Who's next?

We’ve taken a look at some of the companies trading on the London Stock Exchange that could be subject to a takeover approach over the coming months – and the underlying themes that have been driving global M&A towards the third-highest level on record during the first nine months of 2018.

It would be instructive to discover how many of our readers have ever bought shares in a company in expectation that it would be subject to a takeover offer. The rumour mill ensures that stock prices of target companies often bubble up well in advance of approaches being made, providing fertile ground for merger arbitrage, or risk arbitrage, a well-worn investment strategy among City firms. It aims to exploit inefficiencies before or after a deal progresses, including the vagaries of the regulatory process – to determine the probability of a merger not completing on time – if at all.

Sounds simple doesn’t it? But it certainly requires conviction, and you shouldn’t be afraid “to deviate from the consensus”. That independence of thought is a key attribute of the strategists at Edmond de Rothschild Asset Management. Philippe Lecoq, co-head of European Equity Management, stresses the importance of first principles when you’re trying to determine “the underlying rationale” behind M&A activity.

Short-selling strategies and merger arbitrage aren’t the preserve of private banks, asset managers or hedge funds, although many retail investors would probably baulk at the prospect. But given that share prices for target companies are usually below the acquisition price, there’s a very basic trade on offer, particularly given the rise of over-the-counter (OTC) derivatives. And you could always profit from a short position in a company if its share price has increased on the back of takeover rumours but an approach has subsequently failed to materialise.

Admittedly, the world of merger arbitrage is probably a bit rich for most people’s tastes – there’s obviously a more straightforward way of profiting from the share price premiums on offer from most deals. In anticipation of an all-cash M&A deal, investors typically take a long position in the target company.

Bid premiums and counter-cyclicality

Increased divergence equates to increased profit potential, but Mr Lecoq reminded us that a rapid step-up in the level of premiums often signals the peak of the M&A cycle, and he suggested, albeit tentatively, that Edmond de Rothschild has witnessed some early signs to that effect. However, that needs to be set against the view that, all things being equal, M&A activity should be counter-cyclical. If the global economy starts to creak due to increased energy costs, and reduced liquidity through tighter central government monetary policy, it’s conceivable that we’ll witness an increase in deals driven by distressed balance sheets (increased deal volumes at lower premiums) – that’s another point worthy of consideration.

Nevertheless, the premiums on offer provide a genuine financial incentive – at least if you’re willing to employ an M&A strategy as part of a speculative element within your portfolio – but is it a realistic approach? Whichever way you hope to exploit M&A activity – an area of the market that has expanded enormously since the 1980s – it certainly helps if you’re in on the ground floor.

Identifying the deal catalysts

But unless you’re privy to market-sensitive information, you may struggle to identify individual stocks that might fall prey to offers, even though many takeover targets are vulnerable simply because they’re undercapitalised, evidenced by the many deals that have been bound up with a forced restructuring.

But whether you ‘go long’ or choose to exploit deal inefficiencies, it probably makes sense to narrow down the potential field by highlighting sectors – or sub-sectors – that are consolidating and the underlying themes that are driving it.

We got an illustration of this recently, when RPC (RPC) confirmed an approach from US private equity groups Bain Capital and Apollo Global Management. Until recently, the European packaging industry remained largely fragmented compared with its US counterpart, but changes in retail patterns (e-commerce and point-of-sale advertising), together with what Rabobank describes as “slim margins and firms' need for a wider geographical presence” have accelerated a sector-wide trend towards consolidation.

So it’s perhaps ironic that one of the most acquisitive players in the packaging sector is now in the cross-hairs of US private equity. In the early part of 2017, RPC’s share price had come under pressure following criticism from Northern Trust Capital Markets that a spate of acquisitions – 10 deals in a little over 12 months – had masked disappointing capital returns and free cash flows. Whether the charge held any merit is incidental. The point is that RPC has not only driven, but may well become subject to, the trend towards consolidation in the sector.

