Identifying takeover targets: What looks like a good deal?

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.

Super funds 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.

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 (ASX: ORG), with the bidders recently requesting more time to complete due diligence. With Grok Ventures, Brookfield attempted to acquire Origin's competitor, AGL Energy (ASX: 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 (ASX: OZL) from BHP for $10.2b as BHP Group (ASX: 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:

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

#2 - 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.

#3 - Resources boom

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

#4 - 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 (click to enlarge)

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 (ASX: CWY) and Lotteries Corporation (ASX: 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(click to enlarge)

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 (ASX: NTO), Tyro (ASX: TYR), Nearmap (ASX: NEA), ReadyTech (ASX: RDY), Elmo Software (ASX: 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 (click to enlarge)

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(click to enlarge)

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 (ASX: MIN)
• Allkem (ASX: AKE)
• Lynas Rare Earths (ASX: LYC)
• Northern Star (ASX: NST)

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