The rise and rise of M&A activity – The outlook for 2021 and beyond
In response to the COVID-19 global pandemic, Australian Merger and Acquisition (M&A) activity in 2020 experienced a steep decline with a 20% reduction in deals successfully closing compared to 2019. Many companies have survived the economic hardships of COVID-19 by implementing defensive strategies and reducing their corporate spending. Coupled with the government stimulus measures that were quickly implemented, the Australian economy has made a sharp recovery to date. With many Australian companies now sitting on stronger balance sheets, it is seemingly a ripe backdrop for M&A activity to take place this year and beyond with many companies on the lookout to inorganically grow or fill gaps within their portfolios and capabilities.
Media headlines are stating a record breaking ‘frenzy’ of M&A activity has begun and by judging the number of potential transactions that have recently been announced, it very much seems that way. With that in mind, we felt the timing was right to analyse how M&A activity has unfolded over the last decade, review the current landscape and assess what is causing this flurry in deal making activity. In particular, we will look at potential M&A targets which sit within the ASX Small Ordinaries Index and decipher if we are truly in a period of M&A “frenzy”.
M&A History – Pre GFC to now
It may come as somewhat of a surprise but the number of M&A deals that involve ASX listed companies over the last 15 years has been in a steady decline. The below graph depicts the peak level of M&A deals of listed Australian companies that took place just prior to the Global Financial Crisis (GFC).
Source - Factset
Logically, the peak of Australian listed company deal cancellations occurred during the GFC. Somewhat surprising is the number of cancelled deals didn’t dramatically increase during 2020 despite the uncertainty caused by COVID-19. In saying that, the quantity of completed listed Australian company deals did drop significantly during 2020 to levels lower than any other year on this graph. To us this shows that COVID-19 had the effect of cancelling M&A plans before they occurred or at the very least put them on the ‘backburner’ for the interim. If the latter is true, when may these once again become front of mind?
The current M&A landscape
Pitcher Partners, in collaboration with Mergermarket, recently produced the Dealmakers 2021 report to canvass the opinions of dealmakers in Australia for the year ahead.
“The mid-market segment (deals valued between AU$10m and AU$250m) is expected to enjoy a particularly strong uplift in M&A. Two-thirds of respondents say Australia’s mid-market offers better opportunities for dealmaking than what is available in other countries, and more than half expect to undertake at least one mid-market transaction over the next 12 months.” – Dealmakers 2021 Report
One factor that is driving the recovery in deals is Australian companies are not overleveraged and have healthy balance sheets (unlike in the GFC). Along with private equity companies sitting on record amounts of “dry powder”, many key dealmakers believe they will see a dramatic increase in deals taking place over the next 12 months.
The above graph from Dealogic which looks at all Australian M&A transactions (listed and unlisted), highlights the beginning of a recovery in deals occurring in the second half of 2020. Deal volumes increased sharply during the third quarter of 2020 and the total value of deals completed increased significantly towards levels last seen in 2018.
The below Dealogic graph provides longer term look at M&A deal sizes. In the wake of the GFC, businesses that were looking to sell quickly were required to ‘meet the market’ on M&A expectations. Average deal values fell sharply and made a modest recovery in 2010 however it wasn’t until 2015 that the average deal size exceeded pre-GFC figures. The Australian market experienced an average deal value spike in 2018, but if the late 2020 deal value trajectory seen above continues into completed deals throughout the remainder of 2021 and beyond, then we are likely to see not only more but also much larger deals.
The outlook on M&A for the remainder of 2021 and beyond
Whilst we are only halfway through the year, activity is ramping up. According to Dealogic, 2021 has already seen $46.3 billion worth of Australian listed and unlisted M&A deals, compared to $19.1 billion at this time last year.
If we just focus on ASX listed companies, according to FactSet only 9 deals have been completed with 6 having been cancelled with another 41 deals currently pending. The average transaction size for the pending 2021 deals is highlighted in the first graph (far right yellow bar) which speaks volumes (excuse the pun) to the size of deals we are currently seeing.
Looking at some of the pending deals, it is hard to go past some of the big announcements of late including Square Inc’s potential acquisition of Afterpay (ASX: APT) at the same time the consortium bid for Sydney Airport (ASX: SYD) which was recently rejected. However there are several that have been intriguing to watch in terms of bids and offers especially at the smaller end of town as we believe some smaller companies provide strategic value to larger global companies. Mainstream Group (ASX: MAI) is an example of this. MAI provides middle and back-office services for the financial services industry and saw an initial bid in March 2021 of $1.20, however a strong bidding war took place and saw 13 additional bids. MAI has recently entered into a scheme of implementation with global provider Apex Group Limited at $2.80.
Mainstream might be a one-off scenario where the final offer is 133% above the initial bid, nonetheless valuations are moving higher in an environment where lower interest rates have pushed all asset prices up (the ASX 200 delivered a return of +24% for FY21). The below chart highlights the average takeover premium paid, with 2021 currently on par with the long run average.
