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Survival of the fittest

Is now the time for investors to buy into acquisitive companies?
June 25, 2020, Emma Powell & Alex Hamer

In November 1985, the Trinidadian-British singer Billy Ocean released his best-known hit, 'When The Going Gets Tough, the Tough Get Going'. The song may have provided the soundtrack to Michael Douglas vehicle The Jewel of the Nile, but it was an ill-fitting tribute to that winter’s equity markets, then in the middle of an enormous bull run on both sides of the Atlantic. Black Monday, after all, was still two years away.

Given the volatile share price swings of recent months, any claim that investors now find themselves in a bull or bear market could prove both short-lived and partial. But there is no denying that the going is indeed tough for many companies. Several industries remain teetering on the brink, propped up by government or creditor support which could fade away in the coming months.

In the circumstances, it’s worth asking whether corporate events in 2020 might echo Mr Ocean’s adage this time around. For investors, M&A is one key arena in which the tough could soon get going.

 

Making use of a crisis

We don’t need to look back as far as the private-equity-fuelled buyout boom of the late 1980s for examples of deal-making in times of acute market stress.

In the financial crisis, both the volume and value of global M&A cratered after the decade high reached in 2007. Analysis from consultancy EY suggests acquisition value multiples also collapsed from a pre-crisis average enterprise value to Ebitda (earnings before interest, taxes, depreciation, and amortization) ratio of 10.8 times to a nadir of 6.5 in 2009.

These trends mirrored two important aspects of the last crash: the inability of balance-sheet-battered banks to lend, and a decimation in investor confidence. But while the credit crunch limited acquirers’ financial firepower, the evidence suggests that those that did swoop for deals did particularly well.

In fact, EY's analysis of the 1,000 largest US companies by revenue at the start of 2008 found that shares in active acquirers outperformed their deal-averse peers on a one, three and five-year time horizon. This was true for both the mean and the median, suggesting the trend wasn’t skewed by a handful of deals that paid off particularly well.

 

 

It’s the sort of detail that investment banks’ pitch books are built on. Whether investors can expect this dynamic in the era of Covid-19 – and hope to follow future outperforming stocks in the process – will of course depend on plenty of unique factors, from the possibility of second waves of the virus to the reduction in government support measures and the timeline of any potential vaccine. But one refrain is likely to accompany any deals that are announced in the coming months, and it will inevitably be bullish: “Management teams with a track record of successful acquisitions who are confident enough to buy in a crisis are a pretty reliable indicator of future earnings growth,” argues Stuart Andrews, head of corporate at broker FinnCap. The ability to articulate a compelling long-term vision when few business owners can even see past the summer is likely to be rewarded.

There are other parallels with the last crisis, too. Banks’ priorities are again to be found elsewhere, this time supporting corporate clients’ immediate cash needs. Unsurprisingly, that has meant M&A activity by volume and value has slumped across all major sectors so far this year, according to data from Mergermarket and law firm White & Case.

 

 

However, these aggregate stats mean far more to the bragging rights of lawyers and bankers than they do to investors, who are more interested in specific deals and what happens after the paperwork is inked.

 

Follow the dealmaker…

Those thinking of following buyers can at least point to one constant in financial markets. Like 2008, markets are still sailing on the tailwind of quantitative easing, the benefits of which have historically accrued to larger companies – or at least those able to remain in business. With some notable exceptions, a company’s ability to acquire generally reflects its own near-term ability to operate as a going concern. To the victors, the spoils.

Then there is the peculiar nature of a pandemic, which – in theory – could be over in a year’s time, leaving the survivors to clean up. Even if this doesn’t happen, corporate distress is set to create innumerable opportunities for consolidation in the coming months.  

“This time around, the mantra is to protect your balance sheet, maximise your firepower, and wait for what could be enormous economic fallout, which will leave some bargains to be acquired,” says Mr Andrews. “At first, these situations throw up sellers of distressed assets, then you get distressed sellers of real assets; that’s the time you want to strike.”

Added to this, asset-hungry UK-listed companies may face reduced competition from abroad, if government legislation to tighten rules on foreign takeovers are enforced.

 

…or stay cautious?

However, there are just as many reasons to doubt that M&A could be a winning strategy this year. For a start, it's worth remembering that acquisitions are really an unreliable guide to improved earnings growth. Among the largest risks are overpaying, overleveraging, or encountering operational or accounting problems after a deal is agreed, as IC writer Phil Oakley highlighted in these pages in December.

Arguably, the current crisis deepens each of those pitfalls. Forward earnings estimates suggest UK blue-chips are in aggregate more highly leveraged, less profitable and offer a lower return on equity than they did at the end of last year. Despite this, the FTSE 350 is markedly more expensive on several key metrics.

