Takeover activity in my small-cap space has stepped up a gear or two in recent months. True, larger predators habitually pick off the market’s minnows, and my value-focused investment bias means that I am rarely the only one running a slide rule over a company’s investment case, albeit my strategy is to spot the value opportunity at an early stage when companies are well below the radar, thus maximising the gains. But it’s now getting ridiculous as no fewer than nine companies I have been following are either in the process of being, or have already been, taken over this year.
The growing list of takeovers includes software companies Scisys (SSY) and Sanderson (SND), IFA group Lighthouse (LGT) and Europe's largest car auction operator BCA Marketplace (BCA), which I am playing through the shares of closed-end investment company Marwyn Value Investors (MVI). To that list you can add old favourites Manx Telecom (MNX), easyHotel (EZH), Faroe Petroleum (FPM) and Telford Homes (TEF). And while I was convalescing on my sick bed last week, fund manager Miton Group (MGR:51.5p) announced an agreed merger with larger rival Premier Asset Management (PAM:168.5p).
There is sound logic for doing a deal as the enlarged group will have £11.5bn assets under management, offer complementary investment capabilities with limited overlap, evenly based between active single strategies and outcome-based multi-asset strategies, benefit from an enhanced distribution network of financial advisers and wealth managers, and have greater financial strength, too. On a pro-forma basis, the merged group was the fifth largest contributor to net retail UK fund sales in 2018, and generated £76m of revenue and £25m of pre-tax profit. Profits are set to get a significant lift, too. That’s because eliminating the duplication of staff roles, rationalising head office and central functions, and aligning third-party service providers and IT systems should generate £7m of annual cost savings at a reasonable one-off cost of £10m.
The terms of the merger look sensible to me. Premier is offering 0.30186 new shares for every Miton share, and Miton shareholders also receive a 4.9p-a-share special dividend. That’s 55.76p a share in total, a premium to the 47p mark when I last made the case to buy Miton’s shares (‘Miton priced for a re-rating’, 22 July 2019). Including 5.67p a share of dividends paid since I first suggested buying the shares at 23p ('Poised for a profitable recovery', 4 April 2015), the proposed merger delivers a 168 per cent total return on the holding in under four and a half years, equating to an eye-catching annualised return of 25 per cent.
Strip out Miton’s net cash of 13.5p a share from the proposed 55.76p value of Premier’s offer at current market prices, and the exit multiple equates to a cash-adjusted price/earnings (PE) ratio of 10 for the 2019 financial year based on Miton achieving earnings per share (EPS) of 4.2p. True, without the equity element of the deal that would be a stingy offer. But with Miton shareholders set to hold 33 per cent of the equity of the enlarged entity, they will benefit from the value to be created by merging the two fund management groups.
Importantly, Premier’s paper is not over-rated as analyst Stuart Duncan at brokerage Peel Hunt points out that the company is currently valued on an enterprise value to operating profit multiple of less than eight times. Bearing this in mind, the merged group will have a market capitalisation of around £270m, so an unwinding of the liquidity discount embedded in both companies' share prices should lead to a higher rating for all shareholders given its larger scale should attract a larger investor audience.
The merger looks likely to go through, too, as Miton directors have pledged to vote their 9.49 per cent shareholdings in favour of the scheme of arrangement, as have two institutional shareholders controlling 17.43 per cent of Miton’s equity. I would do the same. Accept.
Elektron’s bumper cash return
Shareholders in technology group Elektron Technology (EKT:57p) have voted overwhelmingly in favour of approving the sale of Bulgin, a world-class designer and maker of hermetically-sealed (air and watertight), fail-safe circular connectors used to supply electricity and other vital equipment, to Equistone, a mid-market private equity firm, for £105m on a cash free-debt free basis.
