That’s a Downer for markets...
Downer bids for Spotless
The largest equity capital raising in Australia for 2017 so far was announced - the $1.01 billion underwritten entitlement offer by Downer EDI Limited to fund its $1.26 billion (or $1.15 per share) bid for Spotless Group. This is the largest takeover offer in Australia for some time.
We see this as being a fascinating transaction.
Spotless: from a dry-cleaner to...
Spotless was founded originally in Fitzroy, Melbourne in 1946. It grew into a huge ASX listed services firm employing over 36,000 people. It did/does runs everything from airline lounges, sporting venues, dry cleaning, and army barracks to city offices.
It was acquired by the private equity firm PEP for $720m in 2012. In May 2014 it was refloated on the ASX for $1.60 per share, or $1.75 billion in an initial public offer (IPO). A slightly greater than 2 year holding period resulted in a more than a 140% capital profit for PEP.
In that time PEP streamlined and repositioned the business (selling its international businesses), and increased the company's profitability.
Since then, however, the business has struggled with EBIT (earnings before interest and tax) expected to hit $140m for FY-17 (from $238m in FY-15 the post IPO year and $227m the prior year). It would appear that some of the gains achieved during PEP’s ownership where either transitory or lost on its return to being a public company again.
As a result, prior to the Downer bid, Spotless was trading at $0.725, a capital return for IPO investors of -55%! Whilst we could write here about the potential pitfalls of investing in IPO’s, particularly ones where the business comes from private equity, what interests us more here is the mentality of Downer - and what the bid says about the market today.
We have been actively watching the Spotless story as a potential investment idea. Very recently we spent a good deal of time looking closely at the business, as it was beginning to look “cheap” relative to other large companies. And as you know, this is one element we look to when looking for new companies to invest in on your behalf. Prior to the bid it was trading at 9.5x expected (but downgraded) FY-17 EPS (earnings per share), versus the market currently on 15.5x.
After consideration (and as happens more often than not for us) of Spotless post the profit downgrade, we decided there was significant risk with contracts the company was committed to, and the then current share price was only just equivalent to what PEP had paid. As a result the risk/return equation did not stack up for us.
Obviously this is a little disappointing for clients to hear, as it is admitting that we could have made more money than we did - if we had of lowered our risk bar a little (and also if we had of known of a takeover offer at a 58.6% premium to the prior price!).
However, I am happy to disclose this because it is more important for clients to understand that we are true to our style (risk first: good return second or looking for asymmetric returns), even if we suffer a hit to the ego.
Reflections on the takeover offer
Also it is a useful illustration of the market behaviour we are observing today.
As part of the bid, Downer has disclosed that they see “run rate” synergies of around $20m p.a, and up to $20-40m p.a. “over time”. On a cost base of $2.85 billion for Spotless this represents ~1.4% (i.e. nothing). However, notwithstanding the limited financial benefit of combining the two businesses, this transaction is expected to be EPS accretive by at least 10%p.a.
Eh - why is this?
Well simply put, the market currently values Downer's current earnings on 18.7x FY-17 EPS, and Spotless is being acquired for 14.8x. Because Downer is using its more expensive shares to buy something cheaper than itself, it will improve its own shareholders EPS. Voila! Isn’t life easy. That’s one tick big tick for the bonuses of those at Downer management this year (who are heavily incentivised on the financial return of the business).
In our analysis of Spotless, we didn't consider that Downer may be a potential acquirer of Spotless. This is because it didn’t appear to make any practical sense. Downer, whilst also technically a services firm, operates largely in completely different and unrelated areas to Spotless - more engineering and technical related. A Downer engineer is unlikely to want to call in to run an event at Etihad Stadium, as much as a Spotless laundry employee is likely to want to fix and maintain locomotives.
What we had really missed in our thinking, but glad we missed it, was that a somewhat vaguely similar company (okay they both are in services – but so is a bank and insurance company) may look to use financial engineering to bootstrap its own earnings. This heralds an old strategy (but never a goodie) last seen in 2006-2007.
For some time the market has been trading at and above its long term valuation. However, we have noted from time to time that we haven’t been seeing the behaviour that one usually associates with the top of the market.
We think that the acquisition at above long term market value (14.5x versus the buyout value of 14.8x) by a company which is trading even more expensively (18.7x) is a signal that we are moving towards the top of the current market cycle. It reinforces our strategic position of staying conservative, and only invested where we think we will get good risk adjusted returns over time - even if it makes us look quite different for a while.
Sir John Templeton (renowned UK investor, founder of the Templeton Growth Fund) made the famous quote – “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria”. When we look around today we certainly see a lot of optimism in share prices, and given a weak transaction such as this, arguably now some euphoria.