The smart way to play small-cap M&A

Takeover interest at the smaller end of the equity market is buoyant. On my active watchlist of companies, the takeover of mechanical engineering group TClarke (CTO) completed last week, and there have been recommended bids for commodity royalty company Trident Royalties (TRR:48p) and Trinidad and Tobago-focused oil explorer and producer Trinity Exploration & Production (TRIN:45p).

Although digital media group Brave Bison (BBSN:2.5p) failed to agree an all-share merger with UK advertising and marketing specialist Mission Group (TMG:21p), I still see re-rating potential for both companies as standalone entities. Brave Bison is priced on an enterprise valuation to cash profit multiple of 5.9 times and cash-adjusted price/earnings (PE) ratio of 8, a modest rating given its track record and the improving UK economic backdrop.

Mission’s valuation is also in bargain basement territory, trading on an enterprise valuation to cash profit multiple of 3.5 times and prospective PE ratio of 3.4, assuming the board delivers the profit rebound analysts are predicting.

De La Rue firmly in play

There is potential for corporate activity at bank note printer and authentication group De La Rue (DLAR:99p), a £194mn market capitalisation company that has had a chequered history, and a heavily indebted one, too. On 30 May 2024, the board revealed that it is in discussions with several parties who have made proposals in relation to, or expressed interest in, either of the group's two divisions.

The directors also revealed that De La Rue has reached agreement with two existing government revenue solutions customers for multi-year extensions to their contracts for the supply of a digital tax stamp solution to track and trace excisable products. This doubles the number of substantial contract renewals that De La Rue’s authentication division has achieved within the past 12 months. The unit now holds multi-year contracts that underpin more than £350mn of future revenue, or the equivalent of three-and-a-half times the segment’s annual revenue of £100mn in the 12 months to 31 March 2024. In the 2023 financial year, the authentication division delivered operating profit of £14.3mn on revenue of £91.7mn, so on a maintained margin the multi-year contracts could generate £55mn of operating profit.

Bearing this in mind, investment manager Richard Bernstein of Crystal Amber (CRS:86p), a top-performing UK small-cap fund with a total return of 37 per cent over the past 12 months, according to Trustnet, offers investors a valuable insight into the break-up value of De La Rue. Crystal Amber holds 32.2mn shares, or 16.5 per cent of De la Rue’s shares in issue, having doubled its holding through the purchase of 15.3mn shares at 41.2p a share in September 2023. The holding is now worth £32.2mn, or 44p per Crystal Amber share.

Bernstein values the authentication division at £300mn, a sum that exceeds De La Rue’s market capitalisation of £195mn and net borrowings of £90mn. He conservatively values the shares at 140p, a 65 per cent premium to the current price, after factoring in the group pension deficit and attributing a realistic value to the bank note printing division.

Fair value could be higher still. That’s because Bernstein also points out that “De La Rue’s current plc and head office base is cumbersome and costs north of £25mn could be eliminated. Putting even a four times multiple on that cost base would deliver £80mn of after-tax value [to a trade acquiror], or 42p per De La Rue share”.

The bank note division reported operating profit of £13.6mn in the 2022-23 financial year, but it has been impacted by materially lower demand in the past 18 months. However, news that the divisional order book has increased by a third to £299mn since December 2023 is promising and the unit could attract a bid, too, albeit the majority of the value in the group is in the authentication division.

Playing the M&A game

When De La Rue reports annual results for the 2023-24 financial year later this month, underlying operating profit is forecast to slip a fifth to £22mn. That’s already in the price, although arguably prospects for a strong recovery in operating profit to £29.5mn in the new financial year aren’t.

In any case, the smart way to play the potential for corporate activity is through shares in Crystal Amber. The £62.6mn market capitalisation investment company is trading on a 27 per cent discount to net asset value (NAV) of £85.8mn (117.8p) even though disposals have boosted the fund’s pro-forma net cash by £5.7mn to £9.5mn (13p) since the start of 2024.

A successful exit from De La Rue on the back of M&A activity could boost Crystal Amber’s net cash to above 85 per cent of its current market capitalisation, a point worth noting given that the company is winding down and has been returning cash to shareholders. There is another reason for taking an interest in the closed-end fund, too.

Fighting diabetes

Crystal Amber's other major stake is a £30.9mn (42.4p) investment in Morphic Medical, a privately held company headquartered in Boston, Massachusetts that has developed an endoscopically delivered medical device for patients with Type 2 diabetes and obesity. The fund holds £11.9mn of loan notes and a 81.5 per cent shareholding valued at £19mn in Morphic Medical.

The device is called Reset, a thin, flexible implant that lines the proximal intestine and mimics gastric bypass bariatric surgery as food bypasses the duodenum and the upper intestines. Unlike gastric bypass surgery, Reset is reversible, minimally invasive and temporary. It does not permanently alter the patient's anatomy, but it targets the body's own blood glucose control mechanisms. This is achieved through a 20-minute endoscopic procedure. The patient typically retains the device for nine months, after which it is removed.

Over the past year, treatments for Type 2 diabetes and obesity have become a huge area of focus in both the general and the financial press. Danish multinational Novo Nordisk (US/DNK:NOVO), the maker of weight-loss drugs Ozempic and Wegovy, has seen its share price soar 141 per cent over the past two years. The "trickle down" effect of investor attention has found its way to Morphic Medical's close competitor, Fractyl Health (US:GUTS), which successfully raised $110mn on Nasdaq earlier this year. The company has a market capitalisation of $214mn even though it only reported revenue of $0.1mn in 2023.

While Morphic Medical still requires CE Mark certification, the company believes that its RESET device can deliver superior and durable results. A UK study by Dr Bob Ryder of the Sandwell and West Birmingham NHS Trust demonstrated an average 17.9kg reduction in weight at the end of treatment. Three years after treatment, 75 per cent of patients maintained most of the improvement achieved.

Morphic Medical has been beefing up its sales team in advance of securing UK and European approval for the device in the coming weeks. It has also significantly strengthened its board, appointing an ex-Medtronic executive and the former chairman of Apollo Endosurgery, a company that was acquired for $615mn by Boston Scientific in 2023. An exit from Morphic Medical could deliver material gains to Crystal Amber’s shareholders if all goes to plan.

Clearly, with the fund’s two largest investments accounting for almost three-quarters of net asset value there is a high level of portfolio concentration risk. Potential for material investment upside on both holdings makes that risk worth taking on. Buy.

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