Dana - Doubling Down With GKN

Summary

• Dana has reached an agreement to buy the driveline business of GKN.
• The deal doubles the business to $14 billion, creating the largest supplier of driveline system.
• Greater diversification and financial synergies make the deal worthwhile, yet following 2017 momentum, I am not automatically buying Dana following the deal.

Investors in Dana (NYSE:DAN) were quite pleased with the proposed acquisition of the driveline division of GKN (OTC:GKNCF) in order to create a global leader in the electrified drive systems space. With the deal, Dana will double its sales and become a more diversified play, being better equipped to deal with the transformation challenge which the industry faces as it is moving to electrical vehicles.

I like the proposed transaction for its potential synergies and improved diversification, in part offset by an extensive integration process at a time when the business is undergoing a transformation to EV. While multiples are very reasonable, I am not automatically buying Dana following this deal, and even after the recent correction from January, following a crazy momentum run in 2017.

The Deal

Dana is willing to spent $6.1 billion to acquire GKN's driveline business. The deal consists out of the offering of 133 million Dana shares with a value of $3.5 billion, a $1.6 billion cash payment as well as the assumption of a billion worth of pension liabilities. To illustrate how large the deal is, shareholders in GKN will hold a combined 47.25% equity stake in Dana following the deal.

The acquired activities from GKN have been around for 50 years and generated $7.0 billion in sales last year, including $800 million in unconsolidated sales from joint ventures. This values the activities at 0.9 times sales and 8.1 times adjusted EBITDA. The latter multiple will drop to 5.5 times after incorporating the anticipated synergies of $235 million a year. Roughly half of these synergies are driven by procurement, supplied by operating efficiencies and reduction in selling, general and administrative costs. At 1.7% of combined revenues, synergies look quite achievable.

GKN is active across the globe and offers a complete driveline system offering. GKN derives 90% of its sales from cars, while Dana is heavily focused on SUVs and trucks, as well as commercial vehicles and off-road vehicles. Besides greater product diversification, as well as geographical diversification, the combination will have greater customer diversification as well. It will reduce the large reliance on Ford (F), while increasing exposure to Volkswagen (VLKAY) and Renault (OTCPK:RNLSY)/Nissan (OTCPK:NSANY), among others.

Pro Forma Numbers, Nice Accretion

Dana is just a little bigger than GKN's acquired activities. Dana generated $7.2 billion in sales in 2017, making it really more a merger of equals. Combined sales of $14.2 billion create the industry leader, ahead of BorgWarner (BWA) and Continental among others.

Dana posts EBITDA margins of 11.6% of sales in 2017 while GKN reported margins of 10.8%. Including synergies, the overall number should improve to 12.8%.

Ahead of the deal, Dana operated with $1.18 billion in net debt, for 1.4 times leverage ratio with $835 million in EBITDA. Including the $757 million EBITDA contribution of GKN, this EBITDA number increases to $1.59 billion. Given the $1.6 billion cash component, net debt increases to $2.8 billion based on financial debt. This jumps to $3.8 billion if net pension liabilities of GKN's business are included and $4.4 billion if the same pension liabilities of Dana are included.

Depending on your preference, leverage ratios stand at 1.8 to 2.8 times net debt (depending if pension liabilities are included or not). If synergies are taken into account, this drops to 1.5-2.4 times EBITDA.

Dana reported adjusted earnings of $2.52 per share in 2017 on the back of 147 million shares. For starters we know that 133 million new shares will be issued, thereby increasing the total share count to 280 million.

Dana's adjusted EBITDA of $835 million includes $220 million in depreciation charges and another $18 million in amortisation charges. If we assume a similar percentage ratio of these costs in relation to sales, GKN's activities have combined D&A charges of $231 million.

That makes that adjusted EBITDA of $1.59 billion yields adjusted EBIT of $1.12 billion for the combination. Assuming 5% cost of debt on net debt of $2.8 billion (not including pensions) results in financing charges of $140 million. After incorporating a 20% tax rate, adjusted earnings might come in at $784 million, for earnings of $2.80 per share, which is already higher than the adjusted earnings posted by Dana as a result of lower taxes in the US and tax benefits from the deal.

Note that the calculated pro-forma number even excludes costs synergies. Running at $235 million, these could boost the bottom line by $190 million in a year or three from now, boosting earnings by another $0.65-0.70 per share in three years' time towards $3.50 per share.

Shares of Dana traded at $26 ahead of the deal announcement, giving the business an enterprise valuation of $5.6 billion, equivalent to 0.8 times sales and 6.7 times EBITDA. Note that excluded in this calculation are pension liabilities of another $600 million, which understates the multiples for Dana by about 0.1 times in terms of sales and 0.7 times in terms of EBITDA. Adjusted for that, Dana traded at 0.9 times sales which is the same as the multiple paid for the GKN activities. The 7.4 times EBITDA multiple at which Dana traded looks a little lower than the 8.1 times paid for GKN, although cost synergies and tax efficiencies should reduce the acquisition multiple to 5.5 times.

The Market Likes It

Shares of Dana jumped 3-4% in response to the deal. The $1 jump in the share price corresponds to a nearly $300 million increase in the valuation (including the to-be-issued shares). While the acquisition multiples of the GKN business look a bit rich (compared to the standalone valuation of Dana), this should be justified by the (tax) synergies over time which probably make the deal worthwhile.

One thing is certain, the deal is structured in a way which brings benefits of both groups or shareholders in the sense of combined ownership, modest leverage, greater diversification across regions, products and customers and thereby greater R&D firepower to keep up with future changes.

Earnings power of $2.80 per share (or $3.50 per share including synergies) looks appealing as it translates into low earnings multiples. The reality is that automotive suppliers always trade at lower multiples.

Coming out of the crisis, when shares traded at just $0.20 per share, they quickly rebounded to $20 by 2011 to fall to $10 again in 2016 amidst concerns about losses in market share. After all, revenues fell from $7.5 billion in 2011 to $5.8 billion by 2016 while general economic conditions were quite solid. By now growth has returned (aided by deals) as well as new management, which prompted shares to rise towards $35 in January. Given that shares traded $8 higher just a few weeks ago, reality is that they continue to trade with gains in excess of 40% over the past 12 months.

While the company has improved the organic business as of recent, integrating both businesses is a sizeable task, just at the time at which the transition into EV vehicles and the associated technologies is taking place. While the $2.80-3.50 per share earnings power looks very compelling, I have to stress that these are adjusted earnings as real cash charges do often show up at such large businesses which operate in cyclical markets and operate in changing industries.

Using normalised 6% operating margins, realistic earnings through the cycle come in about a dollar per share lower than the range mentioned above. While this still creates a decent earnings yield, it does not necessarily offer a great bargain yet.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.