Shares digital

The deal could be on. M&A levels may be falling but so are prices in credit-squeezed markets, creating fresh and tasty targets for those with the appetite. Susanna Twidale and the Shares team consider the opportunities for investors

The papers have been full of pulled deals and tales of woe that the bumper M&A market is coming to an end. Punch Taverns (PUB) has recently ended its talks with Mitchells & Butlers (MAB) saying that the terms of the proposed tie-up are no longer in the best interest of its shareholders, while the chief executives of Whitbread and Travelodge can’t even agree on who came up with the idea to merge the two hotel chains in the first place.

According to the number crunchers at investment banking analytics provider Dealogic, the volume of global mergers and acquisitions has fallen to its lowest level in four years during the first quarter of the year. Yet in spite of the number of deals apparently drying up, lowly company valuations suggest that any slowdown could be temporary, with another wave of rumour, talks and takeovers just around the corner.

As recently as 12 March shareholders in Aim-listed Tissue Science Laboratories (TSL:AIM) were rubbing their hands with glee after watching their stock’s value soar 85% overnight after it received a takeover offer from Bermuda-based medical products maker Covidien (COV:NYSE) at 103.5p, which was almost double the previous day’s closing price of 55p. Tissue Science had been making solid progress selling its wound-care therapies, but recent full-year reports also showed pre-tax losses of £3.3 million. The attraction for Covidien, however, was Tissue Science’s Permacol product, which which will allow the Bermudan company to grow its presence in the lucrative hernia repair market.

While a dearth of available credit means the mega private equity buyouts of the past few years will certainly dry up, at the smaller and mid-tier end of the market there is still a huge demand for growth, which for some companies will only be achieved through acquisitions or mergers.

‘What remains to be seen is the extent to which industrial buyers will be attracted into the market by valuations, whether owners will part with their ownership at lower levels and the imperative on the part of corporates to sustain earnings growth through synergies or be kept on the sidelines by their risk aversion,’ say Corporate Restructuring and M&A analysts at investment banking giant UBS. So far the signs are that investment levels, the primary driver of trade sales, have held up despite the depressed market conditions.

Bargain hunting

The FTSE All share index has plummeted 10.8% so far this year to 2,932 and many stocks now trading near all-time lows are primed for takeovers. That’s not to say there aren’t some companies that quite frankly deserve their low valuations, but even in these cases takeovers are strong possibilities. Firms that have seen their share prices plummet more due to mismanagement, or because they are too small to compete effectively are ripe for picking by larger companies with more firepower, the ability to cut overheads, improve efficiency and command better prices.

In mid-2006 the shares of web surveillance and email software expert Surfcontrol were languishing around 400p, with the company struggling with disappointing sales in North America and weaker than expected results. Fast forward to April 2007 and the company was snapped up by rival Websense for 700p a share, a massive 63% premium on its closing price of 428.75p before the news of the bid hit the market. The offer valued the company at £201 million, not bad for a firm that posted pre-tax profits of just £700,000 in 2006. The attraction, however, was its content security software, Blackspider, and the belief that the enhanced synergies could generate much more profit out of its revenues, which also stood at $102 million in 2006.

Sectors where there has already been a significant amount of M&A activity are also good places to look for targets. Last year the media sector saw a number of giants get taken over, with EMI and Emap falling to private equity groups and the largest deal, the recently concluded takeover of Reuters by Thomson. PriceWaterhouseCooper’s report into M&A activity in the media sector counted 75 transactions in the UK media sector alone last year, with the aggregate of these deals up a massive 329% to ?26.6 billion up from ?6.2 billion in 2006. Although it should be noted that the Reuters/Thompson tie-up accounted for 51% of the total value of UK media sector deals done last year.

Even companies that looked almost beyond repair became loved, with the low valuations making them look like steals. Radio giant GCap Media’s (GCAP) shares were shrouded in doom and gloom after worse than expected results led chief executive Ralph Bernard to stand down after 25 years at the company. With the market worried about the outlook for radio advertising there seemed little hope of a turnaround but, with shares languishing around a miserable 120p, all it took was news of a bid from Global Radio and they had shot up to more than 200p within a matter of days.

