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Industrial Engineering : Melrose Dodges the Bullet....For Now
GKN Melrose Industries PLC
GKN has issued another warning in relation to its Aerospace US business. A review of working capital has been initiated across all Aerospace plants in North America. While this review is not yet complete it is likely to result in a further write-off estimated to be between £80m and £130m, much of which built up before 2017. We cut our EPS forecast for 2017 to 23p and we now expect no final dividend to be paid. Our new target price is 230p (300p).
GKN
GKN has announced that they have been made aware of two probable claims which are expected to result in a charge of c£40m in Q417, one relating to Aerospace and the other to Driveline. Consensus FY17 PBT is at £736m, we are forecasting £666m and expect consensus to come off 7% following the announcement. Also, as anticipated aerospace has seen a significant reduction in margin caused by pricing pressures, continuing operational challenges and the impact of programme transitions. Shares are up 13% since late-August, we expect at least half of that to be wiped off this morning
The call provided no update to the customer claims but did reinforce our concerns regarding increasing margin pressures. Looking at our current numbers we maintain our forecasts on the basis that i) margin pressure and wider market risks remain very relevant, and ii) we are already 10% below consensus FY17 PBT at £666m, which is not far from the updated company guidance of “slightly above 2016” at £678m. We reiterate our SELL recommendation and 300p target price.
There is nothing like a hurricane or two to make astrology look even more respectable than economic forecasting. Auto stocks, including GKN, have bounced back since Harvey and Irma on the assumption that the destruction of inventories and rebuilding efforts will boost flagging demand for light vehicles in the US. This is despite the fact that previous hurricanes resulted in weaker sales due to reduced economic activity and increased availability of used vehicles. The recent announcement of management changes may have also boosted GKN’s stock but in a break-up scenario we struggle to get a sum-of-the-parts value above 300p. SELL.
GKN reported its H1 2017 results this morning and overall these were a mixed bag. Sales and operating profit came in 5% (£5,212m vs cons £4,962m) and 1% (£436m vs cons £433m) ahead of consensus. Margins are down 20bps from last year. The dividend increased by 5%. FCF at £116m (H1/16: £40m). Our bear case is predicated on two H2/17 factors – a sharp fall in US car sales and Middle East aircraft cancellations, neither of which were mentioned this morning. We reiterate our SELL recommendation and 300p target price.
Qatar Airways yesterday denied a Reuters news story that is that is scrapping deliveries of four A350s due to “know supply chain issues”. We believe that the sanctions imposed by Saudi Arabia, UAE, Bahrain and Egypt are beginning to bite and the entire unfulfilled order book (we estimate 61 A350s) could be cancelled. Other aircraft orders are also under threat. As we have highlighted before Qatar Airways has had to cancel flights to Saudi Arabia, Egypt, UAE and Bahrain that account for 20% of its total seat capacity. The longer flight times to other routes has increased fuel cost, by 10% according to Crucial Perspective, an independent research house. Losses are accumulating. There are also reports of dollar cash crisis as premium over LIBOR offered by Qatari banks has jumped 100 basis points since the sanctions were imposed.
We expect lots of bullish noises coming out of the Paris Airshow about the health of the aerospace industry. However, with the Gulf crisis now in its 11th day, we believe the pressure on Middle-East airlines, particularly Qatar Airways, to delay or cancel aircraft deliveries is growing. Despite 10% revenue growth in last financial year ending March 2017, Qatar Airways made just 5% net margin. Losses are now accumulating.
Expectations of double-digit growth in 2017 PBT and EPS are looking increasingly optimistic to us given the headwinds in US automotive and Middle East aircraft markets. While GKN has invested heavily in higher-value and next generation products since the 2008 crisis, its profitability is still vulnerable to sudden changes in output. We are now forecasting 2017 PBT and EPS of £666m and 30.1p, around 6% and 10% below mean consensus, respectively. With the stock looking fully valued at 8.7x 2017 EBITDA, we expect a period of underperformance as consensus expectations are cut. We move our recommendation to SELL (HOLD).
The strengthening of the US dollar since the election of Trump is adding to the headwinds in the airline industry: over-capacity and falling yields. The airline industry, which is expected to generate $8bn of free cashflow in 2016 on $600bn of capital employed, needs to spend $120bn annually to maintain current delivery rates. Deferrals and down-gauging is now spreading to narrow-bodies as more and more airlines review their capex plans. We expect acceleration of seat densification as airlines look to sweat their existing fleets. We now expect deliveries to fall by 5% over 2015-18 as opposed to our previous forecast of flat growth. Aftermarket may also suffer as seat densification helps cut number of flights. This leads to reduction in our EPS forecasts for key Civil Aerospace names: Rolls-Royce, Meggitt, GKN and Senior.
GKN MGGT RR/ SNR
Last night, I witnessed the first signs of excitement from the company on electrification of cars even though most of the energy was coming from the Michigan-based SVP of Engineering & Technology (Dr. Ray Kuczera). If GKN was a US company it would have finished the analyst presentation with a tablethumping slogan, instead it ended with "electrification is good for GKN Driveline". While Aerospace has received the bulk of investment in recent years, Driveline still represents 44% and 42% of group sales and EBIT, respectively. The company’s best guess is that by 2030 the automotive world will be evenly split between ICE (Internal Combustion Engine), HEV (Hybrid Electric Vehicle) and BEV (Battery Electric Vehicle). While the presentation focused primarily on technology, the big challenge (and opportunity) for GKN Driveline will be in dealing with the changing structure of the automotive industry as new entrants (Tesla, Apple, Faraday, et al) look to supplant GKN’s traditional customers.
