Equity Strategy
15 February 2023
Identifying Takeover Targets: What Looks Like a Good Deal?
Takeover Targets Can Add Another Element of Returns to Portfolios
 

Identifying companies that will make suitable takeover targets can make for very lucrative investments. Normally, companies are acquired at a significant premium to their latest share price, and any hint of a possible acquisition can trigger positive momentum even before a bid is announced.

Superfunds and private equity firms are still on the hunt for high-quality assets at a fair price. As institutional money continues to flow in the quest for yield, private capital is increasingly looking for opportunities in the listed space.

The Focus Portfolio does not exclusively concentrate on takeovers as criteria for selecting stocks. Nonetheless, it is certainly a valuable overlay to consider when considering portfolio additions.


Appetite For Deals Growing

After a bumper 2021, deal value in 2022 slumped and returned to pre-pandemic levels. Rising interest rates, rising inflation, and recession fears dampened M&A activity in 2022, although activity started to pick up over the 2nd half of the calendar year.

Figure 1: Deals by $ have fallen to pre-pandemic levels

In a year when market sentiment was low, deals kept ticking over. The largest announced deal was Brookfield and EIG Partners' $18.4b takeover bid for Origin Energy (ORG), with the bidders recently requesting more time to complete due diligence. With Grok Ventures, Brookfield attempted to acquire Origin's competitor, AGL Energy (AGL) at $8b, but the bid was ultimately rejected. The 2 bids are for the ever-dwindling pool of listed utilities.

We also saw a successful bid for Focus Portfolio held Oz Minerals (OZL) from BHP for $10.2b as BHP Group (BHP) looks to diversify further into “future metals”.

As we start moving into 2023 we still believe there will be bids made on the Australian market as there are still well-priced equities that represent value for the right buyer.


How Do We Identify Potential Targets?

We have used a combination of qualitative and quantitative methods to identify possible targets.

What are bidders looking for?

Takeover targets generally have a strategic element to them. Therefore, it is worth looking at recent trends in the market to identify potential targets that may be attractive. We find using quantitative screens alone is ineffective at identifying targets.

Acquirers often seek companies that offer synergies, access to new markets and new products. Qualitative factors, such as market positioning and management quality, can play a critical role in determining which firms will be attractive acquisition targets.

We have highlighted in Figure 2 the the key thematics we have observed from M&A activity in 2002.

These key themes are:

Asset-backed steady earners

Super funds and infrastructure funds are searching for assets that can generate a respectable yield.

De-rated opportunities

We have seen a number of opportunistic bids for growth stocks as bidders see value after large de-rates in growth companies in 2022.

Resources boom

Consolidation across the resource market seems to be taking shape. Large players are looking to either diversify or increase production.

More FUM together

Fund managers looking to merge or acquire in a bigger is better approach.

These key themes are expected to continue through 2023, and have been the focus of our analysis.

Private equity considerations

The private equity sector plays a significant role in listed mergers and acquisitions. We should consider what they look for in targets as part of our qualitative overlay.

The companies they buy tend to have:

  • Steady cash flows
  • Quality earning streams
  • Cost out opportunities
  • Strong management teams
  • Industry tailwinds or consolidation
 
