Takeover activity has been a recurring theme among the small-caps on my watchlist over the years.
This is mainly a reflection of my value-orientated focus approach to seek out under-researched small-cap companies that are not only well below the radar, but are significantly undervalued, too. It also reflects more liquid and higher-rated larger rivals exploiting these valuation anomalies, as well as a surplus of 'dry powder’ in the private equity market chasing deals. However, in the past year there has been an unprecedented increase in mergers and acquisitions (M&A) activity, with 10 of the companies I've been watching exiting the stock market.
Another contributory factor is that sterling is trading significantly below its pre-EU referendum levels against both the euro and US dollar, thus offering foreign companies that have enjoyed a rerating of their paper while the UK equity market was being shunned the opportunity to exploit valuation discrepancies. It’s also a show of faith in trading prospects for UK plc as predators look to benefit not just from the solid earnings and cash flows of UK acquisition targets, but from a potentially large windfall gain on their acquisition price as and when the sterling exchange rate mean-reverts. It's no coincidence that foreign buyers are returning to the top end of the London housing market.
Investors are becoming more alert to the ratings discounts, one reason why 2020 has started with a bang for a raft of the small-cap companies I follow as the Brexit discount embedded in rating unwinds. It’s still too large, though, which is why I expect M&A activity to be a recurring theme this year, too. I haven’t had to wait long for the next deal to emerge as aircraft leasing company Avation (AVAP:305p) is in preliminary discussions with one potential bidder, and has appointed US investment bank Wells Fargo to assist with its strategic review.
It’s a company I know well. The holding has produced a total return of 108 per cent since I first advised buying the shares ('Get on board for blue-sky gains', 11 Sep 2014), and I last reiterated that advice just below the current share price at the half-year results (‘Avation in the ascent’, 9 Sep 2019). Perhaps reflecting a paucity of research, Avation’s share price is well shy of my estimated 370p minimum take-out price and offers a potentially highly profitable repeat buying opportunity.
Discount to sum-of-the parts valuations
At the 30 June 2019 financial year-end, Avation owned fleet assets worth $1.27bn (£976m), since when it has taken delivery and leased out two new ATR 72-600 turboprop aircraft. Net asset value (NAV) per share of 374¢ (288p) was based on equity shareholders' funds of $241m (£185m), but there is hidden value in the balance sheet.
Firstly, the carrying value of the aircraft is conservative. For example, Avation sold two narrow-body aircraft for 10 per cent more than their book value in the last financial year, booking a $10m net profit in the process. The segment accounts for $600m, or 46 per cent of total fleet assets and includes seven valuable Airbus A321-200 and two Airbus A320-200 aircraft. Two of the A321 planes were previously leased to Thomas Cook and have since been leased out to Asian airline Vietjet Air, a profitable and publicly quoted company and a valued customer of Avation. The point being that there could easily be $60m of surplus equity in the narrow-bodied fleet if marked to open market value, a sum that equates to 96¢ (73p) a share.
Secondly, Avation owns 21 ATR 72-600s and six ATR 75-500s, and has a further six ATR 72-600 on orders for delivery between 2020 and 2022. The company also has options over a further 25 of these turboprop aircraft, all of which are held on the balance sheet at nil cost. Each option could easily be worth $500,000 to $1m on the open market given their scarcity value – ATR only manufactures 85 planes a year and demand from China, India and Iran is tightening the regional aviation market for these fuel-efficient aircraft. At the lower end of my estimate, the option value boosts NAV per share by 19¢, or 15p.
Thirdly, Avation has a young fleet of planes – average age 3.7 years – with a weighted average remaining lease term of 7.1 years. The planes have unearned contracted revenue of $921m across a diversified base of 18 airline customers, an attractive and solid revenue stream.
Fourthly, the increased scale of the fleet is being recognised in the debt markets (weighted average cost of debt on borrowings improved from 5 to 4.6 per cent in the last financial year), so the profit earned from contracted revenue is rising as debt service costs fall.
Fifthly, Avation is expected to deliver annual revenue of $134m and pre-tax profit of $23.1m in the 12 months to 30 June 2020, having taken into account the security deposits held on the Thomas Cook aircraft, which largely offset lost lease payments between the aircrafts’ repossession last October and subsequent delivery to Vietjet Air. Avation is based in Singapore and pays a minuscule amount of tax, so should have earned net profits of $13m since the 30 June 2019 year-end. Deduct from that sum the $5.3m cost of the final dividend, and I reckon retained profit adds 12.2¢ (9.5p) to NAV per share.
So, even if you ignore all the hidden value of the 25 ATR options, it’s not difficult to arrive at a 370p-a-share sum-of-the-parts valuation. Buy.
■ 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.
The books 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. Full details of the content of both books can be viewed on www.ypdbooks.com.
Simon Thompson was named 2019 Small Cap Journalist of the year at the 2019 Small Cap Awards.
