Japan Post’s takeover of Toll Holdings and a fierce bidding war for iiNet has whipped up a frenzy of mergers and acquisitions (M&A) speculation. Credit Suisse, for example, believes Australia is only halfway through its fourth M&A cycle in 20 years.
Low cost of capital and generally solid balance sheets have local companies well placed to acquire smaller competitors, and a lower Australian dollar makes our companies more attractive to foreign players. Iron Mountain’s takeover of Recall this year is an example.
So expect a pick-up in M&A activity this year, although maybe not the boom that investment bankers seem to predict at the start of every year, as sentiment in executive teams and boardrooms is subdued.
Debt funding costs are low, share market valuations on average are reasonable, and “deal envy” – when CEOs get sick of seeing their peers do big deals while they wait on the sidelines – will drive higher deal flow and opportunities for nimble investors.
Discretionary retail is ripe for M&A. I resisted adding Myer Holdings to this portfolio over the past year because it does not fit this column’s criteria of owning high-quality, undervalued businesses and treating any takeover bid as the cream rather than the investment cake.
But every stock has its price. Myer has almost halved since early 2014 to $1.36, more investors are agitating about the board – often a sign that institutional capital wants to enforce bigger change – and Myer has a challenged position as the economy slows and online competitors grow. Despite relatively solid third quarter sales numbers released today, it needs some serious repair work to lift the business and change market sentiment.
South African retailer Woolworths’ bid for the troubled David Jones last year shows the potential for offshore retailers to improve Australian department stores. Myer could appeal to a large private equity firm or international retailer that can take it off market, rationalise its store portfolio and refocus its product offering and market position.
The timing is right. The departures this year of CEO Bernie Brookes and the chief financial officer, Mark Ashby, earlier than the market expected, paves the way for significant change. An acquirer could spend a few years fixing Myer and capitalise on an improving Australian economy in the medium term.
Myer could get cheaper still before it recovers. But for all its problems, it still has a solid market position and excellent earnings leverage when the Australian economy finally recovers.
Another discretionary retailer, OrotonGroup, makes the takeover portfolio for different reasons. This former star stock has had a difficult few years: the three-year annualised average return is negative 24%. The loss of its flagship Ralph Lauren licence in 2013, a challenged product discounting strategy and general weak retail conditions, were a perfect storm.
Longer term, OrotonGroup has excellent potential to sell Oroton products to the emerging middle class in Asia. Management is doing a good job to reposition Oroton as a luxury brand, reduce price discounting and quicken store rollouts overseas. It opened a new store in Singapore and three department stores in Asia in the first half of 2014-15. OrotonGroup now has 14 international stores and sees strong potential to grow overseas.
I like the long-term strategy and OrotonGroup looks marginally undervalued at the current price. Return on equity should start to rise again in the next three years towards 20%, debt is low and there is good cash flow generation.
If OrotonGroup’s performance continues to lag the market, watch for an offshore or local predator to snap it up and accelerate the international growth strategy as the emerging middle class booms over the next decade and has higher demand for luxury Australian goods.
iSelect on radar
Too often, investors clamour for an overhyped stock in the lead-up to its initial public offering (IPO), dump it at the first sign of trouble and forget about it, just as its looks cheap again. That pattern characterised iSelect, the online insurance aggregator that has renewed momentum as a listed company.
iSelect fits this column’s two main criteria: owning undervalued companies that are good investments in their own right; and those with strategic appeal to a predator. iSelect must look interesting to some larger insurance aggregators at its current price.
It has an excellent position in a long-term growth industry. About a quarter of new insurance policies are bought online, particularly among young people, and the figure is rising rapidly. As health insurance premiums rise, more people will search online for a better deal and iSelect is by far the dominant portal. Also, there is scope to build a bigger presence in home loans, utility bills and other categories.
New management at iSelect is doing a good job improving its business model and cash flow, and one senses the company is regaining the momentum it had in the lead-up to its IPO. It had a disastrous first year as an ASX-listed company in 2013; its revenue was revised lower just months after listing, a terrible look for any IPO.
That led to the Australian Securities and Investments Commission (ASIC) seeking more information and management changes. Its $1.85 issued shares, oversubscribed for during the IPO, tumbled as low as $1.01.
iSelect has since recovered to $1.59 and is attracting more interest from small-cap managed funds. Online businesses that dominate their category are standout stocks: think Seek, REA Group or Carsales.com. If the market takes too long to recognise iSelect’s improving prospects and long-term strategic value, a big United Kingdom insurance aggregator might see an opportunity at the current price.
The latest portfolio has outperformed the broader share market and S&P/ASX 200 Small Ordinaries index. Its average one-year total shareholder return (assuming dividend reinvestment) of 16% compares to an 8% total return for the S&P/ASX 200 Accumulation Index over one year to 11 May 2015, and a 6% gain for the Small Ords index.
The portfolio was boosted by the strong gains in the medical device maker, REVA Medical Inc, which at 51 cents is still well down on its $1.10 issue price.
I thought Reva had great prospects when it listed in December 2010 through an IPO but I am always wary of valuations of offshore technology companies that choose to list on ASX rather than US exchanges. Reva has interesting heart-stent technology and must look interesting to a bigger US player that could do more with its technology.
The takeover tussle for iiNet and solid gains in NIB Holdings and Australian Agricultural Company have also boosted the portfolio. A poor performance from Santos weighed on the portfolio’s return, although in fairness Santos was only added in February 2015. Its one-year total return is shown below for comparability purposes.
Another laggard, the Asia-focused e-commerce site, Ensogo, (formerly iBuy Group) has rallied from 12 cents in February to 19 cents and finally has more momentum after a strategic capital raising. It is a stock to watch for experienced investors, who can tolerate higher-risk micro-cap companies.
Reckon, Nearmap and OzForex Group warrant special mention as takeover candidates. With MYOB Group listing on the share market in May, and Xero continuing to build market share, Reckon has its work cut out. Reckon is a well-run, undervalued company, but the three-year annualised total return is 7% and it’s hard to see the accounting software industry having room for several large players in Australia. Consolidation seems likely.
Nearmap looks interesting as mapping service providers attract greater attention overseas, and OzForex Group has excellent prospects as a disrupter in the financial/technology space but has a market capitalisation that does not fully reflect its long-term potential.
Myer and OrotonGroup are added to the portfolio this month. There are no exclusions.
Source: Morningstar for total returns. SP indices for ASX 200 return. Total shareholder return assumes dividend reinvestment. Prices to May 11, 2015. Returns are indicative only. Monash IVF return based on performance against issue price and includes dividends.
• Tony Featherstone is a former managing editor of BRW and Shares magazines.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.