M&A in the UK – is Brexit opening a (relative) value opportunity?

Whether down to the potential for Brexit or a widening current account deficit the decline in sterling over the last 6m has been substantial. On a quarter-on-quarter basis the trade-weighted value of sterling has fallen by 7%, representing a move of more than 2 standard deviations away from the mean.

Only during the financial crisis and the exit from the ERM has sterling fallen faster, Exhibit 1.

Exhibit 1: 2 standard deviation Q-on-Q decline in trade-weighted sterling

At the same time, the weak sterling denominated performance of the UK’s industrial goods and services sector – which has a large proportion of sales overseas – is becoming notable. Relative to US industrials, UK industrials have underperformed by over 25%, Exhibit 2. This relative weakness has not been seen since the late 1990s.

Exhibit 2: UK industrial sector underperforms US by 25%

Without wishing to become embroiled in the politics of cross-border M&A, especially on the cusp of the Brexit referendum, we believe that valuations of UK industrials are becoming significantly more attractive for overseas buyers, notably those based in the US. We have therefore screened the UK industrials sector for companies with more than 50% of sales overseas to see just how discounted the UK has become. To avoid the results being dominated by the largest companies in the index, in the following charts we use the median rather than the weighted average measure.

For this universe of UK companies, US peers on a price/sales basis at a premium of 50%, close to their highs of the last 25 years, Exhibit 3.

Exhibit 3: US industrials price/sales close to record premium over UK

Furthermore, EV/EBITDA multiples show a 20% premium for US industrials compared to the UK, Exhibit 4, following a decade where EV/EBITDA valuations effectively traded in-line.

Exhibit 4: EV/EBITDA multiple gap widening again

The premiums for US peers do not seem to be borne out by diverging sales growth prospects, as shown in Exhibit 5. US companies would appear to face the same headwinds in generating growth as UK companies with international sales.

Exhibit 5: No difference in sales growth prospects to justify US and UK sector valuation differential

There is however a widening gap in terms of EBITDA margins in this cycle; current margin forecasts for the US are close to 20% versus 15% for the UK. This is notable as before 2011 US and UK industrial margins fluctuated with the economic cycle but otherwise tracked each other closely, Exhibit 6.

Exhibit 6: US industrials deliver stronger margins than UK peers since 2012

Without wishing to suggest that a US-led M&A boom is imminent, the decline in sterling and relative price underperformance of the UK’s industrial sector has opened a significant valuation gap which is in our view likely to have US investment bankers dusting off pitch books for UK targets. Even if a number of high profile but tax-led US/UK transactions have fallen by the wayside, there is no reason why traditional M&A based on earnings accretion, growth and synergies will not attract the attention of growth-starved US executives, at least if the recent improvement in market confidence is sustained.