after them.

However, the big question is how to split exposure to GKN between the bond and its equity. That will depend on each investor's preferences. But an income-orientated investor looking for a combination of recovery potential and yield could put about two-thirds of his capital into the bonds. That would give him a useful equity market-plus yield of 4.0 per cent, with the hope that his holding in the ordinary shares would provide the kicker. Those who are particularly fearful of inflation might want less exposure to the bonds; those who take an optimistic view may want more. That said, those willing to run the bond to maturity - not beyond the realms of possibility - may not care too much about inflation.

Operationally, GKN has put its finances on a much better footing thanks to the rights issue. Management expects that net debt will have dropped below September's £374m by the end of the year; by contrast, it started 2009 at £708m.

But a big reason for City analysts to raise their profits forecasts for GKN is that the performance of the automotive division in the final quarter of 2009 was undoubtedly stimulated by car scrappage schemes around the world. Car sales in the UK, for example, were up 57 per cent during the autumn. However, although it is difficult to say how much of a direct boost this gave to GKN's earnings, analysts at stockbroker Cazenove believe that the company will add 27 per cent to its EPS on the back of a better fourth quarter. The recently enlarged aerospace division is expected to be no better than flat this year, but at least there are few signs of the mass cancellation of orders for civil aircraft that were feared last year.

Buying GKN's bonds and shares could also be a cost-effective indirect way of benefiting from China's growth, especially when most direct investment opportunities in the country look desperately overpriced. The country is fast becoming the largest new market for automobiles, but, currently, GKN receives little direct benefit as most vehicles there use relatively unsophisticated fixed rear axles. This could change quickly if demand for modern transport takes hold. Also, sterling's persistent weakness should play to GKN's role as a major exporter.