Stockwatch: this bid target may have 20% more upside

Does a takeover contest for Lavendon prove the stockmarket is overly pessimistic towards cyclicals? A roller-coaster in the FTSE Small-cap shares of this powered access equipment renter reflects the shifting market bias.

From early 2012 to spring 2014 it soared from 85p to near 250p as quantitative easing (QE) prompted investors up the risk curve. Lavendon's shares reached an annual average historic price/earnings (PE) ratio of 17.4 in 2014, despite drifting back down to 165p by the year end.

After recovering briefly to near 210p in 2015, the shares fell again as the market fretted that six years of economic expansion must herald a downturn.

Typically, shares perceived as cyclical and operationally geared do fall in such a context, even if they continue to report strong results - indeed, Lavendon's 2016 interim results showed double-digit financial growth.

Lavendon is currently being eyed-up by two European suitors, which has driven its share price from about 135p to near 220p - this still represents an exit PE multiple below 12 times (see table below).

The bidders reckon the market has undervalued both Lavendon's earning power and strategic capability in Middle Eastern markets offering long-term growth.

A quarter of its revenue is derived from the Middle East and Africa, growing about 20% annualisedThere's wider relevance among cyclicals where the market is pricing shares low to exact a high yield for perceived cyclical risks.

As a nascent Trump administration lays the ground to prime the US economy, it implies value in cyclical firms with international revenues.

On 18 November I drew attention both to Speedy Hire and Lavendon, suggesting Lavendon was a more conservative pick. A quarter of its revenue is derived from the Middle East and Africa, growing at about 20% annualised, versus near-flat revenue from Continental Europe which represents another quarter.

Such a profile helps explain takeover interest from the Belgian TVH Group and Loxam, Europe's biggest equipment rental group.

News broke on 22 November that TVH had put a 205p per share "final cash offer" on the table, following a private 180p/share cash approach.

Lavendon's board and advisers were ready to roll over and recommend the 200p/share offer to shareholders, which some institutions justifiably appeared to snub - there was no premium for control and the price was modest in context.

The release included a standard caveat of "final offer unless a third party appears", which manifested on 28 November when Loxam said it was also mulling a cash offer.

Deal or no deal

With Lavendon being so accommodative, it's hardly surprising the market senses a contest, which has re-rated the shares further to 220p - about 217p currently.

Resolve is also shown by TVH snapping up 9.0% of Lavendon equity, half from a Dublin-based institution at 202p, which potentially also brings down its cost in a bidding war. Such a move also pressures Loxam to propose a materially higher price, which it may or may not opt for.

In a five-year chart context, 250p was nearly reached in spring 2014Ironically, on 16 November Lavendon's broker Peel Hunt published a 275p per share fair value target for the group, representing a forward PE multiple of near 15 times.

This was possibly a bit rich on a standalone basis, but industrial buyers may be willing to pay a premium both for control, synergies and long-term strategic benefits.

Yes, Lavendon was prepared to recommend 200p but, if it's so meek, it's hardly surprising TVH followed it through.

This is speculative, but the situation offers interesting risk/reward with 20% upside possibly between 250p and 275p per share, versus 6% downside to the "base case" 205p/share offer. TVH's succeeding to buy in at 202p from willing institutional sellers reflects cautious investor thinking, whereas valuation is shifting to another paradigm, that of industry.

Not to confuse market value with intrinsic value (which the bidders will focus on) but, in a five-year chart context, 250p was nearly reached in spring 2014, since when earnings per share has grown by over 30% (see table).

Anything below 275p/share probably represents good long-term strategic value for industryThe market jump from about 135p in the last week can look "high enough" in short-term context, perhaps less so on a medium-term view and considering fundamentals.

In a worst-case scenario of all this falling apart, Lavendon could dive 30% or more, as it's unlikely to settle back to its value pre-bid approaches.

However, the realistic odds-setting is for one of these suitors to succeed, given signs that both the board and institutions are willing sellers and anything below 275p/share probably represents good long-term strategic value for industry.

Behavioural economics

Resolve on both sides is shown by Loxam having appointed Rothschild and Deutsche Bank as advisers.

Conceivably, that could mean advising to step back in the event of significantly higher terms from TVH, although Lavendon is presently valued around £375 million - not a big bite for these larger European bidders, even over £400 million.

Shareholders are more amenable to accepting an offer than risking another price fall Institutional thinking also tends towards a deal if terms are raised, M&G/Prudential being a crux holder with 18.9%.

Fund managers' macro outlook typically frets about Brexit causing disruption, despite "infrastructure" development now being a mainstream theme.

This makes shareholders more amenable to accepting an offer than risking a fall in the price again, such that they are left with the economic risks.

The 22 November announcement cited Unicorn Asset Management giving an irrevocable undertaking to TVH as regards its 5.9% stake.

Independent price target

This is an independent broker's view of the likely outcome, and still values it at less than 13 times earnings. Admittedly, the 2016 interims also showed net debt of £149.7 million at end-June, up from £119.9 million at end-December 2015, after a £62 million investment into its fleet, net of disposals.

Ultimately bid values rest on what these  bidders judge to be their long-term benefitsBefore buying rental fleet assets, first-half cash flow rose from £27.4 million to £31.2 million, however, and the net interest cost was covered 7.2 times by underlying operating profit. Including this fleet investment cash flow reached £5.2 million.

Debt shouldn't weigh heavily on finalising the price, but it's likely a chief factor TVH has used to justify opening offers.

Panmure Gordon's exit price is therefore a pragmatic one, but ultimately bid values rest on what these European bidders judge are the integration and long-term strategic benefits. It could be quite a contest.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.