Stockwatch: A takeover with Brexit in mind

The takeover offer for this recruitment firm is shrewd given Brexit uncertainty. Companies analyst Edmond Jackson considers the shareholder response.

Does a £98.7 million offer for AIM-listed recruitment group Harvey Nash Group – at a price earnings multiple of 14 times - offer fair value ahead of alleged Brexit chaos, or is it an opportunistic grab of the likes we will see more?

Harvey Nash is a quite unique, full-service global technology recruitment and outsourcing group with a strong client base. It's also undergone a major transformation in the last two years to reposition, streamline and raise margins.

Now DBAY Advisors, an Isle of Man-based value investment group senses an opportunity for control and has previous form. It snapped up Creston marketing agencies for £75.6 million in late 2016, after I’d drawn attention to a quite similar repositioning to capitalise on growth opportunities in digital spend.  

A shrewd move amid Project Fear 2

I flagged Harvey Nash's value at 102p last May, when it was on 8.9 times latest core EPS reducing to 7.4 for the current year and with a 4.4% prospective yield. There was also its takeover potential given DBAY's 26.1% stake and scope as a bolt-on for a larger recruiter, as well as the stock’s modest rating and the group being at an inflection point operationally.

DBAY will have got to know its target well since buying low from early 2017, now pitching a 130p a share cash offer (also to include a 1.75p interim dividend) which requires 75% approval among other shareholders. That's a pretty high hurdle but coinciding with Project Fear 2 over Brexit, the offer has great timing. 

Times of higher financial risk mean investors are prone to de-risk, as liquidity rises in importance. What that means e.g. for small cap oriented investment funds is raising cash now lest it gets trickier - and only at much lower stock prices - if fund-holders want redemptions once the jitters strike.

So I appreciate where Harvey Nash's independent directors, backed by adviser Rothschild, are coming from when they say:

"Whilst the company now is better placed to react to any changes to market conditions, there remain significant political and economic uncertainties in the medium and longer-term which may impact future performance."

Yet the business is at a medium-term inflection point

It's necessary to weigh macro risks versus a known factor: that Harvey Nash is now well-positioned to capitalise on IT trends and has kept increasing its dividend (see table) despite an otherwise rather flat financial profile, on a low circa 1% operating margin.

Meaningful revenue growth was achieved from 2016, however, and last year's margin drop (tables basing on IFRS) involved investment/restructuring actions the directors have previously said will reap benefits.

But it's all meant quite a volatile/sideways trading range for a small cap, e.g. between 53p and 131p (hit recently, before the takeover bid) that will have tested shareholders’ patience.

It also means those recommending the bid can say it’s at a decent premium to recent prices, although given a rollercoaster it's no proof of fair value.

Even in the 2009 recession, when I first drew attention, that September the stock was 36p and the business has roughly doubled in size since its 2008/09 financial year. Accounts to 31 January 2010 showed pre-tax profit down from £6.9 million to £1.3 million on revenues down from £420.1 million to £376.2 million.

That was "trough earnings" but the group promptly recovered and its 2016 share price slump to 53p can be seen as little more than Project Fear 1 surrounding Brexit. While the table shows a 37% drop in 2018 headline pre-tax profit, this related e.g. to office closures, with net cash flow down from £15.1 million to £0.5 million due to higher working capital as trading increased. About £4.5 million was spent on “transformation” and £8 million on acquisitions.

Four out of 10 firms globally are raising investment in digital

The idea that Harvey Nash is a vulnerable cyclical – as the independent directors and Rothschild imply – relates significantly to 80% of gross profit deriving from serving technology/digital markets; these I readily admit are exposed to firms' discretionary spending on tech.

Yet at end-April, Harvey Nash management proclaimed four out of 10 firms are raising investment in digital, with skills shortages also driving up demand. It added that its "one-stop shop" approach to tech recruitment across client needs is supportive through the business cycle.

The chief executive declared "a transformational year" with "buoyant demand for technology skills, and a combination of organic and acquisitive growth – together with a renewed strategy and transformed cost base."

Then in June a Harvey Nash/KPMG survey proclaimed: "Boards ramp up investment in data privacy and security" with 23% more respondents than in 2017. "Protecting the business from a cyber attack has jumped further up the boardroom agenda than any other item." Presumably that includes the relatively modest risk of economic disruption from the localised issue of Brexit. 

Source: Company REFS              Past performance is not a guide to future performance

"Strong trading momentum, confident of significant progress"

I suggested in May: "Harvey Nash's modest rating makes it a useful bolt-on for a larger staffing group to achieve capital growth... it's wide open to takeover, institutions that have held through volatility may quite easily accept say a 150p a share offer."

Thus DBAY's shrewd gambit where - if shareholders accept - they get exceptional long-term value for controlling ownership at 130p, or this flushes out a trade buyer at a higher price.

My conclusion is thus perverse: shareholders should reject the offer; and yet the stock continues to rate "Buy" despite the risk of a short-term drop if the bid fails; because realistically I think a 75% majority will indeed roll over and accept, this being a small stock in most people's portfolios and fund managers will welcome the option to raise liquidity.

The stock has stabilised around 132p reflecting consensus the deal will go ahead without a higher offer. Yet one from the industry would have wider implications e.g. for smaller recruiters as targets, and if from abroad then a reminder how UK plc is getting cheaper for overseas buyers as sterling drifts.

In what I believe the less likely scenario of the offer not gaining enough acceptances, holders can be confident about intrinsic value should market price drop.

DBAY's tactic is shrewd: either it gets full ownership/control of a business with great medium-term potential, at a bargain price, or it flushes out a higher offer to roughly double its return since it began accumulating in February 2017.

Existing holders may prefer just sit to this out but those who understand takeover arbitrage will see why I still incline to rate Harvey Nash: Accumulate.

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