Interactive Investor

Stockwatch: how UK’s mini-budget could trigger wave of takeovers

27th September 2022 11:44

Edmond Jackson from interactive investor

The chancellor and prime minister are under real pressure just days after an emergency budget. Shares analyst Edmond Jackson believes there may be unintended consequences for UK Plc.

The week has started with an example likely to develop into a trend. 

Sweden’s Hedin Mobility Group, one of Europe’s largest privately owned auto dealerships and a 26% shareholder in Pendragon (LSE:PDG), has approached the UK firm’s board with a possible cash offer at 29p a share. Hedin has until 24 October, to make a firm offer or walk away. 

This compares with Pendragon’s pre-approach price of 23p, around which the small-cap stock has traded for most of 2022. The long-term chart has been frustratingly sideways since the 2008 crisis, hence the shareholder base – where two hedge funds already own around 20% - may be foot-loose to sell. 

Auto dealers are prime for buy-outs and consolidation  

The presence of special situation-type investors reflects the vulnerability of auto dealers to takeovers. Schroder Investment Management, dominated by the contrarian-value style of Andy Brough, its leading UK fund manager, also owns almost 12% of Pendragon.

Marshall Motor Group was acquired last November at 400p a share by Constellation, “the largest vertically integrated digital car marketplace in Europe”, which also bought a 20% stake in Lookers (LSE:LOOK) last January.  

I had drawn attention to Marshall and Vertu Motors (LSE:VTU) in August 2021as constituting attractive risk/reward, at 247p and 47p respectively, given serial upgrades to projections. The auto market was benefiting from a shortage of microchips during the pandemic, which limited supply of new vehicles and re-rated prices of used, with a net financial benefit to dealerships. 

Covid also accelerated dealerships to move online as buyers avoided showrooms, which offers acquirers the chance to integrate sales into their own digital capability – hence economies of scale.  

Yet as recession beckons, the story on prospects may change, making shareholders amenable to takeover offers.  

While Vertu reached 75p last January, it has since traded volatile-downwards and currently sits at around 43p – its July 2021 level. 

This compares with Vertu’s net asset value of 95p a share, or 65p on a net tangible basis. For investors who recognise risks of buying cyclicals at the early stage of recession, I would therefore double-down on a “buy” stance for Vertu, given the sector’s consolidation trend may outweigh economic risk. 

Vertu Motors - financial summary
Year-end 28 Feb

 201720182019202020212022
Turnover (£ million)2,8232,7962,9823,0652,5483,615
Operating margin (%)1.11.21.00.51.22.4
Operating profit (£m)32.132.329.016.531.685.7
Net profit (£m)24.024.720.53.016.360.0
Reported EPS (p)6.06.25.40.84.416.0
Normalised EPS (p)6.05.64.44.64.315.2
Earnings per share growth (%)2.1-7.3-22.46.4-6.1250
Return on capital (%)11.911.28.54.07.217.6
Operating cashflow/share (p)12.64.813.35.220.018.4
Capex/share (p)7.56.28.94.24.04.4
Free cashflow/share (p)5.1-1.44.41.016.014.0
Dividend per share (p)1.41.51.60.60.01.7
Covered by earnings (x)4.34.13.41.30.09.4
Cash (£m)39.841.766.540.867.883.8
Net debt (£m)-21.0-19.30.312595.672.7
Net assets (£m)246264277263276332
Net assets/share (p)62.368.973.871.776.393.4

Source: historic company REFS and company accounts

Hedin’s approach is enhanced by sterling’s weakness  

Admittedly, sterling is weaker against the US dollar, whereas in euro terms it is essentially back to early 2021 levels. 

That manifestly empowers US bidders for UK plc and plenty such approaches will happen, irrespective of how deep the recession is. 

But I think it will help Hedin to raise any offer terms in due course, as negotiations get underway with Pendragon’s key institutional owners. 

A 29p a share bid would value Pendragon at £405 million relative to consensus for near £4 billion sales in 2023, albeit on a slim margin around 3%.  

Contrasting with Vertu’s strength of asset base relative to share price, Pendragon’s end-June net asset value was £272 million or 19.4p a share - albeit 58% of which constituted intangibles. 

While financial debt involved £92 million long-term and £2 million short-term, there were also £203 million long-term lease liabilities and £21 million short-term.  

It is therefore possible to regard Pendragon as 117% geared, where interim net finance costs took nearly 40% of operating profit. 