Sectors to choose

Despite the flurry of activity, most analysts believe the media sector is set to continue consolidating this year and investors should look for areas where there is still good growth potential, even in the event of a downturn. In the media sector, for instance, spending on internet advertising rocketed by 41% in the first half of last year, and is expected to continue growing at a similar rate even though other advertising media are struggling. This means that companies looking to rapidly increase their exposure to this growing area could be tempted into making acquisitions, especially with valuations in the doldrums. Online advertising and marketing group TMN (TMN:AIM) has recently been the subject of a takeover bid from Tangent Communications (TNG:AIM), which valued the company at around 50p a share. TMN bosses believe this is way too low, especially as only some 40% of the deal would be in cash, but in the weeks before the the offer was announced TMN was trading at lows around 35p. They have since shot up to 54.25p, with shareholder, and former Datamonitor founder Mike Danson thought to be considering a counter offer after upping his stake to 10%. Advertising giants WPP (WPP) and Publicis (Euronext:PUB) have been snapping up similar small companies recently so there is also a chance they could be interested.

The saying goes that something is only worth what someone else is willing to pay for it. However, given the fall in share price valuations this year, bargain hunters are becoming an increasing force, with the potential for stonking premiums to be paid out for the right assets or products. This is particularly true in the biotech sector where bids can be even more lucrative for shareholders as they are often made in cash. Ernst & Young’s Global Biotechnology report 2007 said that the average takeover premium paid for transactions involving biotech companies was 60% in 2006, and while there has certainly been a slowdown in deals, big pharma companies desperately needed to boost their product pipelines and, with valuations at lows, a whole host of companies in the sector are in the frame. In some cases, where a licensing deal is already agreed, a takeover, even at a premium could be more economical than coughing up milestone payments. Oxford Biomedia (OXB:AIM) has a deal with Sanofi-Aventis (SNY:NYSE) for its TroVax cancer treatment, which could be worth up to ?518 million (£410 million) if trials and development go according to plan. Oxford’s share price of 22.5p gives it a market cap of just £120.8 million, so even the most mathematically challenged can see an eventual takeout could be on the cards.

Buying shares in the hope of a takeover is a risky business, and as a general rule before buying, investors should make sure there is more to recommend a company than just the possibility of a bid. However, with many company’s valuations at fresh lows, crying out for fresh management, or with tempting assets that can attract a suitor, there are gains to be had for the canny investor who knows where to look or who has not been panicked into selling

too early. The shares team has put together a list of ten targets likely to fall within the sights of deal-hungry predators before the year is out, and where hefty premiums to current share price valuations will spell a profits boom for investors willing to play the takeovers game.

CRUNCHING THE NUMBERS

Takeover artists are interested in what a company would be worth if it could be broken up and sold, division by division, piece by piece. That figure is its break-up value. Traditionally, a company’s breakup value is estimated at about ten times its pre-tax cashflow. For example, consider ABC plc, a fictitious conglomerate with five divisions or different basic businesses. Suppose ABC has year-end consolidated (all divisions added up) cashflow of:

operating income before tax £100 million

plus depreciation on assets £10 million

less capital expenditure £15 million

total cashflow £95 million

If ABC had 100 million shares in issue the sum would read:

Cashflow per share = £95 million divided by 100 million shares, or 95p a share. The take-over financiers estimate the breakup value to be ten times 95p, or 950p a share. If ABC’s current share price is below 950p, they would think the company is undervalued, making it a potential takeover target or breakup candidate.

The greater the breakup value over the present price, the greater the chance either a takeover or breakup will be pushed through. An alternative is to look at NAV, or net asset value. This is what the company’s auditors believe is the worth of the company’s individual components, property, machinery, tools, vehicles etc. Of course, it gets a bit more complicated when dealing with intangible assets, say intellectual property or client relationships for example, typically seen in firms such as chip designer ARM Holdings (ARM), or advertising group WPP (WPP).

But in a similar way, if the company’s current market value is significantly less than its supposed balance sheet worth, or its price-to- book value, it too would be generally considered ripe for either a takeover or a breakup. It’s not an absolute marker, companies that trade below their book values are also usually compared with their industry peers to provide a better gauge for valuation (real estate companies, for example, often trade at a discount to their property valuations). A breakup figure lower than its competitors is one of the best indicators that a stock is undervalued.

10 TAKEOVER TARGETS

What makes a target?

