Seeking out companies in consolidating sectors can reap hefty rewards. Cybersecurity software provider Kape Technologies ( KAPE: 390p) is a case in point. Buoyed by a combination of organic growth and well-timed earnings accretive acquisitions, Kape’s share price has risen by 714 per cent on the entry price in my 2017 Bargain Shares Portfolio.
I remain positive on the investment case (‘Profit from cyber security’, 22 March 2022), especially as analysts at Progressive Equity Research predict cumulative operating cash flow of $400mn (£305mn) (87p a share) will slash net debt to $39mn by the end of 2023.
But never forget the price paid for deals. Aim-traded beauty brands business Brand Architekts (BAR: 92.5p), a constituent of my 2020 Bargain Shares Portfolio, aims to deliver organic growth and reap the benefits of acquisitions, too. As part of this strategy, the £16mn market capitalisation company has just announced a £13.6mn merger with rival InnovaDerma (IDP). Combining the two operations is forecast to deliver £1.5mn-£1.75mn of annual cost synergies, mainly through reductions in staff and central overheads, and enhanced supply chain and direct-to-consumer relationships. Significant revenue synergies are expected, too. There is a downside, however.
The right takeover at the wrong price
- First-half revenue declines 19 per cent to £7.4mn due to delays in brand relaunches
- Gross margin falls from 36.3 to 32.5 per cent mainly due to higher logistic costs
- Reported operating loss of £0.95mn, reverses £0.56mn profit in same period of 2020
- Net cash of £17.3mn (100p a share)
Strategically, the merger has a lot going for it. That’s because the enlarged group will be able to offer a range of 18 products to a wider customer base, accelerate organic growth rates by utilising InnovaDerma’s expertise in digital marketing, and exploit direct-to-consumer cross-selling opportunities across the enhanced product range. There should also be material upside to marketing InnovaDerma’s leading Skinny Tan brand through Brand Architekts’ new online marketplace, theunexpectedstore.com.
The major issue I have is the price being offered. The £13.6mn acquisition equates to six times InnovaDerma’s net asset value (NAV) of £2.2mn, with shareholders receiving 0.3818 new Brand Architekts’ shares and 7p a share in cash for each share held. The offer has been pitched at a 70 per cent premium to the previous closing price. It means that Brand Architekts will use £2mn of its £17.3mn cash pile to fund the cash element and issue 10.9mn new shares to InnovaDerma’s shareholders, who will then own 38.7 per cent of the 28.1mn shares in issue.
Brand Architekts’ NAV of £22.5mn (130p a share) increases to £24.7mn post acquisition, but with 63 per cent more shares in issue NAV per share declines to 88p. Accounting rules dictate there will be a chunk of goodwill on the acquisition to boost that NAV figure. However, that's an issue as InnovaDerma posted an operating loss of £0.95mn on 10 per cent lower revenue of £3.7mn in the latest half year, so even taking into account a profitable second-half outcome as well as pre-tax revenue synergies from the merger, it’s hard to warrant the price being offered.
The 15 per cent decline in Brand Architekts’ share price following the announcement also reflects an underwhelming first-half operating loss of the same magnitude as InnovaDerma, and a deeper revenue decline. The group’s performance was held back by a three-month delay in product relaunches with three key retailers and compounded by cost prices increases in freight, raw materials, energy and components. The loss also takes into account higher marketing spend for theunexpectedstore.com launch.
So, although I believe that Brand Architekts’ has been making the right strategic moves, I also feel that the board are overpaying for an acquisition at a time when the consumer retail environment is set to become even more challenging and inflationary pressures are unlikely to abate anytime soon.
In the circumstances, I am calling time on my previous buy call (‘Primed to clean up’, 28 September 2021). Fortunately, my 2020 Bargain Shares Portfolio is showing a 58 per cent gain – well ahead of the respective 8.6 and 10.3 per cent total returns on the FTSE All-Share and FTSE Aim All-Share indices – so I can afford to take the hit. Sell.
Please note that this article was first published at 5pm on Thursday, 31 March 2022 and updated at 21.23pm.
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