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Why GKN Shareholders Should Give Melrose the ‘Brush’ Off By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

 

Apologies for writing twice in one week on the same company but read this from Alan Tovey, the respected Daily Telegraph Industry Editor, published on the 31st August 2017:

““Dreadful, horrible” conditions in the oil and gas markets have seen investors shy away from engineering turnaround investor Melrose. The company [Melrose] whose strategy is to buy, improve and sell under-performing businesses, said BRUSH, its investee company which produces generators, is suffering because the continued low oil price means customers’ capital expenditure has been slashed”.

BRUSH Electrical Machines is a name synonymous with great UK based engineering and it is a company with a fantastic past. Born of American foundations and established in the UK as long ago as 1879, Brush has a long and illustrious history during which the company has manufactured a wide range of diversified engineering products, including heavy oil engines and electrical and traction equipment, generators, railway locomotives, bus bodies, battery electrical vehicles and much else besides. The now BRUSH Electrical Engineering is based in Loughborough and from a historical perspective has remained independent until it was taken over by Hawker Siddeley in 1957.

In 1991 Hawker Siddeley was itself to be the last major takeover by BTR (a company built up from a small tyre manufacturer by Sir Owen Green who died last year and synonymous with its earlier takeover of Dunlop, BTR became the largest engineering based conglomerate in the UK) and, as many of us had anticipated at the time in 1993, this would prove to be a very troublesome acquisition and one that Green’s successors failed to handle.

By 1996 Brush had been sold off by BTR to FKI and in turn, in July 2008, FKI was to be acquired by a private buyout company called Melrose. Melrose has grown fast and is today forging ahead with a hostile opportunistic and undervalued bid for GKN offering just 1.49 of its own shares per GKN share, a figure that places a value on its FTSE100 target company shares of 430.1p each and values GKN overall at £7.4 billion.

The bottom line for me is that whichever future course of action takes place – GKN is separated into two distinct units, a strategy that its management has stated it intend to adopt, or acquired by Melrose or someone else, broken up and then the divisions perhaps sold off to foreign owners, the UK will undoubtedly lose out. Companies such as GKN matter to the UK economy and in a post Brexit world, we need all that we can get.

Although there may be no hard and fast rule, my understanding is that Melrose strategy aims to own businesses that it acquires for between three and five years. During that time it aims to turn round what it believes are underperforming manufacturing assets and sell them on. To that end, the majority of subsidiaries acquired with FKI in 2008 for instance have already been sold. However, almost ten years on Brush remains part of Melrose and I doubt very much that the reason is because they like the name.

The principle behind this type of acquisition is often based on buying cheap when, in the case of quoted companies, the shares are on a down and out, stripping out cost without any concern related to long term working capital needs, and then selling the company before it perhaps falls on hard times. Often, although this does not in any way imply that Melrose is guilty of this, assets are then stripped out and sold and borrowing is substantially increased before the company is disposed.

In my long career as an equity analyst I have seen the buy-in/buy-out specialists, the conglomerates, turnaround specialists and asset strippers come and go. No names, no pack drill but worth recalling that when I qualified in this profession in 1984 I had no fewer than 160 quoted engineering companies on my list to choose from to follow. Today in respect of large and mid-size quoted engineering concerns, I suspect I would be talking about less than a dozen.

This is what I said in my 14th January commentary piece, ‘GKN Fights for Its Life’:

“The investment community has wanted to see GKN broken up for years just as it has welcomed and indeed, prospered from bids and break-ups of many once great UK based engineering companies such as Hawker Siddeley, Joseph Lucas and TI Group. Such things would never be allowed to occur in Germany and France but here in the UK, investors care less about the long term future and whether there will be any engineering and manufacturing companies left to invest in.

And where are all those once great companies now? Mostly they have gone to that great graveyard of former British engineering companies in the sky for whom the sum of the parts was deemed by investors to be worth more than the whole! Are we ready to see yet another fine British company in the form of GKN that has a fantastic history of achievement and a collection of hugely important global automotive, aerospace, powder metallurgy and additives businesses potentially disappear without trace for the benefit of a few Vultures?”

