Interactive Investor

Stockwatch: why this takeover deal isn’t ideal for shareholders

2nd November 2021 12:38

Edmond Jackson from interactive investor

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The takeover of this niche development company shows the merit of value investing, but our companies analyst warns its timing could be premature for shareholders.

After my wariness of Microsoft (NASDAQ:MSFT) on 40x trailing earnings and with no margin of safety, it is worth exemplifying how conservative value principles can provide a more satisfactory risk/reward profile. 

Last July, I drew attention to urban regeneration specialist U and I Group (LSE:UAI) at 92p, trading at a discount to net asset value. There were triggers to unlock this, in the shape of a capable new CEO from January 2021 and the emergence of regeneration as a national priority to help re-boot the UK economy after lockdowns. Moreover, the Tories are under pressure to deliver on levelling-up promises. 

U&I is one of only a small number of companies with the capability to deliver on mixed-use urban environments where people can live, work and socialise. 

Far from level playing field enables takeovers 

Land Securities (LSE:LAND) has agreed a 149p per share cash offer for U&I, which in negotiations has gained the support of 32% of shareholders. These, however, are known active investors such as Jupiter, JO Hambro and the hedge fund Ennismore – which do not pay capital gains tax.  

The situation is an example of how private investors can find themselves at some disadvantage, given they have to pay capital gains tax when forced to sell out and move on (unless they hold equity in a tax-free wrapper).

Tax advantages for institutions, which nowadays own the vast bulk of equity, help to drive the takeover culture. As with Morrisons just lately, we are left wondering why management can no longer do the job it presented so glowingly a few months before. 

More positively, the U&I takeover shows how the manic-depressive stock market can offer undervaluation beside overvaluation. 

There is also the ‘agency dilemma’, where company directors are not substantial shareholders and are therefore prone to recommend what makes sense to them managerially. Merchant bank advice then seals the deal as fair terms for shareholders” though it is paid for by corporate interests. 

Sum-of-parts calculations suggest underlying value 

U&Is annual results to 31 March cited a £95 million investment portfolio yielding 8.5%, also £126 million non-core, development and trading assets and £58 million core regeneration assets. Subtracting £150 million net debt - including lease liabilities - relative to 124.8 million shares issued, indicated 125p a share underlying value. 

Landsec looks superficially to be paying a near 20% premium for control – and probably more, after a governmental decision reversed prior permission for U&I to regenerate the old London Fire Brigade HQ. That was set to knock £11 million off its net asset value (NAV), given that prior work had been capitalised. 

U&Is CEO asserted: We are on target to generate £130 million proceeds by the March 2022 financial year,” which should have helped substantially cut its debt, leaving an investment portfolio of 15 assets with an overall rental yield of around 8.5%. 

Four regeneration schemes were estimated to have a total development value above £5 billion and profits potential of more than £1 billion over the next decade. Dilution would be involved, as U&I would have had to partner to raise necessary finance, but if the group had stayed independent then shareholders could potentially have exacted greater returns over the long run. 

This type of valuation dynamics is a rare occurrence, but in oil & gas there was a near 10x return in the early 2000s from Dana Petroleum, which the market disliked. The stock traded around asset value for its producing interests, with high-impact exploration in for free”.  

As part-justification for the deal, U&I now says: disposals are not without risk… the board recognises a wide range of total net sale proceeds outcomes…” Yet there is always uncertainty.  

Did management find it harder than anticipated to proceed independently? We cannot tell, because the interim results to 30 September are not yet released – if they will be at all.  

Might they show worse-than-targeted progress with disposals and finding financial partners, to the extent that capitulating indeed makes sense in order to crystallise cash value?  

Minority private shareholders have to bite their lips and bow to a company board, merchant bank and non-taxpaying institutions as knowing best”.  

Landsec hardly a convincing re-investment 

The U&I directors consider Landsec a highly credible partner for these projects, given its financial strength and long-term track record of delivering complex projects,” read yesterday’s announcement.  