Figure 2: Common themes of deals in 2022
Target Name Acquiror Name Rank Value (A$m) Deal Status ISG Theme
Ramsay Health Care  Investor Group: KKR & Co Inc,
HEST Australia 
30,188 Withdrawn Asset-backed steady earnings
Newcrest Mining  Newmont Corp 26,278 Intended Resources boom
Origin Energy  Investor Group: Brookfield Renewable Group Australia Pty, EIG Global Energy (Australia) Pty 18,340 Pending Asset-backed steady earnings
OZ Minerals BHP Group 10,192 Pending Resources boom
AGL Energy Investor Group: Brookfield Renewable Partners LP, Grok Ventures Pty 7,990 Withdrawn Asset-backed steady earnings
Uniti Group MBC BidCo Pty 3,654 Completed Asset-backed steady earnings
Pendal Group Perpetual 2,131 Completed More FUM together
Tassal Group Aquaculture Australia Co Pty 1,602 Completed Asset-backed steady earnings
Appen TELUS International (Cda) Inc 1,127 Withdrawn De-rated opportunity
Nearmap Thoma Bravo LP 964 Completed De-rated opportunity
Tyro Payments Potentia Capital 830 Pending De-rated opportunity
Genesis Minerals St Barbara 526 Pending Resources boom
Nitro Software Potentia Capital/Alludo ~520 Pending De-rated opportunity
ReadyTech Holdings Pacific Equity Partners Pty 510 Withdrawn De-rated opportunity
Elmo Software Cookie Monster AcquireCo Pty SPV 507 Completed De-rated opportunity
Regal Funds Management Pty VGI Partners 502 Completed More FUM together
Warrego Energy Hancock Energy (PB) Pty 407 Pending Resources boom
Norwest Energy NL Mineral Resources 356 Pending Resources boom
CIMIC Group HOCHTIEF Australia Holdings 1,467 Completed Other notables
Alliance Aviation Services Qantas Airways 762 Pending Other notables

Source: Refinitiv, Wilsons.

 

Asset-Backed Steady Earners

For our screen on asset backed earnings, we screened for infrastructure or ‘infrastructure-like’ stocks with low market betas, free cash flow yields (FY25) above 4% and companies that haven’t seen a material rerate over the last year.

Focus Portfolio names in this camp include Cleanaway (CWY) and Lotteries Corporation (TLC). These look attractive acquisition targets due to their stable cash flows, relatively low debt balances and strong market positioning in their respective markets.

We primarily hold these stocks in the portfolio due to their defensive characteristics and earnings growth potential. However, the potential for a takeover bid adds a further avenue for returns.

 
Figure 3: Asset-backed steady earners screen
Company Name Ticker Sector FCF yield (FY3) Share Price 1y ago Share Price 14/02/23 Share Price Change Dividend Yield % NTM Net Debt/EBITDA FY1 Comment
AGL Energy AGL Utilities 19.1% 6.84 6.89 1% 7% 2.1 Already subject to M&A approach by Brookfield and Grok Ventures.
Aurizon Holdings AZJ Industrials 11.3% 3.64 3.45 -5% 6% 3.3 Infrastructure asset, monopoly, relatively steady (high) cash flows. Might benefit from being taken private from an ESG perspective.
Ramsay Health Care RHC Healthcare 8.3% 63.35 63.55 0% 2% 3.5 Already subject to M&A last year. Cost out and real estate asset sales could be a opportunity for the right buyer. Earnings recovery after the pandemic could also be alluring.
APA Group APA Utilities 6.4% 9.89 10.66 8% 5% 5.8 Infrastructure assets, steady cash flows. High debt might deter buyers. Quality company that has consistently grown earnings and cash flow over the past decade.
Cleanaway Waste Management CWY Industrials 4.5% 2.90 2.67 -8% 2% 1.8 Steady cash flow, short-term weakness due to weather issues presents an opportunity for an acquirer. Low multiple vs global peers and recent bids in industry.
Lottery Corporation TLC Consumer Discretionary 4.2% 4.90 NA 3% 2.9 Steadily growing earnings and cash flows. Monopoly on every State lottery in Australia (excluding WA). Looks well priced vs other infrastructure-like assets. 

*Bold is Focus Portfolio

Source: Refinitiv, Wilsons.

 

De-Rated Opportunities

Growth stocks tend to be the most sensitive to bond yields. These stocks have underperformed during periods of rising bond yields and outperformed when bond yields have fallen. 2022 was no different. The quick-fire rise in bond yields was a significant headwind for growth stocks in 2022.

However, this did not deter bidders that saw an opportunity to buy quality software companies at a reasonable price. Bids were proposed for Nitro (NTO), Tyro (TYR), Nearmap (NEA), ReadyTech (RDY), Elmo Software (ELO). All these stocks had de-rated significantly from their 2021 highs.