 

FTSE 350 IndexDec '19Dec '20EDec '21E
EBIT Margin (%)12.8511.2612.71
Return on Equity (ROE) (%)12.487.4510.10
Price/Earnings (x)12.7119.7414.07
Price/Cash Flow (x)8.3010.608.19
Price/Free Cash Flow (x)16.2324.1115.16
Net Debt to EBITDA (x)1.662.271.82
Source: FactSet, data accurate as of 19 June 2020

 

What’s more, calculating synergies is much more complicated now than it was five months ago. To take just one example, potential suitors simply won't be able to understand its staffing model until furloughing support is withdrawn. In many industries, the ability to conduct a proper due diligence process is essentially on hold.

“I don’t think people generally buy businesses without meeting the people, and observing the business operating,” argues Mr Andrews. “Until social distancing ceases to exist in its current form then that is impossible; multiple deals may have completed over Zoom, but you’re talking about the exceptions rather than the norm.”

Then there are the ways executive teams are likely to navigate the large shifts within and across sectors, and the ever-moving ‘new normal’. In the words of Majedie Asset Management chairman and chief investment officer James de Uphaugh, the coming corporate landscape may well resemble “Darwinism on steroids”. But this is likely to be a mixture of dog-eat-dog deal-making and land grabs for market share.

A Goldman Sachs think-piece on post-pandemic investing argued that for the foreseeable future, customers and businesses are likely to focus on solutions that they know work. That could have the effect of reducing the need for both capital flows and physical investment, and doubling down on what products and pricing strategies are already working. This tendency was borne out by a recent global survey of chief financial officers by PwC. M&A activity was ranked a distant eighth in the list of priorities for rebuilding or growing revenues (see chart).

 

 

Then there are the liabilities that come with striking deals during a period of extreme uncertainty. Earlier this month, ailing picture house chain Cineworld (CINE) announced it was walking away from its debt-financed takeover of Cineplex (TSX:CGX), leading to accusations of buyer’s remorse and a lawsuit from the Canadian group, which accuses Cineworld of breaching the terms of the deal.

 

Cashed up and acquisitive

Despite these obstacles, a spike in deals is likely to come sooner or later. And it’s not unreasonable to expect those companies with strong balance sheets and a history of deal-making to be worth following.

To this end, we have screened the FTSE 350 for the 20 non-finance companies with the largest forecast net cash positions, and which have acquired external businesses in at least one of the past three years. Predictably, given the cash piles they have accrued in recent years, the list is skewed towards housebuilders. But there are several other quality names with asset-light operating models and experience of integrating smaller businesses.

 

TIDMNameFactSet IndustryMarket cap (£m)Fwd net cash estimate (£m)Price (£)YTD price change (%)Fwd P/EFwd P/BV
BBOXTritax Big Box REITReal Estate Investment Trusts2,4921,1091.45-2.122.71.0
BRBYBurberry GroupApparel/Footwear6,33252815.42-28.927.44.8
ABFAssociated British FoodsFood: Major Diversified15,85749719.65-22.429.71.7
BBYBalfour BeattyEngineering & Construction1,8792942.691.620.91.4
JDJD Sports FashionApparel/Footwear Retail6,2972046.34-22.218.45.4
BDEVBarratt DevelopmentsHomebuilding5,1751965.12-32.410.41.1
AVVAVEVA GroupPackaged Software6,72117741.26-11.740.63.4
SPTSpirent CommunicationsTelecommunications Equipment1,4801732.35-2.021.64.0
HASHaysPersonnel Services2,0851701.23-32.030.42.4
RORRotorkIndustrial Machinery2,4221662.77-17.726.34.0
CKNClarksonMarine Shipping74716525.00-18.823.91.9
IPOIP GroupMiscellaneous Commercial Services6911410.65-13.323.00.6
MGNSMorgan SindallEngineering & Construction59111512.70-19.813.00.0
CSPCountryside PropertiesHomebuilding1,550963.44-26.412.41.6
CCCComputacenterInformation Technology Services1,8658115.85-9.418.12.9
QQQinetiQAerospace & Defense1,800683.14-13.416.41.9
RMVRightmoveInternet Software/Services5,069685.83-9.444.261.7
CRSTCrest NicholsonHomebuilding638542.47-43.312.10.7
VCTVictrexChemicals: Major Diversified1,7664120.24-19.723.33.6
SXSSpectrisElectrical Products3,0243626.04-12.024.42.2
MCSMcCarthy & StoneHomebuilding379290.71-52.916.30.5
MONYMoneysupermarket.comOther Consumer Services1,798233.32-0.120.77.9
Source: FactSet, acquisitive FTSE 350 companies with forecast net cash. Excludes banks, investment managers and insurers, data accurate as of 19 Jun 2020.