I cannot agree on the former credential. Landsecs 31 March balance sheet showed no cash at all versus £1,345 million a year before. Note 23 of the last annual report said: As a result of the uncertainty created by Covid-19, the group drew down on its facilities in March 2020 in order to cover the short-term commercial paper in issue at 31 March 2020 and to provide additional liquid funds. These facilities have been repaid during the year ended 31 March 2021.” 

It is unclear quite what Landsecs cash balance is now, which U&I could benefit from. It would seem more likely debt finance where there is £3.5 billion debt in context of £7.2 million net assets. Both companies have their first-half-year ending 30 September, so results are due. 

Landsec is a £5.1 billion company paying £186 million for U&I – so even if it manages to leverage twice that value over time through synergies from integrating the regeneration projects, switching from U&I into Landsec offers nowhere near the same upside potential for shareholders. 

Recalling the Dana Petroleum comparison, it is not dissimilar to accepting an early offer from Shell or BP at the turning point for development.  

U&I Group - financial summary
Year-end 31 Mar

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 242 124 174 160 70.0 45.8
Operating margin (%)             11.9 0.9 18.9 -4.0 -63.3 -140
Operating profit (£m) 28.8 1.1 32.9 -6.4 -44.3 -64.2
Net profit (£m) 21.8 -3.0 40.3 5.2 -55.4 -87.5
EPS - reported (p) 17.5 -2.4 31.4 4.2 -44.5 -70.2
EPS - normalised (p) 17.5 -1.3 31.4 6.5 -33.0 -52.9
Operating cashflow/share (p) -5.0 36.2 -7.5 13.5 2.5 33.7
Capital expenditure/share (p) 4.4 0.5 0.6 1.0 0.6 0.3
Free cashflow/share (p) -9.4 35.7 -8.1 12.5 1.9 33.4
Dividends per share (p) 10.4 9.4 20.7 10.0 2.4 0.0
Covered by earnings (x) 1.7 -0.3 1.5 0.4 -18.5 0.0
Return on capital (%) 5.5 0.2 6.7 -1.3 -9.2 -17.2
Cash (£m) 43.8 23.8 40.6 54.5 31.7 40.5
Net debt (£m) 170 148 131 125 172 135
Net assets (£m) 363 348 379 360 290 203
Net assets per share (p) 291 278 303 289 232 163

Source: historic Company REFS and company accounts.

Beware references to the good of all stakeholders” 

The U&I board say they see this partnership as providing an opportunity to accelerate the core regeneration plan for the benefit of all U&I stakeholders.”  

There you have it: stakeholder capitalism. Wherever you see this term, it means shareholder interests are down the list compared to managers, operating partners and the like. 

This may help to explain the dichotomy of modern markets, where capital gets focused on stocks in vogue, while those with a so-so record fall to discount ratings. A 1980s revival of capitalism gave shareholders in the latter more control, but equity may still be playing second or third fiddle to other interests.

A few such firms ultimately get taken over if someone else can unlock value. In this case, Landsec sees attraction in U&Is pipeline of mixed-use development schemes. One in Manchester and another in South East London are well-progressed through planning and Landsec can allegedly accelerate the pace of development. 

Wage rises in the aftermath of Covid are shifting power to workers – potentially akin to the 1970s – and a UK Conservative government has parked its tanks on Labour turf. Expect to hear plenty more about stakeholders. 

Selling out at relative low on U&Is chart 

149p a share compares with a median price of 175p in recent years, with highs of 240p in 2018 and 270p in 2015 – having fallen from 625p in 2007.  

In fairness, the historic chart is somewhat compromised by declines in the value of retail property as digital consumer sales have soared. Yet I cannot escape a sense that this bid is well-timed, offering an apparent premium” to capitalise on U&Is value and potential. 

If you have other potential investments in mind: Sell. 

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

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