Stockwatch: A bid is on the cards for this share

Is a US takeover of this iconic brand in the making, and at what price? AGA Rangemaster shares have jumped off an 18-month low of 82p to about 143p following news that Middleby Corp is mulling a possible cash offer, with a deadline of 5pm on 15 July.

The market price is still well below the 188p registered in spring 2014 and represents a 12-month forward price/earnings (P/E) of 9 assuming the consensus forecast (involving 3 brokers, see table) for pre-tax profit to rebound to over £15 million. With new products gaining traction and the UK housing market strengthening after the election of a Conservative majority (mortgage approvals are a consistent leading indicator of AGA demand), Middleby's timing is astute.

After introducing new "range cookers" to offset the decline of oil and solid fuel cast iron cookers, last September saw the launch of the AGA City60 aimed at smaller homes and new urban customers. At last August's interims the chief executive said: "we now have the market wind behind us and the product and distribution in place to benefit."

AGA Rangemaster would be a logical addition to Middleby, the $6.5 billion (£4 billion) global foodservice equipment group, which also needs a regular earnings stimulus now Wall Street exuberance has driven its stock over 30 times earnings.

In the long run such a rating is unsustainable - a foodservice equipment maker might respectably trade at 15 times - and it exemplifies the rich ratings of US stocks.

Offer price looks constrained by Middleby's balance sheet

Certainly a cash offer would be preferable to British shareholders who would balk at receiving highly-valued Middleby equity, even as part-consideration. But its latest 4 April balance sheet hardly implies much scope: Middleby had $54.3 million cash, mainly long-term debt of $630.1 million with $285.2 million negative net tangible assets as a result of $819.3 million goodwill.

At 143p a share currently, AGA is capitalised at £100 million or $159 million, based on a 12-month forward P/E multiple of about 9 times and no dividend, while the pension fund deficit thwarts payments. Unless the deficit compromises the overall value the AGA board/advisers/shareholders are prepared to agree - hence why the re-rating is modest in context, to 143p - then the cash requirement would strain Middleby's balance sheet, also by taking on the £72 million pension fund deficit

Pension fund liabilities are AGA's ball and chain

I have several times pointed out AGA's brand and the turnaround programme make it a bid target. Also, the pension fund dilemma means AGA shares can't easily reflect what the business is worth, as investors lose interest. The historic low yield on UK government bonds have expanded the value of AGA's pension fund liabilities, such that the fund's deficit rose from £35.8 million to £72 million during 2014 - pretty much what the company was valued at, prior to Middleby's approach. This ball and chain made AGA shares slump during 2014 despite respectable commercial progress. Without a transformation in gilt yields, a takeover by a wealthier predator has looked the chief way to rid the ball and chain, to deliver value to shareholders, and AGA's gathering turnaround has provided such an incentive.

Company developments show an improving trend

Interestingly, Rothschild was appointed corporate finance adviser last January "to assist in bringing third party agreements to fruition" - ostensibly in terms of strategic and product alliances, although the fees Rothschild could earn in a takeover may also motivate discussions with Middleby.

Last March the 2014 results showed operating profit up 17.1% to £9.6 million, on constant currency turnover up 5.7% to £261.1 million (the company currently being valued at just over a third of annual sales, i.e. modestly on this basis). However, the balance sheet showed a near 8% rise in trade payables to £68.9 million versus trade receivables down over 6% to £33 million, as if the company is dragging on paying its bills - which would boost reported profit and cash. The statement referred to "better working capital management" helping net cash balances rise 56% to £9.2 million. Unfortunately, the income statement was then hit by a £4.1 million pension charge and £3.3 million fair value movement in the pension - a reminder of the "ball-and-chain" - also £1.5 million finance costs and £600,000 tax, which left only £100,000 net profit.

The 30 April AGM statement then cited a "strengthened" UK market and "in North America we are into the third year of growth and the new energy efficiency regulations introduced in September 2014 are helping our market position. The benefits of our strong product introduction programmes should now be seen in our international markets." Also, "we saw really strong performances from Fired Earth Tiles in the UK and from AGA Marvel in North America." All this must sound attractive to Middleby as it pursues domestic and international development.

So how much can Middleby realistically pay?

AGA's net present value is, therefore, a stab between what the business operations could be worth longer-term, and the pension fund liabilities. Both are speculative. A significant unknown is what financial freedom Middleby's bankers will allow for a supposed cash offer, although Middleby should have established that before engaging talks.

The valuation challenges to both sides are complex in terms of any recommended offer they can justify to shareholders, i.e. the likely scenario is "no news" going into July with possibly AGA shares slipping. Simply netting off the pension liabilities is crude, but on such a basis Middleby is going to have to factor in over 100p a share to fully recognise the pension liabilities, so shareholders can't anticipate much by way of an exit P/E multiple.

Whether Middleby is prepared to go up to say 180p a share depends significantly on what benefits of integration it can exact (and also justify to its bankers). The market is correctly balancing risk/reward: possibly 40p to 50p down if talks fail or a similar amount up. The chances are that Middleby will want to close a deal, so keep a watch and see if the price eases.

For more information see: agarangemaster.com.