UK PLC – a relative bargain

Beyond industry themes, there are overarching macro drivers; consider the surge in inward investment that followed sterling’s post-referendum depreciation. It’s a dynamic still much in evidence judging by figures from accountancy services specialist Moore Stephens, which show that the value of M&A deals targeting UK companies by US offerers in 2018 is up by 115 per cent to £79bn. Underpinning all of this, of course, is the low cost of financing.

The surge in capital from across the Atlantic is somewhat at odds with the domestic equity market, as net retail sales across UK mandated funds were negative in August for the first time since the EU referendum result. Given the relative underperformance of UK equities, the market’s valuation is now very attractive versus other major regional bourses, with accompanying sterling weakness acting as another spur to potential overseas buyers.

The rush towards digitalisation

A recent executive survey conducted by global professional services firm Accenture also highlights another overarching theme; namely the rush towards digitalisation. (Indeed, it would have been quite possible to dedicate the entire feature to this theme – and it’s at the heart of some of the case studies we’ve chosen to highlight.)

The usual dynamics relating to scale and industry fragmentation are in evidence in the global ‘fintech’ market, which has been subject to a 26 per cent increase in the value of M&A transactions through 2018, but this is wholly predictable. More tellingly, one of the key conclusions derived from the Accenture analysis is that while traditional M&A activity has been driven by the imperative to build scale, drive cost synergies, or alleviate balance sheet weakness, it seems that digital deals are usually initiated by the acquiring company in pursuit of technologies or capabilities that it doesn’t possess. Of the respondents to the Accenture survey (representing 13 industries in seven countries), nearly one-third of companies logging M&A activity described themselves as traditional companies acquiring digital companies or assets.

Of course, another reason why we’ve witnessed such a marked increase in the volume and value of deals since the 1980s is the influence of the professional advisory complex. It’s hardly cynical to suggest that the financial interests of City law firms, communication consultancies, banks, market makers and nominated advisers (to name but a few) are interwoven with the general level of deal activity. If that leads to skewed incentives, then so be it, but it provides yet another catalyst for the M&A market. MR

Payments: an unlikely hotbed for M&A

Payments wasn’t always a glamorous industry. In fact, it wasn’t really an industry at all; rather, it simply denoted the mundane – but necessary – transference of money from one party to another, allowing goods and services to change hands.

But that has all changed with the rapid digitalisation of our everyday activities – facilitated by huge advancements in internet connectivity, the proliferation of smartphones and the rise of e-commerce. Individuals and businesses alike are now making increasing numbers of transactions online, eschewing physical cash. Indeed, UK Finance found that at the end of 2017, debit card payments overtook cash for the first time as the most used payment method in the UK – with consumers making 13.2bn debit card payments compared with 13.1bn cash payments. Almost two-thirds of Britons now use contactless payments.

Moreover, debit card payment volumes are forecast to grow by more than any other payment method over the next 10 years – rising by 49 per cent to 19.7bn payments in 2027. Contactless cards are expected to account for more than a third of all payments in 2027, up considerably from 15 per cent in 2017.

And more broadly, Capgemini and BNP Paribas’s ‘World Payments Report 2017’ found that worldwide non-cash transactions could reach 725.9bn by the year 2020 – up from 433.1bn in 2015.

That said, changing consumer habits constitute just one driver behind this shift towards digital payments. Regulation has played a role, too. At the start of this year, the EU’s Second Payments Services Directive (PSD2) was introduced – aiming for “more competition, greater choice and better prices for consumers”. This allows customers to open their payments data to businesses ranging from challenger banks to tech-driven financial services start-ups (‘fintechs’).

On the one hand, this could pose challenges to traditional financial institutions, which no longer have exclusive access to their customers’ account information, and now face high-tech competitors. On the other, it creates an enormous opportunity for payment specialists – not only those larger players that have existed for years, but also minnows that are in their infancy.

Against this backdrop, it’s perhaps unsurprising that payments has become an M&A hotbed – garnering the attention of private equity firms, and traditional banks striving to modernise and update their services. We’ve also seen mergers between payment groups themselves, seeking scale and heightened technological expertise. 

