Stockwatch: What now for this winner?

Cape, a provider of "critical industrial services" for energy and natural resources, has had its intrinsic value affirmed by an agreed cash offer at 265p per share by Altrad, the UK's largest supplier of scaffolding and light industrial equipment.

This is notable in terms of takeover potential among listed small-cap cyclicals which are rated cautiously lest one of the longest upturns on record (since 2009) finally eases. Admittedly, Cape is prone to sensitivities in demand within the sectors it serves, and only a month ago cautioned on its 2018 outlook.

The group has also weathered clouds hanging over it due to historic asbestos personal injury liabilities, but a settlement with insurers should have cleared the air, and intrinsically the company is moving on.

Thus, after the stock had plunged from 333p in 2014 to hit an early 2017 low of 150p, I twice drew attention to underlying value: at 177p in January after an update cited strong trading across Cape's three main business regions, especially Asia Pacific amid high levels of project activity; then at 220p in March, when forecasts implied a forward price/earnings (PE) ratio of just 7 times and a prospective yield of about 3.2%.

Strong trading gives way to caution

On 5 June, an update affirmed strategic progress in Australia by way of insulation and coating services contracts, also in the UK by extending Cape's longstanding relationship with BP in the North Sea for a three-year deal worth over £150 million.

"The group continues to trade strongly and 2017 performance will be materially ahead of previous expectations..." But there was a twist: "2018 will be a more challenging year, driven by the expected reduction in construction activity in Asia Pacific and project delays and margin pressures in the Middle East."

That sounds sector-specific albeit involving long-term growth regions, so any setback could be short-term in nature. Altrad is certainly positive, taking out a new debt facility to make this cash takeover: implicitly, its management has identified synergies from combining operations and taking out costs, but it's curious how the Cape board seems to have rolled over and been tickled by this first approach. Either the directors are not up to the task of a robust defence and taking the group forward, or they genuinely lack confidence in the medium term.

How else can a single figure exit PE multiple be justified, according even to downgraded 2018 analysts' projections? If their reviewing group prospects justifies throwing in the towel at this point, at such a value, then it is a warning over the business cycle - and far more widely than the UK, which tends to be most in focus for risk given Brexit and the general climate of political instability.

Yet it strains belief that this deal represents shrewd foresight by Cape's board, to agree an exit for shareholders ahead of a downturn. Industry clearly senses the opportunity, as did both analysts publishing notes on Cape after its 5 June update: independent broker Arden Partners recommended "buy" alongside company broker Canaccord Genuity.

A classic example of true investment value

"Security Analysis", Benjamin Graham and David Dodd's 20th century bible of value investing, can be summarised as favouring companies well-positioned in their markets, with an established financial record, albeit lacking near-term growth appeal.

In such respects, Cape is a classic example, and why I felt it appropriate to reiterate this in barely two months. The situation also affirms virtue in the humble PE multiple, at least awareness of the annual average trend: Cape's had declined progressively (see table below) to an outstandingly low multiple of 5.7 times this year; this for a business making circa £40 million pre-tax profit on £800 million revenue on a 5% operating margin, i.e. financial substance for a near-rival to integrate.

Admittedly, Cape has dealt some surprise updates in its time, but enjoys a market-leading position, so the group either bounces back in time or, as we now see, gets approached.

Arbitrageur bets £37 million on higher offer

Altrad's initiative most likely reflects confidence that relatively low interest rates will persist as central bankers nurture the global economy along. If such a scenario is trusted by other industrial service groups, they will currently have their spreadsheets up on Cape, partly as a defensive measure towards this proposed new combine.

On this logic, and according to RNS, Sand Grove Capital Management LLP appears to have snapped up 11.7% of Cape shares (as it wasn"t on Company REFS prior list of 5%+ holders). while Blackrock is disclosed with 3.4%.

Sand Grove is a Mayfair-based "alternative" fund manager, which suggests merger arbitrage dealing. Its rationale for getting involved at a market price just a few pence discount to the tabled offer would be perceived very low downside risk of it falling through versus the off-chance of a rival higher offer. Such is classic merger arbitrage than speculation of an offer happening at all.

Irrevocable acceptances have been received in respect of 18.2% of Cape shares issued, the offer being conditional on receiving no less than 90% acceptances. It also requires approval by the competition authorities, although there"s no direct overlap between these two groups - Altrad's strategic aim being to create a multi-discipline industrial services leader.

So, at the very least, hang onto Cape rather than sell in the market, unless you really need the money quick. If this takeover heats up, then it will be further indication the market rates some cyclicals too cautiously than their already cautious trading statements.

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.