GKN Driving Ahead

GKN (GKN) bounced cheerfully at the Trading Statement. But on first inspection it is difficult to discern what it was that got the market so positively enthusiastic: as the great Trump of Oz might say, “What the hell is going on here?” However, the reasonable price to earnings ratio, the prospective estimated dividend yield of over 4% for next year, and a decent balance sheet net asset value make the shares attractive at 292p.

The shares of GKN – once long ago a British steel company called Guest Keen and Nettlefold (a name of sheer industrial poetry) – were up 4% on the week after the company published its trading statement.

It has also done very well over the last six months, having risen 10.7% whilst a near stagnant FTSE 100 Index scarcely moved a ripple. However, over a year, the shares are down nearly 18%, underperforming a market which declined a less miserable 10%. Is this a share to be buying, and if so, why?

What GKN does

But first, what is it that GKN does these days now that Messrs Guest and Keen and Nettlefold have long departed the scene?

GKN plc is a global engineering company, engaged in the design, manufacture and service of systems and components for original equipment manufacturers. The company serves four distinct areas of market and industrial demand: Aerospace, Driveline, Powder Metallurgy and Land Systems.

It describes its Aerospace business as being a supplier of aero-structures and engine products and systems to aerospace industry. Its Driveline business is a supplier of automotive driveline systems and solutions to the vehicle manufacturers. Its Powder Metallurgy is a producer of metal powder and a manufacturer of sintered (compounded from metal powder) components. Land Systems is a supplier of power management products and services for a wide range of end markets, including agriculture, construction, mining and industrial equipment.

Why the interest?

If you take a glance at the share price chart, you will see that the share price seems to be on the verge of breaking out from a downtrend that began after it peaked at almost 375p last June. Since September 2015 it pretty much traded between 275p and 300p, albeit sometimes going below 275p for a while and sometimes going above 300p for a while, but mainly trading in that range. So in addition of possibly staging a breakout from a longer established downtrend, it is also on the edge of perhaps breaking out of the sideways trading range. As I always say about charts, where beauty is often in the eye of the beholder, have a look yourself and see what you think.

The problem: red sales in the sunset

Looking at the accounts for last year to December 31^st 2015, from then you see that top line sales revenue has not been growing, which is a problem for a company which is financially highly geared like GKN. Last year, total capital was geared 35% by balance sheet debt, and equity by 54%.

It is part of the company’s recent history that it was perceived to have added a higher margin aviation business with growth prospects to its well known, traditional lower margin motor vehicle ‘driveline’ activities. But the green grass in aviation has proved less green than expected with the downturn in military orders.

Over the last three years, sales revenue has hardly grown. Sales were £7,136 million in 2013, dipped by 2.2 per cent in 2014 to £6,982 million, and reached £7,231 last year – a year on year increase of 3.5%, but only a rise of 1.3% over two years.

The company’s operating profit did much worse, as did its operating margin. Although operating profit increased 11.7% last year it was still 42% below the figure two years earlier. That is best summed up by looking at the operating profit margin, which stood at 7.86% in 2013 and was only 4.46% last year.

Clearly, GKN needs to raise sales revenue whilst holding its operating costs below the sales increase in percentage terms. The report that sales increased by12% was not only good news in absolute terms but also encouraging confirmation that the management’s early guidance to the market was reliable.

That is important because the market consensus of estimates for this year includes a 14.8% rise in sales, implying not only that the market estimates is in the ball park of expectations but that, by arithmetic implication, we could see an even higher figure as the year progresses. Remember that the Fokker acquisition was made last October so the first half statutory results should also have the benefit of a first time sales contribution without comparison. That’s good psychologically and good fundamentally, if the management has enough scope for cutting operating costs on an underlying basis as a means to increase both operating and net profits over the next few years.

The company is on its way, or so it seems, to justifying the current valuation of the shares and pushing the share price upwards. Looking at the market consensus of estimates, it does not foresee an increase net earnings this year – they are shown to actually drop 1% this year to an estimated 27.4p, no doubt due the one off costs normally associated with acquisitions. They should run off at some point and it’s interesting to note that the consensus estimates are for an 8% increase in earnings next year to 29.6p on the back of a more normal 3.2% increase in sales that year.

On that basis, the shares at 292p (last seen) stand on an estimated price to earnings valuation of 10.6 times for this year, dropping to 9.9 times next year’s estimated earnings. That is a multiple low enough to make the shares, on the back of an 8% increase in earnings, look fair value if achieved. It is certainly low enough to justify a punt on the company doing better than currently anticipated. So, what is an investor likely to be paid in dividend “rent” for investing in such an outcome?

Dividends

First, the company’s track record as a dividend payer has been a good one over the last five years. Average annual dividend growth over that period is reported as being 11.7%. The market, looking at the consensus, expects dividends to increase every year out to and including 2018, at an average annual compound rate of 2.76%. Assuming that earnings in 2018 reach 37p a share as estimated, and the dividend payout is 31.32p as estimated, then the dividend will be covered 1.18 times. More to the point, the estimated, prospective dividend yield on the latest share price (292p last seen) is 4% for this year, 4.2% for next year and 4.4% for 2018.

Cash and operating cash flow

One small harbinger of that is to be found in the increase in last year’s operating cash which rose 18% to £775 million. Although that was enough to cover last year’s annual dividend payout of £142 million about five and a half times, it was also helped by a noticeably squeezed working capital figure, which was no doubt a reflection of reduced sales. There was also a large jump in total group investment. At the year end, cash held in the balance sheet was still £291million – down £26 million from the previous year but enough to cover the annual dividend two times.

Net balance sheet assets

It remains to be pointed out that the equity capital of GKN increased last year by more than a quarter. Balance sheet assets accordingly increased to an estimated 100p a share.

Summary

It appears that the company with adroit financial management is giving the market consensus dividend estimates some credibility as it works to make the longer term gross margin improvements. On that basis, the shares do look attractive as a dividend payer over the next year or two. The market’s bullish greeting of the news of the 12% increase in sales revenue looks justified. The first half results are due 26th July.