The payments behemoth Worldpay (WPY) was created in January this year, thanks to a mega-merger worth more than £9bn between two leading merchant acquirers (or payment processors) – UK-based Worldpay and US-based Vantiv.

Initially agreed last July, this deal shone a light on the attractiveness of the payments sector not only because of the enormity of the offer on the table, but also because of a fleeting show of interest from US bank JPMorgan Chase (US:JPM). JPM didn’t ultimately make an official bid, but this was still, perhaps, a sign of just how useful a tech-driven payments specialist could be to a global financial services institution.

While Worldpay is now listed in New York (US:WP), it has a secondary standard listing in London. And, so far, the transatlantic tie-up appears to be going particularly well. Second-quarter net revenues to June rose 90 per cent to $1bn, against Vantiv’s performance over the same period in 2017. And adjusted EPS rose 25 per cent to $1.04. Meanwhile, for the half year to June, net revenue rose 86 per cent to $1.86bn.

Payments behemoth Worldpay was created in January through a mega-merger between UK-based Worldpay and US-based Vantiv

Just weeks after the Worldpay deal, Paysafe agreed to a takeover by a consortium of funds managed by private equity houses CVC and Blackstone. And various M&A transactions between payments groups took place overseas around the same time. More recently, on 20 September 2018, US giant PayPal (US:PYPL) completed its acquisition of Swedish payments firm iZettle for $2.2bn – noting that this would build on its strong set of products and services for small businesses.

However, that same day, the UK’s Competition and Markets Authority said it was looking into the deal and was considering whether it had, or could be expected, to result in a substantial lessening of competition in any market or markets in the UK.

And on the topic of regulation, in July this year, the UK Payments Systems Regulator announced plans to carry out a market review into competition among card-acquiring services, following concerns that these services may not be working well for merchants and consumers. A scenario certainly worth monitoring as we consider the outlook for payments M&A – given recent trends we believe further transactions are likely.

Who’s next?

Worldpay and Paysafe were both FTSE 350 constituents. But London’s junior market also plays host to smaller payments entities that could, potentially, become subject to acquisitive approaches. The catch here is that Alternative Investment Market (Aim) members arguably face less stringent regulation and listing criteria than main-market players, and could thus be deemed a riskier bet. This might, perhaps, instil more caution in would-be bidders.

In any case, IC buy tip SafeCharge (SCH) constitutes one Aim-traded payments group. For the half-year to June, the number of transactions processed rose more than a half to 118m. Revenues reached $66.8m – up 26 per cent year on year. Earnings declined, after higher expenses. But the dividend was lifted and SafeCharge remained debt-free. Broadly appealing qualities, one might venture, in a hypothetical takeover target. And based on broker Shore Capital’s forecast adjusted EPS of 17.1¢, the group trades on a PE of 22. Not hugely demanding against the wider software peer group.

Eckoh (ECK), another IC tip, specialises in secure payments. Not a bad area to be in at the moment, given heightened concerns around data privacy. And full-year earnings and net cash improved over the year to March 2018. Yes, the group trades on a sky-high multiple – a huge ask for a small company. But it could hold appeal for groups hoping to expand into the US, from where 37 per cent of full-year sales derived. HC

The media feeding frenzy

May 2018 was a momentous month for the global media market. The month that marked the changing of the guard, when Netflix (US:NFLX) overtook Walt Disney (US:DIS) to become the biggest entertainment company in the world. It seems completely bizarre that a new tech platform that relies on algorithms and Adam Sandler films to attract its subscribers is worth more than a 95-year-old company that owns four of the most recognisable brands in the world, six theme parks and two major cable networks. But Netflix and its 118m subscribers are the future; Disney could well be the past unless it gets into shape.

That is why the company is in the process of spending $72bn on the media assets of 21st Century Fox. Taking on the might of Netflix requires bulk. The acquisition will make Disney the biggest film producer in the world (together Disney and Fox took 40 per cent of global box office sales in 2017) and give it majority ownership of new streaming platform Hulu. Disney’s chairman Bob Iger is confident the group will “create significant long-term value”.

