6 ASX micro-cap stocks that could benefit as M&A activity rolls over

Mergers and acquisitions among small- and micro-caps appear to be on the rise, as slowing activity at the larger end of the market rolls over amid higher inflation, rising interest rates and offshore conflict.

In recent weeks we’ve seen bids lobbed at payments and software companies Tyro (ASX: TYR)  and Nitro Software (ASX: NTO) by private equity firm Potentia Capital - which have so far been rebuffed. And payroll processing company PayGroup (ASX: PYG) was bought for $119 million by San Francisco-based competitor Deel in late June.

This was one of the few broader themes identified in interviews with Mark Tobin, who runs investment community Coffee Microcaps, and small- and micro-caps portfolio manager Luke Winchester of Merewether Capital.

“A lot of them have interesting products and software, and as the share prices get lower, some of these larger peers who have come out the other side may look to pick them up cheaply to bolt on customers, grow market share or extend geographies,” Winchester says.

And Tobin suggests some of the more mature companies with cash on their balance sheets are weighing up continuing to pay out dividends versus expanding via acquisition.

“Because if you’re a cashed-up competitor now, the multiples have come down and I think M&A is going to start looking attractive to some of those with the balance sheets to acquire their competitors – especially in the private space,” he says.

The pair also discuss some of the microcap stocks they believe are interesting in this environment, which we'll get to later. But from a broader perspective, Tobin believes there’s a clear divide running through the micro-cap segment currently.

“There are those who are continuing to invest in their businesses in the belief they can be re-rated on the back of revenue growth. And others have turned off their sales and marketing, cut down on product development and other bells-and-whistles in pushing to reach the point of cash flow break-even,” he says.

“A long, hard road for microcap tech”

Though neither strategy rewarded some of the unprofitable names in the technology space in FY22. For example, software firm TechnologyOne continues to trade roughly in line with its pre-earnings season level.

“And that’s after the big drop from January. Maybe a few of them had a bounce on the day or the week they reported but a lot of them are back to where they were before they reported, and it made no difference which strategy they told the market they were pursuing into 2023,” Tobin says. “Microcap tech has still got a long, hard road ahead.”

Micro-cap miners are also struggling in this interest rate environment, facing what Tobin describes as a “double-edged sword” as they grapple with higher costs and greater difficulty attracting funding. And while mining companies in the production phase are benefiting from strong commodity prices, earlier-stage companies are missing out on this uplift.

The currency differential between the Australian and US dollar was another of the few broader themes Tobin observed across ASX microcaps more generally during the latest earnings season. He notes that ASX companies generating revenues from onshore businesses are facing a tougher time than those with greater exposure to the US market.

“We only just started to see it in the numbers this reporting season, but the longer the Aussie dollar stays weak versus the US dollar, the more of that benefit they’ll capture,” he says.
“If I was looking at opportunities post-earnings season, I’d be combing through those microcaps with US-dollar exposure.”

Management quality remains critical

In a similar vein, Winchester highlights the contrasting results delivered by furniture companies Adairs (ASX: ADH) and Nick Scali (ASX: NCK). The former has seen its share price decline by almost 45% in the past 12 months, while the latter is down less than 5%.

At face value, both companies have quite similar businesses – so why has there been such a divergence in their share price performances? It all comes down to the quality of management, explains Winchester.

“I know everyone says, ‘own and hold quality businesses’ but you can see why, when you go through a reporting season like this,” says Winchester, a portfolio manager who invests primarily in locally listed small-cap and microcap companies.

“I think NCK had a really good result given everything that circumstances threw at them during the year. But in the same situation, the Adairs result was pretty tough. They might struggle over the next couple of quarters or half years.”

Much like Tobin, Winchester says that individual stock selection, rather than playing broader themes, is critical right now – which is unsurprising given he heads up an actively managed fund. But one broader trend he mentions is mining services, while emphasising the need for caution because of what he describes as “inherently poor economics” in the sector.

“With lumpy fixed-price contracts and low margins, many companies have also struggled with input price inflation and tight labour markets. But there are a few that are a little different,” he says.
“For those that are well managed and that can control their costs and margins, I think the industry’s got some tailwinds.”

Some of these positive signals include commentary from mining services companies about a strong outlook, and the pickup in CAPEX from mining companies after a period of underinvestment that followed the bust.

“I don’t think they’ll get the same sort of returns they earned through the mining boom, which was a unique period. These are very different businesses to those we saw during the mining boom, when they were heavily leveraged, and many acted as if the good times would never end,” Winchester says.

He believes the new crop of small- and micro-cap mining companies are much better run. And while his fund doesn’t invest directly in the sector, Winchester is keeping a close watch and has some exposure.

A watch list stock and 2 holdings

Lycopodium (ASX: LYL) – A mining services company on Merewether’s watchlist, the Perth-based company has operations in multiple international regions including Asia, Africa, the Middle East and the Americas.

With a market cap of around $250 million, it reported $27 million NPAT for fiscal 2022.

“It trades on an earnings multiple of less than 10 times earnings but it’s got $100 million in cash,” Winchester says. “I think that’s an interesting spot to look.”

A couple of companies with some exposure to mining services, and which are already in his portfolio, include:

• XRF Scientific (ASX: XRF) – A manufacturer and distributor of precious metal products, specialised chemicals, and instruments for the scientific, analytical, construction material, and mining industries in Australia, Canada, and Europe.
• LaserBond Limited (ASX: LBL)– Which produces surface coatings for heavy machinery, designed to extend the wear life of drills and other components used.

Potential for a microcap M&A boost

Winchester believes that, as with most things in the market, the trend flows from large-caps through other parts of the market, pointing out M&A activity has already been quite elevated within the mid-cap segment - as shown by the deals and bids mentioned earlier.

“You’ve seen it in the larger mid-caps and I think that, over time, you’ll see people naturally shift down to the micros, assuming that share prices are still depressed. I think M&A will be a theme for microcaps,” says Winchester.

On the buy side of the deals, a few local microcaps that Tobin suggests could hit the acquisition trail in fiscal 2023 are:

• EnergyOne (ASX: EOL) – A highly cash-generative business, the energy software firm has a track record of acquisitions
• Kelly Partners (ASX: KPG) – “You’re going to see more M&A from these guys, they’re on an acquisition build of their business and I don’t see that changing any time soon,” Tobin says of the accounting firm.
• Diverger Ltd (ASX: DVR) – Also in the accounting and wealth management industry, DVR made a tilt at the financial advice business Centrepoint Alliance in late June. In a recent conversation with the DVR CEO, “he said they’re actively looking for acquisitions,” Tobin says.

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