Key points:

L = Low valuation making it vulnerable and a cheap buy

P = Unique selling point or product that makes it attractive to others

C = In a sector where consolidation is already taking place

R = Scope for a change of management or strategy to facilitate a recovery

S = Shareholders building up major stakes

BUY British Energy (BGY) 666p - P, C

Back in January, the government posted a white paper advocating the expansion of nuclear energy, and naturally British Energy shareholders got excited, as the company is the best-placed to benefit from the ramp-up. The shares gained 40% in two months to the current 666p, but further gains could be made as a takeover story unfolds around the UK’s largest energy producer. The company has confirmed it is talking to interested parties and Europe’s major utilities have been named. All of them want to invest in British Energy’s expertise and portfolio of possible sites for nuclear plants. The government, which has a 35% stake and a right to block any takeover bid, is keen not to exercise the right and to let bidders unveil their offers. Market rumours last week had it that Centrica (CNA), would step ahead with an 800p bid. It’s a win-win situation for British Energy shareholders, who will benefit from either a takeover at a premium, or the nuclear programme itself, in a European utility sector that is ready for a wave of consolidation. (CS)

BUY KCOM (KCOM) 44.25p, L, C

Formerly known as Kingston Communications, the £226 million cap stock was widely seen as having been put in play when Hull City Council sold its remaining 31% stake last May. The UK telecoms and related IT services sector remains brutally competitive and Kcom is clearly feeling some pressure, as January’s trading statement made clear margins at the managed services arm will come in at the low end of the forecast range for the year ending March. Kcom itself has made several purchases since 2004 to expand is reach beyond east Yorkshire and, in a sector where rivals such as Redstone (RED:AIM) have also been on the acquisition trail, a further round of consolidation is likely. Kcom was approached by private equity firm Carlyle in 2006 and – should broader market funding conditions improve – it would not be a surprise if the Hull firm’s prospective PE of barely eight and yield of 6% attracted fresh attention. (RM)

BUY Antisoma (ASM) 22.75p, L, P, C

The drug developer is in a strong position, having already secured a licensing deal with Swiss-based pharma giant Novartis for its cancer drug AS404. If trials and data go according to plan, this could net Antisoma up to $890 million (£458 million) in milestone payments, which dwarfs its current market cap of £101.6 million at 22.75p. Phase III trials are due to begin this year and the company’s director of communications, Daniel Elger, has admitted the company is a target. ‘Further down the line is anyone’s guess,’ he says. ‘It is possible that when Phase III data comes out they (Novartis) will do the maths and that’s when companies get taken over,’ he says. Many pharma companies are looking to boost their oncology pipelines but, with Novartis already having its foot in the door, it may look to takeover the company to gain complete control of its products. (ST)

HOLD Debenhams (DEB) 55p, L, C, R, S

The group has endured a torrid two years since it was refloated at 195p in May 2006. However, last month’s trading update suggested that its strategy was beginning to work, with market share up and costs controlled. The company is adopting a cautious approach, which should minimise the need for mark-downs. Andy Wade of Seymour Pierce believes Debenhams is ‘moving in the right directions’. The group has two corporate shareholders – Baugur with 13.5% and Mahesh Jagtiani of Dubai with 9%. Baugur already owns House of Fraser, and merging these two department stores would clearly produce significant synergies. Overheads could be reduced and competing stores closed. Although Baugur is affected in the short term by the credit crunch, the logic of a deal in the longer term is too obvious to ignore. Jagtiani could also have takeover aspirations, and he could be forced to show his hand if Baugur makes a move first. The shares offer a 10.8% yield, which is increasingly attractive within the sector. (JM)

HOLD Burst Media (BRST:AIM) 8.25p, L, C, R

The US-based internet advertising company had a torrid time in 2007, issuing a profits warning that led its shares to slump from highs of 24.5p to lows of just 7.9p. However, a recent trading update said it should ‘modestly exceed’ its revised forecasts and things seem to be looking up. It had a cash balance of $12.6 million (£6.3 million) at the end of 2007, which, compared with its current market cap of £6.85 million at 8.25p, would make it a steal for any company looking for exposure to this growing market. Although newspaper and television advertisers are having a tough time, the internet is one area where ad markets are soaring. Internet advertising and marketing company TMN (TMN:AIM) is already in the midst of a takeover battle and Burst could be the next on the chopping block. (ST)