Disney isn’t the only media giant to have used M&A to fight the shifting trends of the market. In June, after more than 18 months of regulatory tumult, telecoms giant AT&T (US:T) was given the green light to proceed with its $85bn takeover of content producer Time Warner. This month, Sky (SKY) – which has been at the heart of a takeover battle for nearly two years – was bought by Comcast (US:CMCSA), while broadcaster CBS (US:CBS) is reportedly considering merging with Viacom (US:VIA). And though consolidation can hardly be considered a new trend in media – mergers and acquisitions created Time Warner and gave Disney access to Pixar, Marvel and Lucas Film – never before has it been such an important strategy.

That’s because the Netflix-shaped challenges that have stumped subscriber growth at the traditional broadcasters have come at a time when their second source of revenue (advertising) is under siege from social media monsters such as Facebook (US:FB.) and YouTube. In the US, it is expected that 33m people will cut their cable subscriptions this year, while the proportion of UK ad sales directed at TV is expected to fall to 22 per cent, from 24 per cent just two years ago.

But it’s not all doom and gloom. Traditional companies that can align their portfolios to suit the modern trends of TV should be very well placed to succeed. That’s why ITV (ITV) has been busy bulking up its production arm to increase its ability to create its own unique, high-quality content, while Disney’s acquisition of Fox is likely to have sent nervous ripples around Netflix. But media companies need to be careful. Amid the rising consolidation, valuations have climbed sharply, meaning Comcast ended up paying 12.2 times adjusted cash profits for Sky – a 124 per cent premium to the closing price on the day prior to the original offer. Making a decent return on that enormous investment is likely to be a challenge.

Who’s next?

As competition continues to heat up, analysts think the merger frenzy in the media market has a long way left to run. That’s because there are many companies clearly on the hunt for an acquisition – at one stage Verizon and Sony were both considering making a bid for Fox, while Viacom is the last of the four US cable owners not to have been involved in some sort of consolidation this year (the other three are owned by Disney, Fox and Comcast). Meanwhile, Netflix is facing the double threat of a content producer with its own streaming arm – if it can’t bulk up its own production capabilities, it’s likely to struggle. That’s why we think Entertainment One (ETO) looks primed for a takeover. Its original content library was recently valued at $2bn and it is already producing shows and films for Netflix. True, the recent share price surge means Entertainment One is now valued at 13.8 times forecast adjusted cash profits (including debt) but as peers seem desperate to get their hands on quality content, we still think this looks like a takeover target. MB

Taking a punt on the gambling sector

To some observers, the timing of GVC’s (GVC) recent purchase of Ladbrokes Coral may appear odd. When GVC made its third approach for the fellow gambling company at the end of 2017, it knew that the Department for Culture, Media and Sport would soon announce the outcome of its review into fixed-odds betting terminals (FOBTs). With such a risk in mind, it structured the deal so that the amount it would pay for Ladbrokes Coral depended on how much the maximum stakes allowed on FOBTs was cut. In January, the UK government announced that it would take the extreme approach and cut the maximum stake allowed to £2 per spin, sending shares in UK-listed gambling companies spiralling on the day.

On the bright side, the drastic stake cut meant that GVC didn’t have to pay any more for Ladbrokes Coral beyond the £3.1bn base price. The combined group will have a more diversified revenue stream and should make the entity more resilient to regulatory changes in the future. Ladbrokes Coral was one of the most exposed to the FOBT change, and so shareholders were probably motivated to approve the deal in hopes of added protection from a larger group.

Such a deal speaks to the wider state of the UK-listed gambling companies. UK regulators have cracked down on the high-street bookies, prompting many to shift focus to their online business. Digital revenue now makes up 45 per cent of total sales from UK bookies, compared with a third of total revenue in 2011. This has been amplified by a shift in consumer preference towards digital gambling. This could spur further consolidation, as companies band together to complement a retail presence with improved technology for digital.

