Predators. Moreover, it looks like a good time to acquire them with interest rates expected to peak in the second quarter of 2023.
Savvy offshore predators, and a few local ones, no doubt have run their ruler over beaten-up small- and mid-cap Australian stocks. As the market worries about a wave of earning downgrades next year, predators will look further ahead.
Doing deals can be contagious. I recall a chairman of one of Australia’s largest companies telling me how some CEOs cannot resist making acquisitions. When they see a rival buy a business, they feel they must do the same. They get itchy feet watching others snap up assets.
2023 might not the year of takeovers that some investment bankers predict. It seems every year will be a boom year for M&A if some hype merchants are to be believed.
But there’s a good chance more small caps will be acquired next year, largely because they currently trade at undemanding valuations. Here are two to watch:
1. Kelsian Group (KLS)
I’ve written positively on the bus and ferry group several times since it listed on ASX in 2013 (it was known as SeaLink Travel Group back then). SeaLink was one of those cracking small-cap stocks that often go under the radar as a listed company.
In January 2020, Kelsian tripled in size after it acquired Transit Bus Systems. The deal made Kelsian Australia’s largest operator of private metropolitan bus services, gave it a footprint in London and Singapore, and diversified the business.
For a time, the market could not get enough of Kelsian. Its share price almost quadrupled over 18 months to $10.41 in April 2021. Fund managers liked the defensive, recurring nature of Kelsian’s bus business and its government contracts.
But Kelsian has fallen to $5.38 this year. The market was spooked when Kelsian missed out on a few bus-contract tenders. Kelsian needs to have a few upcoming tender wins and restore market confidence. If it doesn’t, its price could fall.
Longer term, Kelsian is a well-run business with excellent assets. Privately run buses are an attractive industry as urban populations grow and more people use public transport. Electric-powered buses have an important role in the urban response to climate change, particularly among commuters who cannot afford electric vehicles.
At $5.38, Kelsian is on a forward PE multiple of 18, consensus estimates show. That is undemanding for a company of its quality. An average price target of $7.44, based on the consensus of nine analysts, suggests Kelsian is undervalued.
I’m not as bullish as the consensus, given Kelsian’s contract-tender risks. But the stock looks undervalued and a good fit for a global private-equity firm – or a super fund – that can see the value in a company that provides excellent exposure to transport.
Chart 1: Kelsian Group
Source: Google Finance
2. Lynch Group Holdings (LGL)
Australia’s largest flower company became ASX’s first floriculture company after its 2021 Initial Public Offering (IPO) that raised $206 million.
Lynch is a fascinating company. The third-generation family company is more than 100 years old. It grows hundreds of millions of flowers at its seven farms in Australia and China and sources flowers from other farms.
Many of these flowers are sold at supermarkets and Lynch does a lot of work “value adding” by putting flowers in pretty ceramic pots, for example (at higher prices). That makes Lynch an agricultural, manufacturing and logistics business.
Two aspects of Lynch stand out. The first is its potential to disrupt our fragmented $1.37-billion flower market. Australia is following international trends where more flowers are sold each year at supermarkets rather than florists. You might have noticed Woolies and Coles selling more flowers and floral arrangements these days.
Lynch’s other big growth avenue is China. Lynch used a chunk of the IPO proceeds to acquire the 80% of VDB Asia it did not own (VDB is a premium rose grower in China with two farms there).
Lynch believes the boom in middle-class consumption in China will boost demand for flowers. Although flowers are an important part of Chinese culture, the floriculture market in Asia is at an early stage compared to developed markets.
For all its long-term potential, Lynch has had a tough time as a listed company. The company had to revise its IPO capital raising from $315 million to $206 million as the market baulked on its valuation. From a $3.60 offer price, Lynch has fallen to $1.73.
Lynch has battled headwinds. The COVID-19 pandemic weighed on the company’s flower supply and profit margins. Freight costs rose and labour shortages emerged, requiring more overtime to be paid.
Geopolitical tensions between China and Australia also hurt sentiment towards Lynch, which made a big bet on China’s flower market. As other Australian industries were rocked by tariffs, investors retreated from Lynch.
Size, liquidity and market profile were other challenges. As with many small-cap IPOs, investors lost interest when Lynch’s share price fell and liquidity was low. In a bear market, investors had little interest in newly listed small caps, such as Lynch.
That’s the bad news. In July, newspapers speculated that Lynch Group was on the takeover target list for private-equity firms. Lynch originally came to market from private-equity ownership, so a bid from a new PE owner made sense.
The speculation saw Lynch rally from $2 to $2.50 but the stock has since given up those gains and more, and takeover speculation has died down (at least in the media).
It’s hard to reconcile fully the extent of Lynch’s recent share-price price falls with its Annual General Meeting presentation on November 25. Lynch reported 11% revenue growth in FY22, but an 18% fall in underlying earnings (EBITDA).
The earnings were thumped by supply-chain disruptions due to COVID-19 and labour shortages. They seem more like short-term problems rather than long-term structural threats for Lynch. Its China business grew revenue and earnings.
Lynch said revenue growth (year-to-date to November FY22) was 4% up on the prior year. That’s slowing, but consumer demand for cut floral products at supermarkets remains strong, says Lynch. The company is in the process of remedying several COVID-19-related operational issues.
Lynch looks like a business that would be better off under private ownership again, away from a disinterested public market.
Lynch has much potential to grow in Asia, but turning around an underperforming small-cap stock in this market is hard work. Lynch doesn’t have sufficient liquidity to attract more institutions or enough of a market profile to attract retail investors.
That’s a shame. The international experience shows floriculture can be a great business and the middle-class consumption boom in Asia will be terrific for flower demand. It just might take new ownership to unlock Lynch’s true value.
Chart 2: Lynch Group Holdings
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at November 30, 2022.
