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Tencent Holdings’ 5% stake this month in Afterpay supercharged the latter’s share price, sparking speculation that heightened takeover activity in Australia is imminent.
Takeover talk is predictable with the S&P/ASX 200 Accumulation index down almost 18% this year and the Australian dollar well down on a year ago. Coronavirus has pummelled strong and weak companies, creating opportunity for cashed-up predators.
Caution is needed. As I have written many times, never buy companies on the basis of takeover speculation alone. In some ways, identifying a takeover target is the easier part: getting the timing right is much harder. Some takeover targets stay that way for years.
Portfolio investors should focus on buying quality, undervalued companies they are prepared to hold, with or without takeover. By all means, factor the company’s acquisition potential into your investment decision, but consider a takeover as cream rather than the cake.
Also, beware predictions from those with vested interests in takeover activity – corporate advisers, for example – about a forthcoming M&A boom. Higher takeover activity is likely, but it may not happen as fast or be as widespread or as lucrative as some observers expect.
For starters, several takeover offers were called off during COVID-19 as bidders sensibly walked away from deals, expecting lower prices this year. Rather than speculate on new takeovers, stalled deals that could be revisited are worth watching, such as those for National Storage REIT (NSR).
Moreover, of the $15 billion or so raised in equity capital since mid-March, only a handful of deals, mostly from smaller technology companies, were for new investments or M&A. Most capital raised was to strengthen balance sheets or improve cash-flow liquidity.
With so much uncertainty surrounding COVID-19, it would take a brave board to approve a company-defining acquisition when the risk of further share-price falls is high. For many boards, the focus will be on shoring up existing operations rather than pouncing on vulnerable competitors or making acquisitions in adjacent sectors.
That said, the global private equity sector was awash with cash at the start of 2020 and there is no shortage of small and mid-size listed companies that would be more valuable after being recapitalised and fixed under private ownership, before returning to ASX.
Cashed-up corporates such as Woolworths, BHP and Wesfarmers could use their balance-sheet firepower to buy complementary businesses during COVID-19. Speculation has focused on Wesfarmers putting cash from its sale of Coles shares to work, through acquisitions.
The tech sector looks a likely M&A source. Since COVID-19 began, I have written repeatedly in this report that the tech sector would recover first, as it did a year after the 2003 SARS crisis. The tech sector outperformed in April and star tech companies are usually acquisitive by nature.
Caveats aside, here are three stocks that should be on takeover-target watchlists. I will add three more in next week’s column for The Switzer Report.
The embattled casino operator is a long-touted takeover target. After horrendous falls since mid-March, Crown’s share price rallied in April when it announced United States private equity giant Blackstone Group had bought about 10% of its shares at $8.15 each.
Blackstone bought the shares from Lawrence Ho’s Melco Resorts & Entertainment, previously a mooted acquirer of Crown. Blackstone’s investment removes an overhang on Crown’s share price (Melco would have struggled to get regulatory approval to lift its stake) and boosts confidence in Crown’s valuation at a time of growing economic and regulatory threats for casino and other integrated resort operators.
Who knows what Blackstone will do next? Private equity firms are rarely content having a small stake and not management control. Also, Crown, for all its problems, has valuable real estate in its portfolio – an attraction to Blackstone, which is known for property investments.
Buying casinos when the sector is on its knees due to COVID-19 must appeal to private equity. For all the immediate problems, integrated casino resorts have an attractive long-term outlook, amid the coming boom in middle-class consumption in developing countries this decade.
Chart 1: Crown
The banking sector’s incredible challenges during COVID-19 were reinforced this month when Westpac, ANZ and NAB announced sharply lower half-year profits, billions of dollars in extra provisioning for impaired loans, and cut or cancelled dividends.
A merger of Bendigo & Adelaide Bank (BEN) and Bank of Queensland was touted long before COVID-19. Notwithstanding potential regulatory issues around competition, a BEN and BOQ merger could provide much-needed scale for a combined regional bank to become more competitive with the four major banks.
That logic surely has greater appeal during COVID-19. Sadly, many small businesses and home borrowers – bread and butter for BEN and BOQ – will go bust during COVID-19. Scale and financial strength will be even more important for both banks.
Longer term, BEN and BOQ need to invest more in technology to keep up with offerings from their larger rivals and counter the threat of emerging financial technology companies, or strategically invest in some fintechs (as BEN has successfully done).
BOQ is down 46 per cent over 12 months on a total-return basis, shows Morningstar data. BEN is off 42 per cent. Although both are well-managed and governed banks, the fallout from COVID-19 could accelerate a marriage of regional banks that seems inevitable.
Regardless of takeover potential, it is time to add more bank exposure to portfolios after the horrendous sell-off, as value emerges in the sector, as I wrote in this report last week.
Chart 2: Bank of Queensland
Macquarie Wealth Management made headlines this month after naming 38 potential takeover targets for Wesfarmers. The list included Qantas, JB Hi-Fi, Crown Resorts, Boral and several small- or mid-cap stocks in retail and other sectors.
I cannot see Wesfarmers acquiring retail businesses given it is already heavily exposed to the troubled sector through its K-Mart, Target and Officeworks operations. Wesfarmers has enough retail challenges with the underperforming Target chain.
Qantas is an unlikely acquisition given the aviation sector has fundamentally changed because of COVID-19 and is not an ideal strategic fit with Wesfarmers anyway, as Macquarie notes.
Acquisition of building-related companies, such as Boral or Fletcher Building, would create synergies with Wesfarmers’ industrial business and both companies are trading well off their high. But with so much construction-cycle risk, acquisitions in this sector could be too early.
Of the 38 targets, Orica and to a lesser extent Incitec Pivot (IPL), are the likeliest targets for Wesfarmers. Both high-quality businesses would be a neat fit with Wesfarmers’ chemicals business, albeit there could be competition issues to sort out with regulators.
Orica appeals, with or without takeover. The leading provider of explosives to the global mining industry is exposed to a sector that, for now, is relatively less affected by COVID-19. As other sectors grind to a standstill, mines are still pumping out iron ore and coal.
Longer term, miners worldwide will have to use more explosives and chemicals as they dig deeper to extract minerals, amid continued declines in ore grades and higher strip-ratios (the proportion of waste rock to ore extracted).
Like most companies, Orica faces COVID-19 headwinds, notably China’s slowing economy and the impact on mining production and explosives demand. Rectification costs from past chemical spills and legacy clean-up costs are another risk for Orica.
Also, Orica, down 16% on a total-return basis over one year, is not screamingly cheap at $17.23, Morningstar values the stock at $17 versus an average price target of $17.51, based on the consensus of 10 broking firms, suggests Orica is only moderately undervalued.
Nevertheless, Orica has world-class technology, a strong global position in its field, scope to increase market share, and exposure to long-term industrialisation and commodity-demand trends in China and India. Leverage to the mining sector is an extra attraction during COVID-19.
At the right price, Orica would be a prize for any suitor and particularly for Wesfarmers as it could use the acquisition to boost scale in its chemicals and fertilisers business.
Orica would also offer less-volatile, long-term exposure to the global mining sector for Wesfarmers (compared to investing in mining producers or explorers).
Having raised $500 million in equity in February at $21.19 a share (fortuitous timing), Orica is well-capitalised and in good shape. The $6.9-billion company would be a large acquisition for Wesfarmers, but the conglomerate has never been afraid to bet big.
Chart 3: Orica