UK regulators aren’t the only ones getting tough on betting. Australian regulators banned credit betting in February, which had previously made up around a third of bets placed down under. Individual states have also started to implement a point-of-consumption tax (POCT). Three states – South Australia, Western Australia and Victoria – have so far approved the tax, meaning that around 45 per cent of the Australian gambling market has POCT in place. This added cost prompted William Hill (WMH) to sell off its Australian business earlier this year.

UK bookies now have their sights set on the American dream. The Professional and Amateur Sports Protection Act (PASPA) banning sports betting was repealed in May, and so it’s now up to each US state to decide whether it will legalise such wagers and on what grounds. But instead of banding together, UK-based gambling companies are partnering with overseas operators that already have an established US presence.

Who’s next?

Who could be the next to do a deal given the current regulatory landscape? We recently tipped Sportech (SPO) as a buy for its exposure to the American market. It already owns and operates sports bars and gaming venues in the US, so offering betting at these locations would be a natural next step. It also provides technology for gaming companies, sports teams and racetracks, handling around $12bn (£9.1bn) in bets every year. These venues and established technology could be appealing for a larger UK-listed gambling company looking to increase its footprint in the American market. GVC has already done the biggest American deal of the UK bookies so far with its partnership with MGM Resorts, so competitors such as William Hill or Paddy Power Betfair (PPB) might be keen to catch up. This could also be good for shareholders in the £112m market cap Sportech, since a bigger partner could expedite expansion plans and offer a full sports betting platform to complement its existing technology. JF

Grocery sector: the scramble to head off Amazon

This year’s £3.7bn merger between Britain’s largest supermarket chain Tesco (TSCO) and wholesale business Booker is the clearest example yet of how the UK grocery sector might try to combat the continuous march of online behemoth Amazon (US:AMZ). True, Amazon’s influence extends well beyond this corner of the retail industry, but the launch of its Prime grocery service last year catalysed what is likely to be a permanent structural change in this market. In fact, recent rumours that it plans to trial its Amazon Go stores in this country – where customers are tracked as they shop and charged when they walk out rather than queuing to pay at a traditional checkout – suggests it’s not just the digital side of things that Amazon is aiming to capitalise on. For that reason, it’s safe to say that the Tesco/Booker deal is unlikely to be the last example of M&A activity we’ll see in the British grocery sector.

On 27 January 2017, the boards of Tesco and Booker announced they had reached agreement on the terms of a recommended cash and shares merger. Later, on 5 February 2018, Tesco bosses had this to say about the potential tie-up: “The food market is constantly evolving. The Tesco board recognises the attractive opportunity which exists for the merger to bring together retail and wholesale expertise to create a market leader in products and procurement, with extensive reach, distribution and supply chain capabilities to create the UK’s leading food business.” Suffice to say, management believed it could build a far more resilient business via vertical integration, which would be better able to tackle a host of issues facing the sector.

True enough, in its praise of Booker, Tesco managers said that although the business was “predominantly engaged in the wholesale supply of food and non-food products to a range of catering, retailer and other small businesses”, Booker’s cash and carry business also brought with it delivery capabilities with national coverage to supply its 198 branches at the time. Together with Tesco’s own supply chain and delivery operations – which at the time spanned 3,500 directly owned and operated stores, the combined group would be able to leverage significant control over a multi-channel supply chain “covering the whole spectrum of food, grocery and catering supplies”, while its enlarged asset base would allow for “enhanced delivery service propositions and digital offerings for all customers”.

Who's next?

The major hurdle Tesco and Booker faced came in the form of an investigation by the Competition and Markets Authority (CMA). The regulator was most preoccupied by the severe overlap between the two groups’ convenience chain businesses (Booker owns the Budgens and Londis brands). Eventually, the deal was given the green light, paving the way for similar deals.

