Stockwatch: A template for more bids?

by Edmond Jackson from interactive investor |

Does the recent offer for this well-regarded IT small cap signal the start of a Brexit-related trend?

Is the recent US offer for Sanderson Group (LSE:SND) coincidental with Brexit, or cause to plan for plenty more - especially among well-established UK small caps?

Aptean, a US applications software business originating itself from 2012 mergers, aims to acquire AIM-listed Sanderson for £90.1 million by way of a 140p per share, recommended cash offer.

Ultimately this reflects private equity backing industry consolidation, given the way Aptean is controlled by two such funds, and Sanderson looks a smart fit for a US company making the equivalent of £53 million operating profit on £135 million revenue.

Why has this been agreed at such a modest premium?

The chairman's somewhat apologist line is this is "now enabling shareholders to realise the rewards for their patience, support and investment over the past few years" although according to online posts some are puzzled why this should be happening at all, given Sanderson rates e.g. 7 out of 10 on a system of corporate health, and the consensus among brokers is "strong buy".

A tipsheet has also ended up embarrassed, having met the company a month ago and made the stock its chief August recommendation, only for the deal to be agreed at 140p - barely above the 136.5p level twice reached in early July.

The offer document claims premiums around 15% relative to May-July market prices and 42% in the last year; but after several intelligent acquisitions and demand for its services, Sanderson appears to be undergoing a step-change.

Interims in mid-May showed operating profit soaring 34% to £2.9 million on revenue up 18% to £17.2 million, helped by high gross margins continuing around 80% with the cash balance jumping 136%, ahead of management's expectations.

Sanderson Group - financial summary              
year ended 30 Sep 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 13.4 13.8 16.4 19.2 21.3 21.7 32.1
IFRS3 pre-tax profit (£m) 1.5 1.9 1.9 2.0 2.8 2.7 3.2
Normalised pre-tax profit (£m) 1.7 2.0 2.2 2.4 3.0 3.8 5.2
Operating margin (%) 17.8 14.3 13.5 12.0 14.1 13.4 11.2
IFRS3 earnings/share (p) 2.8 3.9 3.1 3.4 4.4 5.2 5.2
Normalised earnings/share (p) 3.5 4.4 4.6 5.1 5.5 6.4 7.9
Cash flow/share (p) 2.0 2.5 4.5 4.5 6.6 9.9 8.8
Capex/share (p) 0.9 0.7 1.5 2.1 2.0 2.3 3.7
Dividends per share (p) 1.2 1.5 1.8 2.1 2.4 2.7 3.0
Covered by earnings (x) 2.9 2.9 2.6 2.4 2.3 2.4 2.6
Net tangible assets per share (p) -5.5 -5.2 -5.0 -7.4 -10.2 -4.5 -14.7
Source: historic Company REFS and company accounts              

Justified if the best years for IT spend are fading

The exit PE looks to be around 15 times which is modest indeed for a growth company albeit fair if cyclical.

While I've drawn attention to Sanderson various times as a "buy", from July 2016 at 73p as far back at August 2009 at 10p, more recently I've found the stock hard to update with a firm buy or sell call.

IT spending can be cyclical according not only to technology upgrade cycles but also the general economy - the kind of capital spending that can be deferred if absolutely necessary.

As confusion has festered in the last two years, over Brexit, I've been cautious about the upshot for IT given we keep hearing firms aren't investing in new plant and machinery.

Yet IT upgrades appear to have blissfully escaped this, possibly helped by digitisation which represents about a third of Sanderson's business and is enjoying double-digit growth – although interims showing the main "enterprise" software side also in rude health.

Logically, if Aptean is similarly wary then it would wait for Brexit to cause disruption, yet all-considered it's bidding now.

Realities strike, which apply more widely to UK small caps

A more cautious domestic UK view is not to push such luck with IT demand, too far, that Brexit realities could mean at least a year of more difficult trading if not a recession given the worsening global context.

