Beyond buybacks: UK firms find new ways to close the valuation gap

This article was originally published on Citywire.

In the years following Brexit, the UK equity market de-rated markedly compared to those of its peers. This has led to a notable gap between what UK companies are worth and what UK public markets are prepared to pay.

What’s my evidence for this claim? Just look at the sheer scale of takeover activity of listed UK companies. According to Peel Hunt_­1 45 UK companies with a market cap of more than £100mn were acquired last year. Another 33 have gone this year. In most of these cases they’ve sold for a healthy premium to their share price before the news of takeovers gets out.

Sometimes that has sparked bidding wars. The best recent example is instrumentation company Spectris, which has had competing bids from two private equity firms, reaching (so far) an over 90% premium to the undisturbed share price.

Taking themselves off the UK market by going private or moving primary listings overseas is one way Boards have sought to address this price gap.

The second, and more frequently used, has been share buybacks. These work because shareholders that don’t choose to sell into the buyback end up (all else being equal) owning more of the company. Company earnings are spread across a fewer number of shares and should therefore be worth more.

A buyback is tempting in comparison to, say, a capex project (that may overrun on costs, or end up underutilised), or an acquisition (where even the most thorough due diligence can’t entirely nullify the risks of an underinvested business, a poor culture etc). But there are drawbacks, too.

The issue with share buybacks is that the temptation to buy back may over the long term erode the companies’ capacity to grow. A company that only buys back shares rather than invests will, over time, dampen its potential revenue growth. And that could mean it ending up on a lower valuation multiple. If the objective is to deliver value for shareholders, buybacks may only prove a short-term boost, not a long-term solution.

Break up to make up 

There is a third way for companies to bridge the valuation gap. Britain has quite a few businesses whose parts are greater than the sum. I’ll explain more shortly. Suffice to say, if you do your research, identifying these companies may open the door for savvy investors to make attractive gains… eventually.

The point is perhaps best illustrated with an illustration. Johnson Matthey₂ specialises in advanced metals chemistry that can help the world’s leading energy, chemicals and automotive companies to decarbonise and reduce harmful emissions. It has a rich 200-year history – it supplied catalysts that helped to power the onboard systems in the Apollo missions and also within the group is the world’s largest refiner of recycled platinum metals. It employs over 10,000 people in 19 countries, working in a broad range of sectors.

Earlier this year Johnson Matthey took the market by surprise when it announced the sale to US firm Honeywell of its catalyst technologies division for £1.8bn. This division, which delivered approximately 20% of group earnings, was sold for the equivalent of 80% of the company’s market cap at the time.

Johnson Matthey shares naturally rose as a result – by 27%₃ on the morning of the announcement. The market had been valuing that part of the business wrong, and here was substantive proof of it. Johnson Matthey remains listed on the UK market, but when the deal completes it will have a substantial pool of capital, some of which it is likely to return to shareholders.

The same playbook

Where might we see other examples of this? Interdealer broker TP ICAP has built up a data subscription business (called Parameta) with high recurring revenues and attractive margins. It has publicly stated that it is looking to potentially list a stake on the US market. You might ask why you would want to own less of the best part of your business. In an ideal world the UK public market would already fully reflect the value of that division. The reality though is that with the net outflows in the UK market this is not always the case.

And a share price does matter. This is more than just a number on a Bloomberg screen – it is a company’s currency. If a separately listed Parameta needed to raise capital – perhaps for an acquisition – it could issue shares in itself. It is likely to have a higher earnings multiple than its parent. This could make a meaningful difference. Let’s say Parameta traded on 20x earnings and wanted to buy something on 15x earnings, the numbers look like they’d work. If it had to issue TP ICAP shares (which currently trade on 9x earnings), the numbers look much less plausible. At the moment the low rating of TP ICAP shares is acting as an effective blocker to Parameta doing larger deals. A separate minority listing opens a route round that, while TP ICAP shareholders can still have exposure to the faster growing, better bit of the business.

There are plenty of other UK companies with divisions beneath the surface that could, with more light shone on them, be worth much more than is being reflected in the parent company’s share price. Unless the valuation backdrop changes in the UK, I expect to see company Boards increasingly pulling this additional lever to create value for us, the shareholders.