Interestingly the next deal could be similar in size and scale, but different in scope. A potential £2.98bn tie-up between Sainsbury’s (SBRY) – whose £1.4bn purchase of Argos in 2016 was also a response to Amazon's broadening threat – and Walmart-owned Asda is under consideration, having already progressed to a phase two enquiry by the CMA. As of the end of September, the regulator had identified 463 areas where the two groups overlap, which it argues could give rise to a lessening in competition – and therefore unfair prices – for shoppers.  There’s no knowing how many disposals could be required to push the deal forward – current estimates range from 12 to 300 – but Sainsbury’s boss Mike Coupe has warned that an “unreasonable” number of closures could put a stop to the merger altogether. While this is arguably a ‘horizontal’ deal compared with Tesco’s ‘vertical’ integration of Booker, we’d still be surprised to see the match-up fall apart. HR

Recruiters evolving to meet the tech revolution

Software is eating the world, as famed venture capitalist and technology entrepreneur Marc Andreessen likes to say, and as it does so, companies that can source top tech talent will come into ever-higher demand.

As computing power and data sources proliferate, more and more businesses are getting turned on to the idea that harvesting and analysing data can lead to massive competitive advantages in their field. Companies from across all sectors from Goldman Sachs (US:GS) to G4S (GFS) are angling themselves as technology-based businesses. However, as more companies look to bring in computer science specialists, they will need help finding the right people and convincing them to move into new sectors.

That's why asset manager DBAY made an all-cash offer of 130p a share for Harvey Nash (HVN) in August, prompting the share price to jump by a fifth to within spitting distance of the then 135p target price laid out by analyst Panmure Gordon. In the deal announcement, DBAY’s investment director, David Morrison, said the investor was looking to “further strengthen [HVN’s] leading position in the specialist technology recruitment and outsourcing markets”.

The deal shows that investors see value in the focused strategies of specialist recruiters. The UK’s three largest recruiters – PageGroup (PAGE), Hays (HAS) and Robert Walters (RWA) all rely on a diversified approach to sectors and geographies to protect themselves from the cyclical risks that staffers often face. However, while their mixed approach is paying off – all three have comfortably outperformed the FTSE All-Share in recent years – the Harvey Nash deal shows there is an appetite for specialists. The group made 65 per cent of gross profits from technology recruitment in the year to January 2018, with a further 12 per cent coming from IT outsourcing.

Conventional wisdom supports technology recruiters for two reasons; the highly technical nature of the jobs they are recruiting for means they command high pay rates, and IT-related jobs are often carried out by contractors. Temporary recruitment is seen as more resilient in a downturn than permanent, as employers are less likely to want to take the risk of employing someone indefinitely when resources are tight. However, that is not to say that tech recruitment is a panacea for challenged markets. Indeed, Harvey Nash and peers Gattaca (GATC) and SThree (STHR) have all struggled in the UK despite all having a focus on the technology and engineering sectors, but this is more indicative of the depth of challenges in the UK market. Analysis of global hiring trends by Robert Walters mentioned technology and IT as a key growth sector in all but one of the group’s eight geographic regions.

Who’s next?

DBAY’s offer for Harvey Nash implies there could be an appetite for tech-focused staffers among UK-based investment firms, but large overseas players such as Adecco (SWX:ADEN) or Randstad (AMS:RAND) are also a possibility. Both groups have market capitalisations that dwarf those of the UK staffers, and the management of both groups has highlighted technology skill shortages as “megatrends” driving the recruitment industry. The cyclical nature of the recruitment market presents obvious risks, as has been seen with the impact of the global sell-off in recent weeks, but buyers with an eye on the long term could view share price weakness as a buying opportunity.

Acquirers looking to tap into the trend would look favourably on tech staffer FDM (FDM), which recruits graduates, ex-military personnel and people returning to work and trains them to work in tech-related fields such as data services and cybersecurity, before deploying them in client companies. At 28 times forecast earnings, the group’s shares are a little ahead of the two-year historical average, but the price has dropped off 16 per cent from the June high of 1,120p. Looking outside the FTSE 350, both SThree and Gattaca offer IT and technology expertise and are trading at a discount to peers. TD