Why our small caps team likes IPH

IPH Limited (ASX:IPH) is the leading intellectual property services group in the Asia Pacific region and its shares had fallen as much as 15 per cent from their 2020 highs, for no apparent reason, at which point Gary and Dominic from the Montgomery Small Companies Fund added it to the portfolio on the back of its defensive growth characteristics, strong balance sheet and monumental cash generation. The shares have subsequently rallied from $7.16 to $8.80 prior to today’s results announcement.

We’ll come to the result in a moment because they were overshadowed by the announcement of a long-awaited acquisition.

Growing offshore earnings

For some time the market has known the company’s growth plans lay offshore. Having pioneered the listed patent-business model, and after acquiring its way to dominance in Australia, the market correctly viewed Australia as mature.

And even with Asia growing – I will never forget my visit to the cash generating machine I witnessed first-hand in Singapore – the market was anticipating another jurisdiction would be added to turn the company into a growth story again.

IPH had signalled an overseas acquisition could be in China but eventually it was concluded such a move would be challenged. The market subsequently believed an acquisition would be made in South America or Canada, both of which are major secondary filing jurisdictions.

Pleasingly, today’s announcement of the leading player in Canada sets the company up to repeat its Australian model of owning the dominant player, bolting on the smaller players, playing the private-to-listed multiple arbitrage and extracting the resultant synergies. The model is successful partly because it provides an exit or liquidity opportunity for the owners of many smaller, century-old, multigenerational firms. Synergies largely arise from digitising operating processes which significantly increases productivity.

And keep in mind IPH will be the first listed IP player in the Canadian market.

IPH will pay 10x EV/EBITDA for Canada’s version of the company, called Smart & Biggar. With a 16 per cent market share S&B is Canada’s number one operator and at a price of A$387 million the company does not need to raise capital. Debt, cash and scrip will fund the acquisition.

Specifically, the transaction will complete in September 2022. The acquisition will be funded by an upfront cash payment of CAD$241 million, as well as the issue of 5.3 million IPH shares initially (with value of CAD$41 million and escrowed for two years). A deferred issue of new shares with a value of up to CAD$66 million will represent the earn-out consideration. IPH’s pro-forma leverage ratio will move to 1.8 times and the company’s total drawn debt will sit at A$390 million.

According to the company, the acquisition will be EPS accretive in its first year to the tune of 10 per cent, which helps the market gain comfort there is no ‘valley of the shadow of death’ before shareholders begin seeing returns. This accretion is before CAD$4-6 million of synergies expected to be realised over the first three years of ownership.

Turning to the results

IPH slightly beat consensus expectations at the important net profit after tax (NPAT) level and reported strong cash generation and excellent growth in Asia. Australia’s result was understandably reflective of its maturity here.

The company’s Underlying FY22 EBITDA was $137.4 million, and marginally ahead of market expectations. Underlying FY22 NPAT of $86.7 million was also marginally ahead. If we remove the effect of an A$800,000 net EBITDA contribution from new businesses and a A$10.4 million benefit from currency movements and revaluations, the underlying like-for-like organic EBITDA increased by two per cent like-for-like.

Australian and New Zealand’s revenue was down one per cent and EBITDA was up one per cent (remember; mature business). The company also arguably lost a little market share in terms of market filings. This reflected short-term disruption from integration and reducing filings from Australia’s largest filer.

In Asia, both revenue and organic constant currency EBITDA were up 10 per cent.

The results proved the small caps team’s thesis of defensive growth characteristics by producing a resilient result despite macroeconomic challenges.

We conclude by reminding investors of the possibility the acquisition of Canada’s leading market operator, and a highly respected one, transforms sentiment towards this company into attractive defensive grower with now a much longer runway for that growth.