I also sense a behavioural aspect I've drawn attention to since April 2015 when the stock was 64p.

While flagging "Sanderson is a long-term bid target for another IT company looking to develop capability in multi-channel retail and e-commerce... any software group lacking a weighting in this area is liable to be at strategic disadvantage" I noted how the chairman owned 21.6% of the company and in terms of eventual retirement planning I suggested he'd be amenable to a premium offer.

Obviously the 140p/share terms have the support of other directors and Sanderson's advisers, so it's not a selfish move.

Yet it's interesting to consider – in terms of takeover prospects more widely among small caps – whether there's some extent of throwing in the towel by a UK smaller company chiefly oriented to the domestic market (like many listed are); securing better prospects for the company and its employees if it's part of a global group.

Aptean plans to invest and develop Sanderson as part of its European growth strategy.

Yet the market also entertains a higher offer

Normally you'd expect such an offer to result in market price converging on it, shy of a few pence to reflect the time value of money – if you were to sell in the market versus waiting for the deal/payout to complete.

In larger more liquid stocks, takeover arbitrage specialists would scalp this margin (which adds up when repeated across a portfolio of situations) once a declared offer is made: risk/reward being attractive where there's very low chance of the offer falling through (unless due diligence uncovers trouble) versus modest chance of a higher rival offer.

Notably Sanderson has already converged on the offer price with a few smaller buys already, just over 140p.

You could say the "time value of money" is immaterial under such low interest rates; but looking through the offer document, three institutions owning 17% of the company have taken care with their "irrevocable" commitments.

While Sanderson directors, senior managers and their relatives – owning 22.3% of the share capital – appear to have accepted the offer on a "hard" irrevocable basis (i.e. binding in all circumstances) the institutions – respecting their clients' best interests – are in "semi-hard" mode.

Point 17 in the 1 August RNS cites Unicorn Asset management (with 3.7%) declaring a 155p threshold for a higher offer; Downing LLP (4.3%) at 150p; and Gresham House (8.9%) at 154p.

It suggests they have done their sums to conclude that if acting as responsible stewards of capital, fair value of 150p to 155p is also worth holding out for. This also reflects the market working efficiently in the balance of interests: informing advisers to a potential rival offeror, how high they need go.

Aptean (implicitly its private equity backers also) would then need to trump this. It's likely they've war-gamed such a scenario i.e. 140p is effectively the opening bid and if they are lucky to get away with it, then it's been a fine tactic. Proof of Sanderson's current market value depends on flushing out any rival.

Sanderson has history in this respect

As a long-term follower since the mid-1990's I recall a late-1999 buyout led by the current chairman and financed by venture capital firm Alchemy; the chairman subsequently buying Alchemy's stake then to own just shy of 30%.

Sanderson was subsequently re-floated in 2004. There was quite similar concern at the company being taken off-market at modest price when profit had halved albeit somewhat due to timing differences of orders.

I reference this occasion not to imply something underhand about the current offer but possibly – from a "behavioural finance" view – the chairman is aware, good times don't necessarily last.

From the outside we can't tell, but Aptean's offer may have been the only one appearing that also secures decent prospects for Sanderson to thrive in a post-Brexit environment.

What realistic chance of a higher offer?

I wouldn't entertain high hopes, this being the relatively smaller end of the software industry: i.e. harder for a small-scale offeror (rival to Aptean) to make a sudden radical move.

But we also don't know what American business may be thinking, and it will underline the value of listed UK plc if another offer does materialise say at 155p. For this reason alone the situation is worth watching.

Point 16 in the offer RNS says any dividend Sanderson may declare before the takeover completes, will be respected (although the 1.5p interim payout was to holders up to 5 July).

I mention this as a potential albeit low-chance sweetener for considering a takeover arbitrage "buy" of the stock currently around 140p – the downside being transaction costs, the upside potentially 10% or better if rivalry breaks out.

For traders who understand this kind of special situation: Buy.

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

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