'M&A' ? Mondays and Acquisitions

Tuesday, 7th November 2017 07:54 - by David Harbage

Corporate news can be categorised as being either expected – serious investors will have a diary of corporate events to tell them when companies are due to announce trading updates or formal results - or unexpected. The latter, characterised as reporting good news or bad news, will range from accounting scandals to boardroom changes, and will include all new news flow which a company might deem to be meaningful enough as to have a significant impact on the worth of the business.

Accordingly, a major deterioration in trading (beyond that reported in the last statement) should be advised, as might the award of a major contract (perhaps in a new product or area of geography). However, the most exciting development is likely to surround an announcement that the company could be making or is subject to a takeover or other corporate activity. Most announcements of such merger and acquisition (M&A) activity seem to occur on a Monday morning – after long weekend hours in the corporate finance departments of the investment banks who advise the parties to such deals.

This Monday brought two notable announcements: a potential £130bn take-over by US-Singaporean microchip giant Broadcom of its San Diego-based rival Qualcomm and, closer to home, newcomer bank Aldermore has agreed to a £1.1bn offer from one of South Africa’s leading financial services business FirstRand.

Broadcom’s US$70 bid ($60 cash, $10 scrip) represents a 28% premium to the pre-bid level and could be viewed as opportunistic. Qualcomm stock began 2017 at the $70 level, but had been marked lower since falling out with iPhone and iPad manufacturer Apple. (Reminds one of the recent experience of the domestic chip manufacturer Imagination Technologies)

This blog has a focus on UK equities, so won’t comment further on the latest action in the technology-dominated US stock market – except to say that the valuation of these businesses is extreme, by reference to size (market capitalisation) compared to a lack of earnings or tangible assets. These are the six largest businesses on the US stock exchanges, as at 1 November 2017, along with share price performance over the past year (in local currency terms):

1. Apple  - $873bn market worth – stock rose 48.9% in the year to 31/10/17
2. Alphabet - $715.8bn market worth – stock rose 27.6% year to 31/10/17    
3. Microsoft - $640.7bn market worth – stock rose 38.8% year to 31/10/17
4. Amazon.com - $531bn worth – the stock rose 39.9% in year to 31/10/17
5. Facebook - $522.9bn market worth – stock rose 37.5% year to 31/10/17
6. Alibaba Group - $470.2bn worth – stock rose 81.8% in year to 31/10/17

Most of those names will be familiar businesses (Alphabet was formed out of the corporate restructuring of Google in October 2015, Alibaba is China’s largest shopping website) and all six are inherently technology businesses. Optimists or bullish investors would assert that these firms are on a clear long term growth trajectory, aided by either cannibalisation within traditional industries (for example Amazon.com the retailer) or, more particularly, by the new technology itself creating new markets (products and services) for consumers and corporates. Pessimists or bearish commentators would point to the lack of supportive fundamentals and, as a consequence, worry about the overall valuation of the US stock market.

To put the size of these American tech firms into context, the two largest UK listed companies are Royal Dutch Shell, whose market capitalisation of $258.8bn ranks the oil & gas giant at only number 14 in the US listing, and global banking giant HSBC whose market worth of $197.7bn made it number 26 on the US stock exchange. Another Anglo-Dutch giant, Unilever, comes in at number 36 and another multinational energy group BP made it into number 48 (via market values of $159.3bn and $133.4bn, respectively as at 31 October 2017). 

Back to today’s domestic takeover story: Aldermore may not be well known to private client investors as the FTSE250 index constituent has only been listed on the London stock exchange since March 2015. It has not been a comfortable ride for investors in this challenger bank – a share price that began life at 220p reached 310p two months later, before falling to 110p in July last year and then recovering in the second half of 2016, to 213p. On 12 October, FirstRand indicated that it would pay 313p per share (a 22% premium to the stock price at the time) and could go hostile. The shares responded positively, pushing on to reach 312p today upon obtaining approval from the board of Aldermore.

