Fighting bid, GKN pledges 2.5 billion pound cash sweetener

* GKN (Frankfurt: 694194 - news) plans asset sales to help fund cash return

* Bidder Melrose dismisses GKN plan

* GKN has rejected 7.4 billion pound Melrose (LSE: 136541.L - news) bid (Adds comments from Melrose, analysts, more context, updates shares)

By Justin George Varghese and Paul Sandle

Feb 14 (Reuters) - British engineering group GKN, stepping up its efforts to fend off a hostile takeover bid, pledged on Wednesday to return 2.5 billion pounds ($3.5 billion) to investors over the next three years.

GKN, facing a 7.4 billion pound hostile bid from turnaround specialist Melrose Industries (Frankfurt: 27MA.F - news) , gave more details of its strategy after saying last month it would separate its aerospace and automotive divisions to try to improve profitability.

"This strategy is expected to generate significant cash for shareholders in the short term and meaningful sustainable cash flows over the mid to long term," said Chief Executive Anne Stevens, appointed last month on a permanent basis.

GKN said asset sales would help to free up cash to return to investors.

Its statement prompted fresh criticism from Melrose.

Melrose described GKN's announcement as "long on adjectives and promises but desperately short on detail."

"It is a stark admission of management failure combined with a series of promises which fall well short of what Melrose is proposing," a spokeswoman for Melrose said.

Investors had been calling for GKN to split its businesses after management persistently failed to meet targets to improve profit and cash flow despite growing sales. GKN issued a profit warning in October, which was sparked by the difficulties at its aerospace business.

The company said on Wednesday it had begun an operational separation of the divisions.

GKN, which makes parts for the Boeing (NYSE: BA - news) 737 jet, Black Hawk helicopter and components for Volkswagen (IOB: 0P6N.IL - news) and Ford cars, says it also expects to deliver a recurring annual cash benefit of 340 million pounds from the end of 2020 from its cash improvement initiative, known as Project Boost.

SALES PLAN

Melrose made a firm offer to buy GKN on Jan. 17 valued at 430.1 pence per share or 7.4 billion pounds, which GKN swiftly rejected the same day.

Melrose's offer for GKN consists of 1.49 new Melrose shares and 81 pence per GKN share.

"GKN outlining Project Boost likely will not end the debate about who would better execute it or a namesake – likely similar in objectives," said Jefferies analyst Sandy Morris.

"The interesting thing is that Project Boost fulfils our expectations in that GKN's problems appear to be of the scale and nature that we had sensed, not insurmountable."

GKN said a significant component of the cash return was expected to come from divestments executed within 18 months, including the sale of its Powder Metallurgy business.

Powder Metallurgy comprises two businesses that manufacture metal powder and automotive components - Sinter Metals and Hoeganaes.

Melrose said it would not sell the divison and would keep it for "further improvement."

GKN shares traded 0.5 percent higher at 400 pence by 1105 GMT, after rising as much as 1.7 percent. Melrose stock was up 1 percent at 214.2 pence. ($1 = 0.7198 pounds)

(Reporting By Justin George Varghese in Bengaluru and Paul Sandle in London; Editing by Keith Weir)