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Why I’d sell GKN plc and buy this 5.2% dividend yielder instead

Two of the UK’s biggest industrial companies are currently fighting over what is becoming one of the most contested UK takeover battles in recent history.

Industrial turnaround specialist Melrose is currently fighting for control of GKN (LSE: GKN), which has been floundering for the past few years. Indeed, prior to the takeover approach, shares in GKN had lost 11% over the four years since 2014 excluding dividends.

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However, GKN’s management believes that Melrose’s offer deeply undervalues the business and has accused the acquirer of trying to buy the group with its own money. The £7.4bn offer (equivalent to 405p per share) will be funded 20% in cash with the remainder in stock. 

Restructuring to unlock cash 

To try and convince shareholders that remaining independent is the better offer, today GKN announced a capital return plan that will see up to £2.5bn (around 36% of its current market value) returned to investors over the next three years. Most of this cash return will be funded by the sale of the group’s metallurgy division, the company’s highest margin unit, which management expects to dispose of within 12 to 18 months.

The industrial group is also planning to increase its dividend policy with a target of returning 50% of free cash flow to investors from 2018 to 2020. Restructuring and streamlining efforts are expected to deliver £340m in annual cash benefits from the end of 2020. Still, despite this promise to return a hefty slug of cash to investors, I believe that investors should sell GKN following recent gains.

Melrose has a history of successfully buying, improving and selling industrial businesses, producing annual returns for shareholders of 26% since its founding in 2003. GKN, on the other hand, has struggled to create value even though it has invested £3.2bn in acquisitions over the past few years. 

History suggests that an acquisition by Melrose would be the better option for GKN investors but opposition to the deal is building on all fronts. A merger has been called a “national security risk” by an American congressman as well as the country’s largest union. Meanwhile, here in the UK Labour and the Liberal Democrats have called for the takeover to be blocked. 

Dividend champion 

Considering the above, I would sell GKN in favour of dividend champion Photo-Me International (LSE: PHTM)

Like Melrose, Photo-Me has shown that it can create value for investors over the long term. Over the past decade, the stock has produced a total return of 21.5% per annum for investors through a combination of dividends and steady earnings growth. 

At the time of writing, shares in the photo booth and washing machines business trade at a forward P/E of 16.6 and support a dividend yield of 5.2%. The payout is only covered 1.2 times by earnings per share but it is also backed up by £49m of cash on the balance sheet, enough to sustain the distribution for a year-and-a-half if earnings collapse. This cash balance is worth around 13p per share, giving a cash-adjusted forward P/E for the business of 16.4. That’s hardly cheap but this valuation is acceptable considering the stability of Photo-Me’s earnings and the firm’s historic shareholder returns. 

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Rupert Hargreaves owns no share 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.