Net of transaction costs, settlement of management bonuses and share option plans, the directors of Elektron expect to have a net cash pile of £95m (51p a share) on completion of the disposal on or around 24 September 2019. The plan is to return £81m of the cash pile to shareholders through a tender offer of shares at 65p on the basis of two shares repurchased for every three held. Full details of the tender offer will be released after receipt of the funds. The tender price represents a 48 per cent premium to your 44p entry point in my November Alpha Report. I also reiterated that advice when the shares were trading at 45p earlier this summer (‘Elektron’s electrifying growth’, 17 June 2019). This means that if you bought 30,000 shares at a cost of £13,200, you can tender 20,000 of them back to Elektron to receive cash of £13,000, so giving yourself a free ride on the balance. It makes sense to tender your shares and hold on to the balance.
That’s because £14m (a sum worth 22.5p a share post the tender) of Elektron’s cash will be used for product development, and sales and marketing of the group’s core businesses: Checkit, a proprietary work management ‘software as a service’ (Saas) product that has been designed to replace paper-based systems with a centralised, interactive cloud-based way of managing the multitude of tasks that staff have to carry out on a daily basis; and Fleet-based Next Control Systems (NCS), a leader in high-end service-based temperature monitoring for healthcare and life sciences within the UK, and data-related building energy management system services. NCS was acquired by Electron for £8.8m (14p a share post the tender) in cash in May 2019. It’s a profitable business, although Checkit is lossmaking, albeit scaling up fast. I conservatively value both these businesses at £20m (32p a share) which when added to the £14m cash pile backs up all of Elektron’s share price post the tender offer. That leaves the value of Elektron’s management team in the price for free.
Moreover, Elektron’s cash pile could be boosted further as its non-core Elektron Eye Technology (EET) business, a developer of portable analysers that are used to detect age-related macular degeneration, is also up for sale. I maintain my valuation of EET at £2m (3.2p a share) based on a multiple of 10 times divisional operating profit of £200,000 as forecast by analysts in the current financial year. Tender your shares.
Exploit BP Marsh and Partners anomalous discount to NAV
Financial markets should operate efficiently, embedding all known information into asset prices. However, if they did so then the share price of insurance sector investment company BP Marsh & Partners (BPM:216p), a company that has delivered 11.9 per cent average annual compound growth in net asset value (NAV) since 1990 by backing the management of its investee companies, would not have fallen by a fifth last week.
The share price reversal was prompted by news that LEBC, a financial advisory group in which BP Marsh holds a 59 per cent stake, agreed voluntarily to cease providing defined-benefit (DB) transfer advice following a market-wide review by the Financial Conduct Authority (FCA). The DB segment of the business accounted for a fifth of LEBC’s annual revenue. The stake in LEBC has a carrying value of £35.5m (98.6p a share) in BP Marsh’s accounts, implying an enterprise value of 13 times LEBC’s operating profit after adjusting for net cash on its balance sheet.
The stake also accounts for over a quarter of BP Marsh’s last reported net asset value (NAV) of £126.2m (350p a share). LEBC has performed well to date, but clearly there will be an impairment charge on the holding when BP Marsh reports its interim results on Tuesday 15 October. But what investors have ignored is that BP Marsh’s board have said that “the strong performance delivered by a number of our investee companies in recent months means that the company will emerge in a satisfactory position as regards its financial results.” In other words, expect valuation uplifts on the rest of the portfolio to largely offset the write-down on the LEBC investment. In fact, the directors brought forward a pre-close trading update to highlight just how well some of the investee companies have been performing.
For instance, BP Marsh holds a 44.3 per cent stake in CBC, a retail and wholesale Lloyd's insurance broker, that has a carrying value of £4.9m, implying an equity value of £11m for CBC as a whole, or 11 times last year’s annual operating profit. But the directors has revealed that CBC’s cash profit is on target to increase by 40 per cent in 2019, the same rate of growth as in 2018. It’s not the only high-growth company that BP Marsh is invested in either.
