Why this small-cap healthcare stock could be a takeover target

Investing in companies that later become takeover targets is a particularly lucrative strategy. Think OZ Minerals (ASX: OZL), which saw its share price soar on the back of an offer from BHP (ASX: BHP). Or Liontown Resources (ASX: LTR), which recently skyrocketed nearly 70% after an offer from Albemarle (NYSE: ALB). 

However, having the foresight to identify such companies is far from easy. 

According to PWC, there were 1,699 deals locally in 2022 (down from 2,118 in 2021). Of these deals where values were publicly disclosed, almost $120 billion changed hands (down from around $300 billion in 2021).

That said, Pitcher Partners recently found that 56% of dealmakers believe M&A could rebound in 2023 (after values and deal volumes fell in 2022 by 52% and 5% respectively). 

And while there are a variety of headwinds facing markets - including higher inflation, higher rates, and weakening economic activity - Eiger Capital's Stephen Wood believes we are far closer to a rebound in small caps than many would think.

In this environment, Wood believes defensive businesses are likely ripe for takeover activity. And there's one heavily sold-off healthcare stock, in particular, that has caught his attention. 

In this interview, Wood also outlines where he believes we are in the small-cap cycle after years of underperformance, as well as how investors can identify quality companies in this environment. 

Note: This interview was recorded on Thursday 25th May 2023. You can watch the video or read an edited transcript below. 

Edited Transcript 

LW: Where are we in the small-cap cycle? 

We hit 2022 and what happens? Inflation turns up, interest rates do a massive U-turn and lo and behold, small caps which are more exposed generally, but not definitely to economic activity have started underperforming, hence that underperformance over five years. But the bulk of it has been shorter and sharper and has happened in the last 18 months. 

The minute we think we hit the end of that interest rate rising cycle, which feels like it's sooner rather than further away, we think at that point, small caps will start to recover their underperformance.

LW: Do we need a recession for a recovery in small caps? 

But just because we get an earnings recession, if we start getting interest rates being cut, what might actually happen is the actual stock prices might bottom. Because you'll have a period where the earnings flush out, cost bases get reset, but the market will anticipate that the recession will last one quarter or two quarters and then things will start to recover. 

It feels like this telegraphed recession has been the most telegraphed thing of all time, but it definitely feels to us that the pressure on earnings just continues to slowly but surely build. Trying to put a timeline on it is difficult, but we think it's coming. Whether the bottom is the August reporting season, probably feels a bit soon. If I was to take a stab at it right now, I would say February, somewhere in the middle of it.

LW: How are you identifying quality companies in this environment? 

The other one that in our suite of commandments people often find amusing is we are just very, very wary of companies that overindulge in paying consultants, where they've hired former investment bankers as their senior executives. And as a rule, it takes a lot to convince us to buy stock off private equity when it either IPOs or when they're doing consequence sell downs, so there are just a couple of things that we follow.

LW: We've witnessed a lot of M&A activity recently. Which company do you believe could be a takeover target? 

Stephen Wood: One that we think is probably in a slot, and funnily enough, having just talked about private equity, they are also often the purchasers of businesses and we've seen Nitro Software, for example, was one that recently got taken out by private equity. A company we think looks ripe for this sort of activity would be Integral Diagnostics (ASX: IDX). It is one of Australia's largest groups of imaging - MRIs, CAT scans, PET scanners, x-rays, that sort of thing. They've got a large network around the country. It's been a very, very poor performer over the last couple of years. COVID has seen elective surgeries be deferred. Surgeries are constantly being scheduled and then cancelled. Consequently, that volume of elective and essential surgeries has hammered their volumes through their radiology practises.

But radiology is a very stable business. It's recently got some price rises in the latest budget that the government have put through. It would appear to be off its knees. Volumes are returning, but the share price is way down from where it was a couple of years ago. But if we're going to run into tough economic times, this is a business that is as immune as it gets. It's really struggled. The share price is up a little bit from the bottom, but not a lot. It's very defensive and it's the sort of business someone could buy and probably out of the restrictions of public markets, it can carry a lot of debt, which is normally something that private vendors like. They can gear these things up and that's a good way of extracting capital, so that's probably an M&A target we think is out there.

Digging deeper to find the best opportunities

Eiger Capital is an active boutique Australian equities investment manager specialising in small companies. For further information, please visit their website or fund profile below.

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Eiger Australian Small Companies Fund

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