The business, led by ex-Barclays Philip Monks, is set to make real progress this year but, like the other newcomer banks, is ‘having to run hard’ in order to make progress against the inertia that hampers client migration in the banking industry. The group focuses on the small business sector (currently has 230,000 customers) and today provided an upbeat trading announcement (featuring a 12% increase in the loan book to £8.4bn) covering the third quarter of 2017. The balance sheets and potential worth of the equity of banks are notoriously difficult to assess and price. Suffice it to say that what might appear cheap could turn out to be rather more expensive. Aldermore is no exception, its shares – monitored by no less than 16 brokers – are priced on a PE ratio of 9.8x for forecast earnings in 2017, offer a dividend yield of just 0.9% (it is a start-up), and earnings growth of just 2.7% is predicted for next year.      

Two questions: is there a logical or successful formula for identifying potential takeover targets and does M&A activity tell us anything useful or interesting about the economy or stock market? The writer would suggest a negative response to the first poser; corporate activity can be driven by a variety of different factors – defensive (consolidation within mature or slow/no growth industries) where cost cutting is often the prime consideration. More obviously, an aggressor might seek to extend its business reach by acquiring a competitor – often timed to take advantage of a short term weakness in the share price of the ‘prey’ or financially predicated on the predator using more highly rated stock to acquire a peer’s more lowly valued equity (essentially an immediately earnings enhancing trade purchase, if not paying too high a premium to gain control).

While lowly valued (think low price-to-earnings multiple) company stocks could be deemed as appearing at most risk, their attractiveness will depend on their particular worth to a predator (perhaps offering complimentary activities, revitalising a balance sheet, potential synergy benefits or cost cutting potential). Having said that, both poorly trading and strong growth businesses could be participate in M&A.  In addition, certain industries are more likely to engage in corporate activity than others. Industries whose products or services can be applied across country borders – such as pharmaceuticals or health-related firms – may see more cross border M&A, while government controlled regulated industries like water or electricity may possess more state-imposed hurdles.

When economic activity is dull, cyclical companies will find it difficult to grow their ‘top line’ revenue (never mind ‘bottom line profits) and may choose to acquire and ‘bolt-on’ one of its competitors as an alternative, logical strategy to grow its market share and earnings. Countries whose currency has been weak are also likely to find their assets, including businesses, are being ‘eyed up’ by predators who see an increasingly attractive price label. Sterling’s fall will no doubt have enhanced the appeal of UK property and listed shares to many overseas buyers.          

Looking for businesses whose shares have recently been marked lower (perhaps quite fairly based on diminishing future returns) can be an interesting exercise. Investors searching for apparently cheap equity should be wary of ‘value traps’ (per 26 October article on domestic motor retailers – a sector that witnessed more weak data today, as car registrations in October 2017 showed a 12.2% decline compared to the same month of last year), even as they seek ‘price tags’ that might attract predators. Diligent investigation and research is essential to ensure that a profit warning, the catalyst to a share price slump, is not the first of more to come.

A very recent example of a £3bn FTSE250 size business whose shares were marked significantly lower by the market is Playtech, a provider of software for the gaming industry. The firm’s track record of profit growth, which has come from both organic and acquisitive sources, is impressive and attracted domestic institutional backers like Fidelity, Legal & General, Newton Investment Management and Standard Life. Post management’s 2 November advice of trading difficulties at Sun Bingo and in certain Asian markets, which will result in profits this year being 5% below the bottom end of market forecasts, consensus forecasts for calendar 2017 EPS have been lowered by 6.6% from 74.2p to 69.3p. The market marked the shares down from 986p to 768p, a fall of 22% - overdone perhaps, but reflecting disappointment with the adverse surprise (after a half year report on 24 August 2017 had given no indication).   

The lower earnings estimate still anticipates profit growth of 19% this year (with 12% EPS growth anticipated in 2018 incidentally), and puts the stock on an undemanding PE rating of 10.4x for 2017 and 9.2x the EPS forecast for 2018. Five brokers have issued supportive Buy recommendations (Canaccord Genuity, Deutsche Bank, Investec Securities, Morgan Stanley and Numis Securities), with price targets in a fairly tight range between 1030p and 1090p.

While Playtech stock has rallied 7% today to 826p, in part heartened by this support from the ‘Sell side’, investors should be mindful that profit warnings are rarely exceptional one-off events and more commonly one incidence leads to another. Perhaps this setback in the share price could attract an opportunistic predator, and one day – not necessarily a Monday – we will read of another corporate raid on one of the few (compared to the US in particular) of the UK stock market’s technology successes.