Shares digital

Indiscriminate selling of small caps means Aim is packed with bargains. Rachel Robson highlights five stocks to buy – before someone else does

A volatile equity market and tighter borrowing conditions may have halted the mega-merger and acquisition activity that characterised the main market in 2006 and for most of 2007, but the flow of deals looks set to remain as strong as ever on Aim.

This year, private equity funds have already snapped up names well-known to investors on the junior market, including public sector IT services expert Civica, supply chain management software specialist Chelford and inspection and testing specialist Inspicio. Other firms, including broker WH Ireland and Interactive Prospect Targeting have been the subject of approaches and could be again.

This year’s deals have seen companies taken out at levels way above where their shares were trading before a bid approach was made public, offering shrewd investors who had spotted the opportunity themselves a quick killing. Civica was taken out at a 34% premium to the previous day’s closing price, and Chelford 25%, while Inspicio shareholders got an 18% mark-up against the price level seen prior to the preliminary announcement of an approach.

Shares has therefore examined what has made past deals succeed or fail, and drawn up an exacting list of criteria to identify stocks that look most susceptible to a public-to-private buyout in the coming months, and therefore appear most likely to offer investors a juicy profit.

Smaller deals but more deals

Despite the credit crunch coming into full force during the second half of last year, fundraising by European private equity funds remained resilient throughout 2007. Although data from the European Private Equity & Venture Capital Association (EVCA) reveals a sharp drop from 2006’s record ?112 billion, 2007’s ?74 billion in cash raised was still a figure way in excess of that raised in previous years. According to the EVCA, of the ?74 billion raised, the majority was allocated to buyouts (?60 billion), and ?10.4 billion to venture and growth capital.

This makes it clear private equity and buyout funds still have plentiful cash sloshing around and they are still hungrily on the look-out for suitable investments. The parlous state of debt markets means 2008 and 2009 are unlikely to see a repeat of last year’s £11 billion Alliance Boots transaction, Europe’s largest-ever leveraged deal. But this does not rule out deal-making completely. During the last equity bear market of 2001/02, average transaction sizes fell but the actual number of bids rose dramatically.

Data from the Centre for Management Buyout Research (CMBOR) shows at that time there were 55 public-to-private buyouts in the UK, worth a total of £7.6 billion. In comparison,

during the 2006/07 bull market run, there were 49 public-to-private buyouts and they were worth a whopping £25.5 billion.

But 2007 showed the first signs of a move back toward small-cap deals. CMBOR’s data shows the amount of mega-buyout deals, defined as ?300 million and above, fell by 31% in the UK last year. By contrast, large deals, worth between ?150 million and ?300 million rose by 103%, while mid-market buyouts, worth between ?15 million and ?150 million, rose by 27%.

If the right deal can be identified, it can still therefore be done.

Little fish are sweet

Log-jammed credit markets mean these trends are likely to become more pronounced, with smaller deals becoming more common and large ones less so.

Small caps are also becoming more attractive relative to their large-cap peers in terms of valuation, as they have come off worst in the summer market rout. After marked outperformance in the first quarter of 2008, both the FTSE Small-Cap and Aim have markedly underperformed their larger cap peers and suffered particularly badly during July’s calamitous market plunge.

Falling valuations will inevitably attract predators, particularly cash-rich ones. ‘Faced with an increased pool of relatively low-priced assets, available on markets such as Aim, we would expect to see corporate predators begin to emerge from within and more especially, outside the UK,’ say researchers at investment bank Noble Group. ‘On this latter front, economies such as Japan, China, India, the Middle East and continental Europe may be the most likely source of overseas acquisitors.’

Noble’s research identified 20 companies that could fall under the category of ‘ones to watch’ from a private equity fund perspective. The bank’s analysts established a filter to help select which firms were the most likely to become targets. These included a market capitalisation of between £15 million and £100 million; a single-digit price/earnings ratio (PE); a net cash balance sheet; poor share price performance; and the presence of a large stakeholder, or stakeholders, who could be persuaded to sell at the right price.

Shares has also drawn up a list of exacting criteria to help identify potential private equity takeover targets.

