Are More Companies Considering Going Private?

I continue to deploy my cash as fast as I can find it. Volatility has provided what I believe are truly outstanding opportunities. This past week I added to a relatively new name, a micro-cap that announced a 57% increase in revenues and a 226% increase in net income.

This is their 3rd profitable quarter in a row and the company generated just over $2 million in FCF this past quarter. Not bad for a company with a market cap of roughly $32 million.

This is a security business which monitors over 80 fixed site locations for customers across various industries. They started this new line of business by providing services to the oil and gas industry but has begun servicing other sectors as well.

What I need to understand is how much of their new business is from less cyclical industries away from energy. It’s possible that the stock is being ascribed a lower energy service company multiple instead of a security business multiple which tends to be significantly higher.

It could be one of those cases, where as the market comes to appreciate the new business, its valuation multiple expands.

Speaking of multiples expanding…. Multi bagger stocks, stocks that go up many multiples in price, usually need two things to happen to increase dramatically in price. They need the underlying fundamentals to keep improving meaning revenues and earnings need to grow rapidly AND they need to see the valuation multiples expand.

This is the true magic formula.

And it’s much easier to see this happen if the stock starts with a relatively low multiple. A company growing at >25% with a stock trading at a 20 PE multiple needs to do a lot of work to double or triple if the multiple stays at 20.

But it doesn’t have to work quite as hard if it’s starting at 5 times earnings and because of market discovery and attention, the PE grows to 20. Right now, I see a lot of very healthy growers trading at single digit PE ratios. Almost all of them are in the nanocap and microcap space.

I spoke with a colleague of mine in New York, and we got to talking about the markets and what I am seeing up here in Canada. He was quite surprised by some of the microcap valuations that I mentioned.

His immediate reaction was “Why is no one buying these companies and taking them private?” It was a bit of a tough one to answer. I believe we will see more go-private transactions.

The recent announcement that the Canadian government will start taxing company share buy backs was probably another incentive to take these small, profitable companies private.

If I’m the manager and significant shareholder of a small public company in Canada, I have to ask myself, why stay public if investors won’t fairly value my business? With fewer tools at my disposal to correct my market value, what benefit do I get in being public.

The whole idea of being a public company really stems around the fact that public companies are traditionally valued higher than private market comparables, and this allows for lower cost of equity capital if a company needs it.

But what if a company doesn’t need capital as is the case with so many of these great little companies? And if the company is a roll up business like Atlas Engineered Products and investors value you less than companies are being sold for in the private market, what’s the point in having a publicly trading currency?

Now add in the ongoing costs of being public, exchange filing fees, regulatory and financial filing fees, legal and consulting fees, investor relations costs and now a dramatically higher cost for annual audits Audit fees have exploded this year and it’s not unheard for these fees to have tripled and that is IF you can find an auditor to take on these “small” clients.

I know of one small company whose audit fees went from roughly $40,000 to over $120,000 this past year. Add the time and manpower needed to oversee and manage these items. The cost can easily start to add up to +$500,000 for a decent little nanocap. This is cash that basically would fall straight to the bottom line.

Canadian micro-caps are very cheap right now, with good fundamentals. It’s no wonder many CEO’s we speak to are so frustrated with their company share price. I’m hearing more discussions about going private and fears of hostile takeovers.

Over the past few weeks Thunderbird Entertainment has become the target of dissident shareholders who want to takeover the company’s board to look at selling the company to a larger entity.

Without the usual public market premium, I think we will see many companies being swallowed up by larger players, hostile takeovers or taken private by management, this in turn should spur better valuations for these companies and likely reinvigorate investor interest in similar companies. These cheap companies getting taken out at healthy premiums is usually one of the triggers to start a new bull phase in the market or sector.

Many of the companies I own fit into this category. They are healthy growing businesses that are starting to make much more sense as private businesses. Adding $500,000 to the bottom line can be a big incentive to take on the cost and effort of going private. Their value is so much more significant without the public market expenses.

As I’ve said before, the cure for low prices… is low prices.