GKN Is Geared for Growth

GKN at 290p have pulled back a little on the half-year results. If they were to move down towards 260p again they would be attractive on an estimated dividend yield of 3.6 per cent.

In the three years to 31^st December 2015 (the financial year end) GKN (LON:GKN), the aviation and automotive engineering company, had two structural problems of a financial nature. First, it was – and is – a group of businesses highly leveraged with borrowings; second, it had not been increasing sales revenue. That is neither a healthy nor, in the long run, a sustainable situation. These are conditions which in principle inhibit ‘organic’ growth and leave a company more of a hostage to fortune than it reasonably should be.

In 2013, sales revenue was £7,136 million; that fell by 2 per cent the following year, and even if that did increase to £7,213 million last year, it was in part helped by about two months of sales revenue contribution from the newly acquired Fokker aircraft company business. Earnings per share were equally lacklustre having risen by a mere 1 per cent to 29p in 2014 and then falling back by 4% last year. Somewhat in contradiction with those numbers is the fact that the management of GKN have enjoyed a reputation for dividend growth. From 2011 the GKN annual dividend has increased from 6p a share to 8.7p a share last year (representing compound interest growth of 7.7 per cent). Future dividend growth is at risk unless the company can produce the earnings per share to buttress such dividend payouts in the future.

The latest results, in the shape of the first-half figures, show a big jump in Group sales revenue, which rose 17 per cent from £3,616 million in the first half of 2015 (before the Fokker takeover) to £4,237 million for the first six months of the current year – which includes a full six months contribution from Fokker. Thankfully, the management have given us a good idea about the size of the Fokker contribution to sales revenue by telling us that ‘organic’ growth in sales was 2 per cent; not a lot but useful enough in a low inflation, low interest rate world.

However, and inevitably, operating profits in the first half year tumbled 15 per cent to £209 million against an original, presumably pre-acquisition, expectation that operating profits this time would be up 13 per cent. I take that to imply a deferral of operating profits to which should in due course incorporate operating profits arising from the eventual and successful bedding in of Fokker as an operating part of the GKN aviation business.

In line with that, profits before taxation fell 14 per cent and earnings per share by 4 per cent. Significantly, the management raised the interim dividend payment by 2 per cent to 2.95p; again not a bad outcome just when banks are talking about the possibility of charging customers for depositing cash with them.

The other bit of good news is that free cash flow nearly doubled from £21 million last time to £40 million, which no doubt reflects the non-cash charges against profits at a time of ‘berthing’ costs for the new acquisition. Net debt, on the other hand, was reported to have jumped a fifth from £769 million to £918 million.

The latest accounts, including a full half year of Fokker, show that operating cash flow had improved 11 per cent in relation to the same period a year before despite a 24 per cent decline in statutory net profit. That was in part attributable to a 17 per cent increase in the depreciation charge year on year. Although operating cash flow was insufficient for payment of capital and expenditure costs in the half year, the fact that the company nevertheless raised the dividend must be viewed as reassuring for those investors seeking growing income. Logically, one supposes that once the new acquisition is fully installed as an operating part of the Group, operating cash flow will grow, reflecting not only the increased depreciation charge but also an estimated growth in net income.

That seems to chime with consensus estimates of future sales, earnings and dividends. By the end of next year they suggest that turnover will have increased by more than a fifth year on year. Earnings per share are forecast to fall by 2 per cent this year but then rise by 9 per cent next year. The annual dividend is estimated at 9p for the current year, rising by an estimated 5 percent next year to 9.45p. Those forecast dividends are well covered by estimated earnings per share figures of close to 27p (down 2 per cent) this year and to about 29.6p (up 9 per cent next year). This year’s dividend is covered by estimated earnings three times and by next year’s by a similar amount. In other words the ‘earnings’ yield of GKN shares this year is 9.2 per cent and 10.0 per cent next year. The amounts forecast to be paid out as annual dividends from those estimated earnings imply an annual dividend yield of 3 per cent for this year and 3.2 per cent for next year.

I add that balance sheet assets in relation to the share price (‘price to book’ valuation) are estimated to be worth around 110p a share which when deducted from the share price (294p last seen) reduces next year’s purely price to earnings multiple to 6.2 times estimated earnings. It is to be understood that those balance sheet assets are largely intangible thanks to a large goodwill entry in the balance sheet.

At 294p these shares seem more fair value than cheap. The chart shows the price, during the last year, trading (roughly speaking) between 260p and 300p. If it does come down to 260p again, the shares will look attractive on an estimated and well covered dividend yield of 3.6 percent for next year.