The management is talking about sharper focus on productivity and cash but any benefits are likely to accrue to its pension funds: the pension deficit ballooned by over £0.5bn in six months to June 2016. When we turned Buyers back in July 2015, we were partly basing our recommendation on rising discount rates and a reduced pension deficit. However, this was a blip. Insanity still reigns in the monetary planet and worryingly, for GKN’s shareholders, the UK and US discount rates are still 2-3% above Europe and Japan. Each 1% reduction in the discount rate increases the total accounting deficit by over £800m. Of course, actuaries will decide the funding valuation but the direction of travel is clear. We estimate that the annual UK deficit payment will increase by £30m from next year, which will offset the £30m annualised cost saving announced today. We move our recommendation back to HOLD and cut our target price to 300p (375p).
We continue to believe that GKN is one of a handful of UK Industrial Engineering stocks that will produce EPS and dividend growth in 2016 and 2017, and should continue to outperform the sector. The focus on automotive and aerospace sectors may not have produced spectacular EPS growth in recent years but as 2015 results on Feb 23 will confirm GKN has avoided the boom & bust of natural resources world. More important, GKN's EPS growth has not come at the expense of consuming capital stock. Capital employed has nearly doubled since 2008 and peak returns on these investments is years away.
The industrial world may be in recession but the party in the US car market continues. US light vehicles grew by 14% YOY in October. On an annualised basis light vehicle sales in the US reached 18.12m units, the highest level since July 2005 and 10% higher than October 2014. Even Volkswagen managed to grow sales, albeit by just 0.2%. Fortunately, car production remains under control and is only expected to grow by just 2-3% in 2015, and therefore we do not expect any major adjustment to output should US car sales reverse trend.
GKN will provide Q3 update on 22nd October and based on Faurecia's Q3 update last night we are reasonably confident that the VW emissions scandal and China destocking should not impact 2015 forecasts. Faurecia has a much higher exposure to VW (25% of sales in 2014) than GKN (15% of Driveline, 7% of 2014 group sales) but its management seemed confident last night that any fall-out should be limited as other customers gain market share. With regards to destocking in China, this is being easily offset by strong growth in North America and Western Europe.
The first significant data point since the VW emissions scandal suggests that the US buyers have not been turned off buying cars, they are just not that keen on buying VW cars. Lightweight vehicle sales totalled 1.44m in September, up 15.8% from a year ago. The annualised rate of sales, a more reliable indicator seasonally adjusted, rose to 18.07m, the fastest pace since July 2005, according to Autodata.
GKN continues to grow its aerospace portfolio, providing a cyclical differential to the automotive activities. The knee-jerk reactions to recent events (China, VW) suggest that the market continues to fret about GKN’s ability to manage automotive demand falls and destocking. However, the track record from the 2009/10 auto downturn also suggests the company should be better positioned to trade through market disruptions.
Retail auto sales increased by 0.6% YoY in August, having falling sharply in June and July, according to the China Passenger Car Association. Compared with July, deliveries in August climbed 11%. More importantly, from GKN's point of view, SUV sales gained 55% while sales of sedans fell 13%. In July, Chinese auto sales had fallen by 11% YoY increasing fears of a sharp decline in the largest car market in the world. In any case, as we had argued in our 24 August note, China accounted for just 11% of Driveline sales in 2014: Europe and North America accounted for 70%. GKN's China Driveline sales would need to fall by 25% in 2015 for the whole division to report a flat year.
Weekend reports that GKN is mulling the sale of Land Systems follows yet another warning from Deere on Friday. We will be surprised if the business is sold at this stage of the agriculture cycle. Agriculture-related equipment accounts for over half of divisional sales. Deere now expects farm equipment sales to fall by 25% in 2015, compared with its forecast of 24% decline in May. Prices of corn, soya and wheat have fallen by 10-14% in the past year and this continues to impact farm incomes.
With the benefit of hindsight, our decision to upgrade to Buy before the analyst meeting yesterday was fully justified by the change of the venue from UBS to the opulent Grand Hall at JPM. On a serious note, GKN may have pulled off a great deal in acquiring Fokker Technologies. Strategically, we estimate GKN has increased its market share of aerostructures market from 6% to 8%, albeit still well behind Spirit AeroSystems on 19% and gained a foothold in China. The deal looks much better financially. Even before any savings or synergies are gained, GKN can comfortably earn its target post-tax return of 9% from 2016 including €50m of integration costs and enhance EPS given the tax losses that are available to be utilised for several years. Cost savings of 3% of sales should be deliverable, given Fokker's EBIT margin at 7% in 2014 were 5% below GKN Aerospace' 2014 margin. The ambition must be to emulate current group post-tax return on capital employed of 13%.
Interim results were better than we had expected thanks largely to a good performance by Land Systems despite the pressure on sales. Land Systems generated margins of 4% against our expectations of break-even. As a result, we are increasing our PBY forecast for 2015 by 4% to £614m. Other divisions performed in line with our expectations. Another positive is that the pension across all schemes at 30 June 2015 was £1.533bn, a £178 million decrease over the 31 December 2014 deficit thanks to partly to rise in discount rates. The acquisition of Fokker will also be seen favourably by the market as it fills a strategic hole in GKN's aerospace strategy. We are upgrading our recommendation to Buy with a TP of 375p (from 324p).
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