HOLD Medsea Estates (MEA:AIM) 2.38p, L, C

When you consider that just three years ago Medsea’s share price stood at 72p, its current 2.38p looks pretty appalling. In the past year alone, its share price has dropped a whopping 87%, although this is perhaps less surprising given the performance of the property sector as a whole. Thanks to the credit crunch, many property companies are now trading at large discounts to net asset value, and this may help to spur on an increase in M&A activity. Large, cash-rich companies are set to be tempted by cheap deals, with rumours already putting several firms in the takeover firing line. Medsea, which primarily operates in Spain, but also has businesses in Italy, Portugal, Turkey and Bulgaria, could be next in line. The group has been struggling of late, with property sales falling below expectations and a profits warning being issued last September. Recovery seems a long way off and as a result, any company looking to expand its portfolio in the European market could easily be tempted by a cheap deal. (RR)

BUY IMI (IMI) 441.25p, L, C

Takeover activity is heating up once again in the UK engineering sector. After Cookson’s (CKSN) swoop for Foseco late last year, this year has already seen Melrose (MRO) up its offer for FTSE 250 firm FKI (FKI), while steel wheels specialist Titan Europe (TSW:AIM) revealed that it had received an approach in early February. Elsewhere, Bodycote (BOY) rejected a now very good looking bid from a Swiss company last year, and its shares have since fallen 35%. Now fluid controls group IMI has seen its share price soar from recent lows of 320p after better-than-expected results for 2007 sparked a fresh wave of takeover speculation. US controls giant Honeywell International is most mentioned as a potential bidder. There is also a chance that a private equity firm might make an approach, as IMI generates plenty of cash. IMI lifted profits 8% to £171 million last year and is forecast to comfortably top £200 million in 2008. This would cut the PE to just under ten, and the yield is a handsome 4.5%. The order book rose 13%, profit margins are rising due to cost cuts and there are plenty of new products in the pipeline. A bid would need to be pitched at around 600p valuing IMI at £1.9 billion compared with its current value of £1.4 billion at 441.25p a share. (TD)

BUY SciSys (SSY:AIM) 22.5p, L, C

The shares of the IT consultant have slumped from 110p to just 23.25p since it was spun out of CodaSciSys barely 18 months ago. Sentiment was badly damaged last year by a trio of profit warnings, when the Chippenham firm mishandled a pair of contracts and suffered delays in two further defence deals. However, experienced chairman Mike Love took over the reins from chief executive from Mark Hampson late last year and swiftly overhauled the management team, bringing in several old hands. A recent fresh share price slump suggests there may be more problems to emerge and the stock is therefore not without its risks. But assuming Love is able to draw a line under the botched deals with the full-year results due next week, SciSys does look cheap. A market capitalisation of £6.5 million is barely a quarter of last year’s sales, compared with the one times’ sales Italy’s Finmeccanica paid to acquire one-time CodaSciSys suitor Vega late last year. (RM)

BUY Omega Insurance (OIH:AIM) 152.25p, P, C

The shares of the specialist property insurer are back at around the 150p they were at before news in February of the bid interest. While it seems the market has gone cold on the idea of an acquirer ever since making a move, analysts maintain interest is still there and flag a takeout price of around £2. It is said that Bermuda-based insurance companies are keen to diversify following pressure from the ratings agencies. Many of the Bermuda companies are monoline, whereby they rely on only one line of business. The rating agencies are demanding these businesses hold more capital to offset the risks, so they’re now left with the task of either raising more equity (difficult in today’s markets), writing less business, or diversifying to reduce the risks. The preference is for diversification, making Omega a prime target. Historically, bidders have paid about twice net asset value, which, given Omega’s latest NAV per share of $2.09, suggests a takeout price of around 200p. (SK)

BUY Xstrata (XTA) £35.18, P, C

Brazilian mining giant Vale may have failed to agree a price on Xstrata (XTA) but that won’t stop others having a go. Anglo American (AAL) has long been mooted as a possible contender to merge with Xstrata. This would strengthen its position in iron ore and coal, two commodities in strong global demand. Glencore, a Swiss commodities trader and 35% owner of Xstrata, indicated in the Vale discussions that it would be fine with a takeover if it got to keep a lucrative marketing agreement on Xstrata’s production. A rival suitor now knows this is a condition to any bid, which should ease any corporate discussions. Merging two large mining houses makes sense on the grounds of cost efficiencies. The weak financing market is the deterrent to making a deal happen. Analysts aren’t sure that Anglo will actually make a move on Xstrata as the business itself could become the new target for Vale, alongside Freeport and Alcoa. Termination of talks last week with Vale has wiped out Xstrata’s bid premium, but the reduced share price level provides a suitable entry point for investors wanting to benefit from anticipated commodity price strength. (DC)