Source – S&P CapIQ
A spotlight on ASX Small Industrials
Turning to the potential drivers of M&A going forward, one of the clear differences between now and the peak pre-GFC M&A activity of 2006 is interest rates. While interest rates didn’t peak until mid 2008, they did reach a level of 6.25% in 2006 which is a vast contrast to the current RBA cash rate of 0.10%.
According to Deloitte’s 2021 Head of M&A Survey, which conducted interviews with ASX200 business leaders involved in M&A:
“100% of respondents are confident that credit will be available at favourable rates and 98% are confident that balance sheets will be strong with adequate cash reserves.”
The current low return environment is placing pressure on company boards and management teams to increase scale and potentially enter new markets to generate returns. The abovementioned Deloitte’s report noted that:
“more than half of respondents have listed acquiring assets to fill gaps in the core portfolio, enter new growth segments and accelerate digital transformation as priorities over the next 12 months.”
At NAOS, we focus our attention on industrial companies that appear outside the S&P/ASX 50 index. Whilst the companies that appear in our investment universe might vary in size, operations and characteristics, like many other companies those within our universe were not immune to the impacts, uncertainty and headwinds brought on by COVID-19. It goes without saying that many companies are yet to fully recover from the pandemic.
When looking at the S&P/ASX Small Industrials Index, the table below outlines performance of the constituents from their pre Covid-19 share market highs in January/February 2020, to their highs in July 2021. Of the 197 companies currently in the index, excluding 4 that listed after March 2020, 97 companies are yet to fully recover from their pre Covid-19 highs. Depending on your perspective and philosophy this may present an opportunity or potentially pose significant questions around their long-term business models. Or could they be seen as M&A targets?
Taking an optimistic viewpoint, it’s worth looking at what the market is forecasting in terms of earnings per share (EPS) in the years to come. The below chart looks at estimates for EPS in FY23, which is hopefully far enough out that COVID-19 will be behind us. This is compared to the pre COVID-19 environment of FY19. For the 97 companies above that have not yet recovered their pre-COVID-19 share price performance, this comparison presents some interesting results.
In our opinion, it is unsurprising to see the number of companies that are not forecasted to recover in terms of EPS by FY23 (34 in total). On the flip side, surprisingly there are a large number of companies that are forecasted to experience solid growth. As depicted below, 32 companies are forecasted to have in excess of 50% growth in EPS from FY19 to FY23. Some names within this cohort include Redcape Hotel Group (ASX: RDC), IOOF Holdings Ltd (ASX: IFL), Viva Leisure Ltd (ASX: VVA), oOh Media ltd (ASX: OML) and Ansarada Group Ltd (ASX: AND).
Finally, given the current low interest rate environment, finding companies that can generate strong free cash flow (FCF) is desirable. In the graph below we have looked at what the market is forecasting for FCF in FY21 and comparing this to FY19, there are 45 companies from the abovementioned initial 97 companies after taking out some outliers, that are expected to generate positive FCF growth from FY19 to FY21. The sectors that are most represented in the below chart relates to property/infrastructure firms, finance/leasing and consumer discretionary. Interesting, two companies that appear in the list are Blackmores Limited (ASX: BKL) which is reported to be in discussions with several investment banks on their defence mandate and Australian Pharmaceutical Industries Ltd (ASX: API) which recently received a bid from Wesfarmers Limited (ASX: WES).
Finally, its worth noting that as depicted in the above charts of share price, EPS and FCF recovery, there are always a vast array of results. At NAOS, we focus on a concentrated universe of small and micro-cap industrial companies that have a genuine competitive advantage and are run by strong management teams who have a track record of excellent capital management.
Don’t lose sight and only focus on M&A
Whilst we will continue to have periods of COVID-19 uncertainty ahead, we shouldn’t lose sight of the economic environment that is creating this platform for heightened M&A activity. Record low interest rates are likely to remain for the medium term, corporate balance sheets appear to be in good shape and there is relatively accessible capital available for businesses.
The environment to have the confidence for undertaking M&A transactions also lends itself to provide confidence to company boards and management teams to reinvest in their own businesses. At NAOS we don’t focus on M&A outcomes within our investment process, rather we look for companies that are focused on this notion of reinvestment.
Along with many other factors, reinvestment is important in order to improve the longer-term quality of a company’s existing operations and create further shareholder value over time. This should benefit FCF generation and the company’s overall competitive advantage. If this is done consistently then the outcome should be an improvement in a company’s strategic value to a wide range of stakeholders including shareholders, customers, competitors and maybe even potential acquirers.
 Source: Mergermarket
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Jared is a Senior Investment Analyst and has been with NAOS since April 2021. Jared holds a Bachelor of Commerce, majoring in Accounting and Finance, from the University of Notre Dame, Sydney and is a CFA Charter Holder
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