For instance, BP Marsh has a 20 per cent stake worth £6m in EC3 Brokers, an independent specialist Lloyd's broker and reinsurance broker. The business was founded by its current chief executive, Danny Driscoll, who led a management buyout to acquire EC3's book of business from AJ Gallagher in 2014. BP Marsh invested £5m in EC3 in December 2017, since when it has grown revenue from £9m to a forecast of almost £14m this year, while maintaining a good underlying profit margin.
I also note that BP Marsh’s 40.5 per cent stake in Walsingham Motor Insurance, a niche UK fleet motor Managing General Agency, looks set for valuation uplift, too. The holding is in the books for £1.37m, implying an equity value of £3.3m. However, Walsingham has already generated £21.5m of premium income in the first 10 months of the 2019 financial year (£19.8m for the whole of 2018) and is expected to “report cash profits significantly ahead of the 2018 result (£0.6m)”.
I could go on highlighting other portfolio companies that are set for a valuation upgrade, but I think I have made my point. Namely, the steep fall in BP Marsh’s share price since its annual results (‘BP Marsh posts record net asset value’, 11 June 2019) means that the shares are now trading on a 38 per cent discount to the company’s last reported NAV even though the board is guiding shareholders to expect a satisfactory first-half NAV performance. Markets are not working efficiently here.
Shares in BP Marsh have produced a 175 per cent total return including the recently paid final dividend of 4.76p a share for the 2018-19 financial year since I first advised buying at 88p ('Hyper value small-cap buy', 22 Jan 2012), a performance driven by the strong investment performance of its holdings. I expect that outperformance to continue, making the deep share price discount to NAV not only anomalous, but well worth exploiting. Buy.
A banking conundrum
When I last analysed private banking group Arbuthnot Banking Group (ARBB:1,300p), I suggested running profits, at 1,533p, in anticipation of an upward move in the share price to 1,600p, and possibly beyond (‘Bargain Shares: Another chance to bag some bargains Part II’, 16 May 2018). That did indeed happen as Arbuthnot’s share price subsequently peaked at an all-time high of 1,650p last summer before profit-taking prompted what was a sharp pullback during last autumn’s stock market rout.
Since then the board has paid out total dividends per share of 51p to take the total to 461p after I first suggested buying the shares, at 1,459p, in my 2015 Bargain Shares portfolio. The board has also listed the shares on NEX in April 2019 when shareholders received a bonus one-for-100 non-voting share issue. Effectively, this means that if you have been following my advice then your break-even is 987p a share.
As was the case when I first spotted the value opportunity, Arbuthnot is not highly rated. Its market capitalisation of £195m is in line with book value of £197m and the balance sheet includes 1.8m shares in challenger bank Secure Trust Bank (STB:1,270p) that are worth £22.9m, and investment properties valued at £69m. However, the general trading outlook is far more important to me at this juncture.
Management has been sensibly diversifying revenue streams in recent years, increasing commercial lending volumes, so much so that this side of the business is expected to increase its profits by around £3m this year. That’s just as well because Arbuthnot’s private banking arm written loan volumes declined by a third in the first half of this year, lending outside the private bank’s mortgage book fell in the first half, too, and the divisional impairment charge rose by £700,000. Hardman expects the private bank’s pre-tax profits to fall by £1.8m. Loan repayments have remained at high levels as the unit refuses to defend refinance offers, preferring not to chase business that is not appropriately priced for the risk taken. Low loan-to-value (LTV) residential mortgages had previously been a core element of Arbuthnot’s historical lending.
I also note that Arbuthnot’s Renaissance Asset Finance lending business is seeing pricing pressure. So, despite much higher levels of lending volumes, profitability from this unit actually declined in the first half due to yield compression and the decision by clients who purchased high-value cars on credit to hold on to their vehicles for longer, thus resulting in the income earned on these contracts being spread over a longer term rather than being brought forward by early termination of contracts.