• Share price has fallen at least 30% from its 12-month high

• Net cash balance sheet

• Solid business model

• Lowly valuation

• Availability of large blocks of stock from potential sellers

This approach throws up five names: toy maker Character Group; provider of educational qualifications and assessment services, Education Development International; traffic data specialist ITIS; stockbroker Panmure Gordon; and restaurant group Carluccio’s.

Not all deals work

Of course, not all bid targets are happy to be swallowed up. Financial services firm W H Ireland rejected several bid offers late last year and one from rival Blue Oar in April. The Manchester firm then issued 3.37 million shares at 100p to a consortium of investors, who included Carphone Warehouse co-founder David Ross and former Southampton Football Club chairman Rupert Lowe, in a deal that gave them a 25.1% stake.

Nor are all firms with depressed share prices, low valuations and healthy balance sheets appropriate acquisition targets. German online poker and casino operator Gaming VC is involved in bid talks, understood to be with activist hedge fund Audley Capital, which owns 29% of the company.

Uncertainties about the legality of Gaming VC’s online gambling services will deter private equity, which focuses on certain key features defining a firm’s business.

Mark Hall, fund manager at Rensburg Fund Management, notes private equity firms will look for companies with high barriers to entry, good cashflow and those with strong market positions in niche areas, thus reducing competition.

One example of this is British drug and alcohol testing company Concateno, which admitted earlier this month it has received ‘a number of expressions of interest.’ The identity of the suitors has not been revealed, but Concateno’s strong growth profile, boosted by last year’s acquisition of drug testing firm Cozart, make it an attractive proposition. Consensus estimates expect earnings per share (EPS) to jump 40% this year and 43% next.

Cash is king

But cashflow is often more important than growth. This explains why IT services firm Civica was the subject of a 3i-backed management buyout, which offered shareholders a juicy 40% premium to the average share price across the six months preceding the deal. A £96 million order book worth three-quarters of the previous year’s annual sales, an operating margin of 17%, a profit-to-cash conversion rate of 92% and strong recurring revenues ticked the right boxes, particularly as Civica’s prospective PE had plunged below ten before the bid approach. Civica’s sales grew only 1% in the year just ended, and were unlikely to grow much faster than a mid-single digit clip, but no matter. Cashflow was king, as it is in nearly all private equity deals.

Rensburg’s Mark Hall explains part of the problem at the moment is that when making a bid for a company, private equity firms must ensure they can finance the debt element of the deal. The target therefore needs either strong cashflow, assets that can be sold or, preferably, both. But even then the bigger deals are harder to justify, as the banks continue to tighten up on the availability of credit and increase its cost. Smaller deals are easier to finance and, since valuations have plunged this summer, more smaller cap market transactions are likely. ‘Given where valuations are, a lot more takeover activity is at the smaller end of the market,’ says Hall.

John Hinton of Ernst & Young agrees small cap deals will be easier to pull off in the current credit environment, and adds there are currently a lot of good-quality undervalued companies to be found on Aim. However, he is less convinced public-to-private buyouts are increasing at present, although he accepts several deals are under consideration. Hinton says activity will certainly pick up once the banking market recovers, although he does say it is ‘anybody’s guess’ when that will be.

Juicy stakes

Deals can also be easier to push through if there is a big block of stock to be picked up in one go. Research on this subject by Noble Group noted ‘Analysis of recent public-to-private moves on Aim over the past couple of years suggests the ownership profiles of the stocks concerned were also worth watching, with notable investment company and, to a lesser extent, employee strategic stakes (being over 5%) in evidence ahead of the eventual announcement of any deal.’

David McBain of Absolute Strategy Research explains on Aim, ‘you tend to find that further down the pool there are different levels of ownership than on the main market.’ This is important in terms of the buyout element. If a large amount of stock can be acquired quickly from one willing seller, the chance of the deal going through smoothly is much higher. All

five of Shares possible buyout candidates have at least one shareholder with a stake bigger than 11%.

How quickly further buyouts happen this year still depends to a degree on whether the markets can regain their nerves. If the private equity firms take the view further falls are likely they will hold off and wait for valuations to become cheaper still. But once activity does pick up, it is certain to snowball. After all, they do say the best things come in small packages.