Our search is looking for more of these opportunities at the larger end. We have looked for stocks that have de-rated significantly over 2022 that offer substantial growth potential.

 
Figure 4: De-rated opportunities screen
Company Name Ticker Sector Share Price 1y ago Share Price 14/02/23 Share Price Change ETBIDA CAGR Growth % (FY0-FY3) 12mth fwd EV/EBITDA (14/02/23) EV/EBITDA (14/02/22) EV/EBITDA Derate -1Y Comment
Xero XRO Information Technology 110.65 76.88 -31% 33% 34.5 63.7 -46% SaaS business with recurring revenue. Strong growth with the potential for substantial cost out. High multiple might deter but has de-rated heavily over the year.
Domain Holdings Australia DHG Communication Services 4.63 2.93 -37% 12% 14.6 20.2 -28% Strong market position, in an effective duopoly with REA. Looks oversold on negative housing sentiment, but likely to grow earnings over the cycle.
PEXA Group PXA Real Estate 17.42 13.05 -25% 2% 22.3 30.4 -27% Strong market position, monopoly on digital settlements in Australia. Looks oversold on negative housing sentiment, but likely to grow earnings over the cycle. UK a growth option.
Netwealth Group NWL Financials 15.40 13.09 -15% 23% 25.8 34.3 -25% Growing quickly and taking market share with Hub24. De-rated over the past year, potential for an opportunistic bid.
Iress IRE Information Technology 11.30 9.04 -20% 5% 13.3 16.4 -19% Subscription based recurring revenue. High quality company that has been impacted by disruption this FY. Expected to grow ROIC over medium-term.
Altium ALU Information Technology 34.65 38.39 11% 20% 30.5 35.8 -15% Transition to SaaS business causing slight disruption (margins contraction) but should be short-term. High quality business that is taking market share. High multiple might deter.
NEXTDC NXT Information Technology 10.23 9.93 -3% 19% 23.9 25.8 -7% Recurring contracts, stable cash flows, leveraged to a megatrend. Assets hold substantial value, market seems to ignore the stocks NTA. Peers considered REITs in US.

Bold is Focus Portfolio

Source: Refinitiv, Wilsons.

 

More FUM Together

In high-fixed-cost businesses (like fund managers), mergers can boost earnings through synergies that can eliminate a lot of duplicated costs.

A number of fund managers are currently trading around 10x earnings. When an entire industry is relatively inexpensive compared to the rest of the market, it is likely to result in consolidation.

A recent example of fund management groups seeking scale through acquisition is Perpetual's $2.4b cash-and-shares deal for Pendal or Regal’s acquisition of VGI Partners (VGI).

Figure 5: More FUM together screen
Company Name Ticker Sector Market Cap (AU$b) Share Price 1y ago Share Price 14/02/23 Share Price Change 12mth fwd PE Dividend Yield % NTM
Magellan Financial Group MFG Financials 1.6 18.11 9.03 -50% 10.4 8%
Perpetual PPT Financials 2.9 35.92 25.91 -28% 11.3 7%
HMC Capital HMC Real Estate 1.4 6.34 4.56 -28% 18.1 3%

Source: Refinitiv, Wilsons.



Resources Boom

We are anticipating a robust year for resources stocks, which will include M&A activity as the sector undertakes growth and consolidation to take advantage of strong balance sheets after a bumper 2022.

We believe the large major miners are looking to diversify towards EV minerals. We saw this with BHP’s bid for Oz Minerals last year.

Gold miners have also continued a 5-year trend of deal-making which has largely been driven by an arms race between the two biggest miners Newmont and Barrick Gold. We saw this with the recent bid for Newcrest from Newmont in January 2023.

Our picks in this space are:

  • Mineral Resources (MIN)
  • Allkem (AKE)
  • Lynas Rare Earths (LYC)
  • Northern Star (NST)
 
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Written by

Rob Crookston, Equity Strategist

Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.

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