I also said this: “Investors should not lose sight that despite the regrettable situation that has required GKN to make massive provisions in 2017 in order to cover issues relating mainly to its US aerospace activities the company continues to fire on all cylinders meaning that all four of the main business divisions – automotive driveline, aerospace, powder metallurgy and additives are strong, growing and profitable”.

I guess that Brush remains part of Melrose (Brush mainly produces electricity generation equipment and generators) today not because it is an intrinsic part of the strategy but because they are stuck with it as it struggles with low sales activity due to the low oil price and no doubt, intense global competition. In order to better demonstrate the seriousness of the current situation and show just how bad the market currently is, Brush has said that it expects to sell just 80 of its big £2 million generators in 2017 compared to the 208 that it sold in 2012. Not much that Melrose can do about that save sit on its hands and wait.

The point behind this is that not all companies acquired by buy-to-sell mini conglomerates like Melrose are that easy to turn around. GKN is a very big fish in a very big market and while it has itself stumbled as a result of unexpected issues that have occurred in its US operations, it is a very well-managed company producing half decent margins in the majority of its operations. In other words, despite its current difficulties it is not a turnaround situation.

Neither, unlike some, can GKN be accused of overpaying its directors or giving out fancy undeserved bonuses. Despite problems at Brush which have clearly dragged down Melrose financial performance and this despite representing a mere 5% of overall operations, the Daily Telegraph reported last August that in May last year Melrose CEO and three other senior executives “are in line to share a £36 million share bonus” as a long term incentive plan matured, a situation that, whether deserved or not, plays into the hand comments made by the Prime Minister, Theresa May last year when she raised the matter of executive pay rises exceeding corporate performance and which she observed as being the unacceptable face of capitalism.

While one can hardly argue that overall the track record of Melrose, a company that has seen its market capitalisation rise from £13 million to £4.49 billion, is good do we really want to see the potential for thousands more UK jobs being exported? True, GKN is truly global company in all of its four main activities – aerospace, automotive driveline, powder metallurgy and additives.

For the record, Melrose was established in 2003. In 2005 the company acquired Dynacast, a manufacturer of diecast products and components and this, together with the already much slimmed down Aldridge based engineering and plastics group that used to be known as McKecknie Brothers. McKechnie Aerospace was sold in March 2007 to private equity company JLL Partners for $855.6 billion and in 2007 a large part of fastener manufacturer McKecknie PSM was sold to Petrus Holdings (BVI), a company which itself is controlled by EQT Greater China 11 Ltd Partnership.  Interestingly, in September 2010 JLL sold McKechnie Aerospace on to aircraft parts maker TransDigm Group in a deal worth $1.27 billion.

The acquisition of FKI, a quoted buy-out company that was originally built up by Tony Gartland and Geoff Whalley and had been born out of Fisher Karpark Industries, occurred in 2008. For the record, FKI had in 1987 in a very poorly handled rights issue acquired the very much larger Babcock International, then chaired by the late Lord (John) King. Over the next few years around two thirds of Babcock International activities were either closed or sold and just two years after its acquisition FKI floated the remaining heavy interest of Babcock off. The other large FKI acquisition came with Bridon, a manufacturer of cables and steel rope, in 1997. As a buy-out company, suffice to say that FKI struggled. Bogged down in debt and with a range of national and international activities struggling in difficult economic conditions, as an independent this one did not enjoy the fruits of success.

When Melrose acquired FKI in 2008 for around £478 million the main subsidiaries that it brought into the group were Bridon, Brush, Crosby, Truth, Harris and Acco. In one way or another these companies were turned round and improved with the majority, excluding Brush, now sold. Bridon which FKI had paid £131 million for in 1997 was sold by Melrose for £365 million in October 2014.

CHW (London – 17th January 2018)

Howard Wheeldon FRAeS

Wheeldon Strategic Advisory Ltd,

M: +44 7710 779785

Skype: chwheeldon

hwheeldon@wheeldonstrategic.com

@AirSeaRescue

 

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