Pendragon - financial summary
Year end 31 Dec

 2015201620172018201920202021
Turnover (£ million)4,4544,5374,3244,1494,0842,7673,421
Operating margin (%)2.72.21.8-0.7-2.80.53.3
Operating profit (£m)12210077.9-27.3-11512.5113
Net profit (£m)72.955.553.3-50.5-117-24.761.5
Reported EPS (p)5.03.83.3-4.1-10.7-1.64.6
Normalised EPS (p)5.24.03.02.7-1.40.75.1
Earnings per share growth (%)51.8-24.1-23.5-14.3  610
Return on total capital (%)16.213.310.0-3.7-15.41.818.4
Operating cashflow/share (p)5.14.16.53.71.52.14.5
Capex/share (p)9.410.113.59.58.34.31.3
Free cashflow/share (p)-4.3-6.0-7.0-5.8-6.84.3-2.2
Dividend per share (p)1.31.51.61.50.00.00.0
Covered by earnings (x)3.82.62.2-2.7   
Cash (£m)13984.053.351.455.756.037.6
Net debt (£m)79.691.7124128381344272
Net assets (£m)395373425346169127226

Pendragon is therefore not a “distressed” financial situation but is exposed to recession should operational gearing compromise an already slim margin.  

In fairness, last Wednesday’s interim results showed the like-for-like operating margin up from 2.6% to 2.9% - enabling £26.4 million interim net profit of £26.4 million, 7% easier like-for-like, on revenue up 2% to £1,846 million.  

Management has been able to counter inflationary pressure with operational improvements, although there may be a limit to such. 

Looking odds-on for a deal to consummate 

Pendragon cited the proposal as “preliminary and highly conditional” and the stock rising from 23p to 27p is a fair compromise as to event risk.   

Yet Hedin is dug-in, effectively needing to tidy this matter up. 

It accumulated 26% of Pendragon’s equity a year ago, then (despite no Regulatory News Service (RNS) announcement) reportedly made a 28p a share offer in early 2022. This was rejected by Pendragon’s board, yet Hedin’s resolve was shown by increasing its stake to 27% last May. 

It then blocked a 29p a share offer from Lithia Motors (NYSE:LAD), a US-listed dealership valued near £7 billion equivalent. While four of Pendragon’s largest shareholders engaged on the offer, Hedin refused and so Lithia backed off.  

This does however show fund managers are willing to engage at 29p, and UK economic prospects have significantly worsened since this bid story broke (despite no RNS) last August. 

Hedin probably recognises it is prime time to seal a deal now that investors are cutting exposure to cyclical stocks as the UK outlook deteriorates. Fund managers need bids to exit less-liquid small-caps.  

Another factor is Pendragon’s long-time former CEO being a non-executive director of Hedin, hence able to advise Hedin on a capable integration. Since he only resigned in late 2018 after 30 years with the group, his insight may be as good as any due diligence.  

I therefore expect a deal will get negotiated, subject to due diligence, although it is questionable whether the stock’s risk/reward profile has shifted firmly to “buy”. 

This is not a takeover arbitrage situation, between market price and agreed terms, hence: Hold. 

Further takeover activity among indebted companies 

Last Friday’s mini-budget has put the Treasury in a tug-of-war with the Bank of England, as tax cuts and other stimulus raise inflationary risks, which the central bank is already late in tackling. 

Liz Truss pitches herself as Margaret Thatcher 2.0 but it was not until Nigel Lawson’s 1988 budget that tax cuts were made. The early years of the Thatcher administration prioritised curbing inflation and trade union power. Yes, I favour tax cuts at the right time, but it is not now.  

This new government appears to be hoping to call an election on the back of “feel good” sentiment in a year or two, but as classic ideologues they fail to empathise beyond their natural support base.  

We already face quite a financial crisis, not primarily due to weak sterling but the costs of UK public debt now being priced in excess of Italy and Greece. Markets have sensed the chancellor’s naivety. 

It exposes indebted UK listed companies to greater risks of a downturn yet raises the odds of takeover approaches – especially from the US, as sterling trades around par with the dollar. 

So, while for investment purposes you would normally favour strong UK companies with little to no debt – to hold through a recession – on a speculative view we may see relatively more bid activity where shareholder sentiment is “get me out of here”. 

This latest approach for Pendragon, while only in small-cap terrain, therefore has wider relevance to the equity landscape. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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