 

Mine for the taking

Below the majors, the whole mining world is built on mergers and acquisitions. Why? Finding and building a mine is hard and expensive, so juniors often want to find a big deposit and get rich by selling it on to a bigger company. Covid-19 has done little to disrupt that dynamic.

Even at the top level, buying ounces of gold, for example, is more attractive than spending 10 years up a mountain drilling holes. Even before gold spiked a year ago, the industry had seen major consolidation, most keenly felt in London by the loss of Randgold Resources through the merger with Barrick Gold (Can:ABX). Now the playing field is different.

The big company moves have largely been made in the gold space and the largest players are looking further afield, beyond the pure money creation of gold mining. Barrick chief executive Mark Bristow has floated a takeover of major copper miner Freeport-McMoRan (US:FCX). This would have been unthinkable two years ago, when Barrick was worth under C$20bn (£11.9bn) and Freeport worth around $24bn (£19bn). The diverging paths of copper and gold since then has seen Barrick jump up to a C$58bn valuation and Freeport remain the same.

Further down the chain in London, miners with some cash flow are looking around for expansion options. Hummingbird Resources (HUM) has just bought a project in Guinea that suited it better than an existing development it had in Liberia, while Centamin (CEY) has cemented its West African interest by hiring former Toro Gold boss Martin Horgan. Mr Horgan moved on from Toro, a private company that brought a mine to production in Senegal, when Resolute Mining (RSG) bought it out last year.

Among the developers, SolGold (SOLG) is the focus. It has said for years it wants to take copper-gold project Alpala all the way to production, but a cash takeover offer from BHP (BHP) somewhere above 40p is likely to be persuasive to shareholders.

It’s harder to say whether this amounts to a window of opportunity for investors. While the pandemic’s economic scars will change the outlook for all commodities – thereby raising the cost of capital for some producers – miners must always take a multi-decade view. But for those groups that are newly flush with cash, the temptation will always be to recycle profits into empire building. AH

 

Real estate: a value trap?

A decline in commercial property values over the remainder of this year seems to be a given, particularly judging by the heavy devaluations reported by landlords in the wake of lockdown measures being implemented. But given the extreme stress facing certain corners of the commercial real estate market, sifting the bargains from the assets whose lowly price tag reflects dire income prospects is a tougher ask.

The purchase prices attached to shopping centres, retail parks and high-street stores were steadily falling long before Covid-19 reared its head as acquirers have discounted assets to compensate for the growing risk of falling rental values and rising company voluntary agreements and administrations among tenants. Post-pandemic that risk has increased and has already cost Hammerson (HMSO) the opportunity to offload seven retail parks after private equity group Orion walked away from the deal. It seems unlikely the group will achieve the £400m price it managed to negotiate last year. 

However, some UK property groups have not been deterred by the difficulties in calling the bottom when it comes to retail and leisure rental values. At the start of this month Capital and Counties (CAPC) sparked rumours of a full-blown merger with rival Shaftesbury (SHB) after it bought a 26.3 per cent stake in the group, which owns swathes of Carnaby Street and Shaftesbury Avenue. The deal was struck at 540p a share, a hefty 45 per cent discount to Shaftesbury’s September 2019 net asset value. 

Yet there is more promising acquisition activity taking place within the logistics property market. Industry heavyweight Segro (SGRO), LondonMetric (LMP) and Warehouse Reit (WHR) have all raised cash via placing new shares to capitalise on the acceleration in ecommerce, which has sparked even more demand for warehouse space. Although competition remains high for assets, more quality sites are coming to market, according to LondonMetric chief executive Andrew Jones, who said more businesses needing to raise cash had been looking to sell properties and lease back the space. EP

 

Fintechs: disruptor to target?

For several years, ‘fintech’ has become a byword for the capacity of small development teams with well-branded products to steadily erode the market share of asset managers, banks and insurers. Juiced by funding from private and public markets, these high-growth enterprises have attracted high multiples to match, seemingly regardless of their profitability.

This narrative is suddenly up in the air, as several digital-only lenders, peer-to-peer platforms and currency transfer groups face down their first major economic crisis. Risk models are being put to the test, and investors are less likely to forgive rampant cash burn. Could this provide an entry point for banks with the liquidity and long-term horizon?

Some signs suggest they might. A recent report in the Financial Times quoted investment bankers who think banks are looking to cheaply acquire the intellectual property, platforms or technology of fintechs as a replacement for in-house capital expenditure. A fortnight ago, Metro Bank (MTRO) confirmed it is in early-stage talks to buy peer-to-peer lender RateSetter, in a bid to expand its unsecured consumer lending book. Larger peers might conclude that Funding Circle (FCH), with its high-volume loan processing technology and participation in the UK government’s SME lending scheme, might be worth a punt, regardless of their views on the company’s liability structure.

Whether inorganic expansion can help banks offset the effects of rock-bottom interest rates and economic recession remains another question entirely. AN