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Should I pile into GKN plc, up 25% today?

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Shares in FTSE 100 engineering group GKN (LSE: GKN) rocketed 25% higher when the market opened this morning, after the group said it had rejected a takeover approach worth 405p per share from turnaround specialist Melrose Industries.

That news would have been enough to perk up the share price, but GKN has gone one better. After “an intensive analysis” it has decided to separate its Aerospace and Automotive businesses into two separate companies.

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Many investors have been calling for the firm to split itself up in this way for some time.

Their view — which I share — is that it should release considerable value from both businesses. Although a takeover bid would be welcome, I’m inclined to agree with the GKN board’s view that Melrose’s offer was “entirely opportunistic” and undervalued the company.

Why the bid is good news

Under UK takeover rules, Melrose has until 9 February to make a firm offer for GKN or to withdraw from the process. If I was a shareholder, I wouldn’t be too concerned either way.

In my view, what’s most valuable about this bid proposal is that it provides the market with a credible independent valuation of GKN’s business. Melrose is an industrial turnaround specialist with an excellent track record. If it’s willing to pay 405p per share (about £7bn) for GKN, then I feel confident that over perhaps a five-year period, GKN could be worth significantly more than this.

Interestingly, Melrose shares have risen by about 6% today. That suggests to me that the firm’s investors also think GKN could be a profitable buy at this level.

How the split will work

GKN hasn’t yet confirmed the process for separating its aerospace and automotive divisions. But it has confirmed that they will become separate companies.

I suspect that one will retain the GKN branding and stock market listing, while the second will be spun out to become a new listed company. Existing shareholders may receive shares in the new firm, while future shareholders will be able to choose which they wish to invest in.

History suggests that separating these businesses will improve the focus and accountability of management at each firm. This should result in stronger growth and a higher valuation than the combined business would have achieved.

What’s next? Project Boost

GKN’s management admits that “while sales have been growing, both profit margins and cash generation have been below expectations” in recent years. They aren’t wrong.

According to the data service I use, sales have increased by an average of 9% per year since 2011, but after-tax profit has fallen by an average of 2.8% per year over the same period.

To address these issues, the company is now entering into a comprehensive two-year turnaround programme dubbed Project Boost under its new chief executive Anne Stevens. This will run in parallel to the work needed to finalise the split.

Should I buy?

I don’t know what GKN’s share price will do next week. But based on today’s news from the company and the view taken by Melrose, I’m fairly confident this stock should be worth substantially more than 405p over the next few years.

On that basis, I’d continue to give GKN a ‘buy’ rating.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of GKN and Melrose. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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