Taking all of the factors into account, as well as Arbuthnot’s acquisition of a £266m residential mortgage loan book last month, analysts at Hardman still expect Arbuthnot to deliver a near 8 per cent rise in reported pre-tax profit to £7.3m based on a 14 per cent rise in annual operating income to £77.6m. That seems a realistic assumption to me, but I have serious doubts that Arbuthnot will be able to deliver the step change in profitability in 2020 when Hardman forecasts pre-tax profit of £12m on an ambitious-looking 16 per cent increase in operating income to £90.3m. That’s predicated on a relatively flat impairment charge of £3m in 2020, an optimistic assumption in light of the macroeconomic backdrop. If you have been following my advice, and haven’t already done so, take profits.
TMT Investments gains worth banking
It’s fair to say that investors have warmed to the investment case of TMT Investments (TMT:600¢), an Aim-traded venture capital company that invests in high-growth, internet-based companies across a variety of sectors – and with a significant number of Silicon Valley investments in its portfolio.
In fact, TMT’s share price has surged from 250¢ when I launched my 2019 Bargain Shares portfolio to the current bid-offer spread of 580¢-600¢. For good measure, the board has also paid out a special dividend of $5.8m (20¢ a share) out of the $22.6m cash received from selling its stake in Wrike (wrike.com), the collaborative work management platform that provides workplace teams with a single digital platform to maximise their operational performance. TMT invested $1m in Wrike in June 2012, highlighting the eye-watering returns that can be made.
Indeed, TMT owns a valuable 1.7 per cent stake in Bolt (bolt.eu), a leading international ride-hailing company, which has since soared sixfold in value to $22m (£18.3m) in the past year following a series of funding rounds. Expect a $5m (17¢ a share) valuation gain on this holding to be booked when TMT releases interim results next week. It’s not the only significant gain either as a few weeks ago TMT’s directors revealed that they are selling 9 per cent of their interest in Backblaze (backblaze.com), a leading data back-up and cloud storage company, for $2m. The partial disposal implies the value of TMT's interest in Backblaze has increased to $23.2m, or 120 per cent higher than the $10.5m carrying value as of 31 December 2018. The implied uplift adds a further 43¢ a share to TMT’s last reported NAV, suggesting that the company is set to increase NAV per share by north of 20 per cent to around 350¢ (after adjusting for the special dividend) in the first half of 2019.
|Simon Thompson's 2019 Bargain Shares portfolio performance|
|Company name||TIDM||Market value||Opening offer price 01.02.19||Bid price 06.09.19||Dividends||Percentage change|
|Jersey Oil & Gas||JOG||£52m||205p||236p||0p||15.1%|
|Litigation Capital Management||LIT||£94m||77.5p||86.6p||0.28p||12.1%|
|FTSE All-Share Total Return index||6,852||7,403||8.0%|
|FTSE AIM All-Share Total Return index||1,023||999||-2.4%|
|Source: London Stock Exchange opening offer prices at 8am on 1 February 2019 and closing bid prices on 6 September 2019.|
I have no doubt that TMT is likely to continue growing NAV per share at quite a lick in the future, hence the reason I suggested buying the shares below book value in the first place. However, they are now trading on a significant premium to book value, albeit a healthy premium is justified given expectations that TMT’s diversified portfolio of 27 investee companies (focused around big data/cloud, e-commerce, marketplaces and software-as-a-service solutions) will continue to produce eye-watering gains. It’s just a case of the level of the share price premium to NAV that’s justified.
I also note that TMT’s shares were priced at the 300¢ level in April this year, so some of you will have doubled your money in a very short time frame after taking into account the payment of the special dividend. In the circumstances, I am happy to bank my 140 per cent paper gain. Take profits.
■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK]. Postage and packaging is only £3.95 for purchases of both books.
Details of the content of both books can be viewed on www.ypdbooks.com. They include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential, too.
Simon Thompson has been named 2019 Small Cap Journalist of the year at the 2019 Small Cap Awards, a prestigious event celebrating the best and rewarding the finest professionals and companies that work within the AIM and NEX communities. It is attended by institutions, fund managers, brokers and advisors operating in the sub-£100m market cap quoted company sector.