Take Aim takeover targets

Carluccio’s 127.5p BUY

Share price relative to 12-month high: -50%

Prospective PE: 15.8

Cash pile: £3.6 million

Cash as % mkt cap: 5%

Largest declared stakes: Innes (Richard Caring) 12.05%, BlackRock

Investment Management 6%

The cash-generative nature of restaurants makes the good ones obvious targets for private equity. Carluccio’s certainly fits the bill with no debt and plenty of expansion potential. The Italian restaurant and deli model has proved successful with pre-tax profit rising 19% to £2.8 million for the six months to March 2008. It continues to open new sites, including its first overseas franchise store in Ireland. The shares have come off in light of a downturn in consumer spending across the leisure sector, but Carluccio’s has proved to be one of the more resilient operators in terms of earnings. (DC)

Character Group 92p BUY

Share price relative to 12-month high: -57%

Prospective PE: 6.1

Cash pile: £10.2 million

Cash as % mkt cap: 27%

Largest declared stakes: 26% 3i Quoted

Private Equity; 15% Kiran Premchand Shah

A product recall, safety issues in China and a poor Christmas season in 2007 have all battered the toy maker’s share price and left it vulnerable to an approach. Character’s shares halved after disappointing trading updates in December and January and further weakness in consumer confidence remains a risk, despite an attractive portfolio of products, which includes a raft of Doctor Who-related gadgets, Hannah Montana and the new Pixar films phenomenon Wall-E. However, it is worth chancing the prospect of a buy-out after interims showed a return to profit, particularly as the firm’s £92 million of prospective sales are valued by the market at just £37 million, or on an EV/Sales multiple of just 29% once the company’s £10.2 million cash pile is accounted for. (RR)

Educational Development International 32.5p BUY

Share price relative to 12-month high: -30%

Prospective PE: 6.2

Cash pile: £1.1 million

Cash as % mkt cap: 5.9%

Largest declared stakes: 16% Wynford Dore

It may only be valued at £19 million, but Educational Development International is a steady performer, growing each of its profit, cashflow and dividend payouts. The company is an awarding body offering a broad range of vocational and professional qualifications. It runs online assessments for schools, training programmes for employers and other education services. A private equity buyer recently swooped for larger rival Nord Anglia Education, and a 28% correction in the share price following a nine-month bull run, could be just the opportunity potential bidders have been waiting for, as the stock now trades on a prospective PE of just 6.1 for the fiscal year ending September 2008. (DC)

ITIS 30p BUY

Price relative to 12-month high: -56%

Prospective PE: 7.6

Cash pile: £2.0 million

Cash as % mkt cap: 6.7%

Largest declared stakes: 31% Stewart Adam Marks, 16% Peter Smedvig Capital

We know private equity has an appetite for the traffic information sector as ITIS purchased Trafficlink from mid-market buyout specialist Dunedin in December. It would be an irony if the combined group was now bought back by private equity at today’s lowly valuations but the prospect looks very real. The shares have come off because of concerns about the health of the automotive sector, into which the company sells its technology. But long-term growth prospects are still encouraging owing to the potential for international expansion. (SK)

Panmure Gordon 37.5p BUY

Share price relative to 12-month high: -77%

Prospective PE: 4.8

Cash pile: £34.4 million

Cash as % mkt cap: 131%

Largest declared stakes: 23% Praxis

Trustees, 18% UKPG Holdings

There was talk of a management buyout (MBO) in March when the shares stood at 74.5p. Since then the stock has plunged to 39p, 70% lower than where it was a year ago, and this should increase the chance of an MBO spearheaded by chief executive officer Tim Linacre.

Little has changed since March. Panmure’s UK investment banking business continues to struggle with much-reduced deal flow, as Aim floats have largely dried up. A private equity buyer would have a chance to buy into a financially sound business near the bottom of the investment banking cycle, since Panmure has a £34.4 million cash pile, against just £3.5 million of debts. Key shareholder, Iranian-born investor Farhad Moshiri, is said to be keen to sell, increasing the chances of a deal. (SK)