Consolidation plays – finding value

Consolidation plays – finding value

A “roll-up” is a term used to describe a broad-based acquisition process of many smaller and similar businesses by a company. There are two motivations that investors are commonly attracted to with a consolidation play – one increases the parent company’s share price, while the other increases the value to shareholders. It is important for investors to distinguish between these two distinct reasons before making any investment.

The first motivation seeks to leverage the discount that is applied to private companies versus their publicly-listed peers. It is common for private companies to be purchased on an EBIT multiple of ~4 times, while publicly-listed companies trade at around 7 to 8 times. Upon purchasing a private company at a discount, the public company’s share price can re-rate based on the combined entity’s earnings – and yet the underlying earnings of the two companies have not changed.

This business model is ultimately unsustainable – management is simply playing off this share price re-rating without focusing on generating organic growth within the combined entity. If this is management’s primary motivation, it will become increasingly difficult to find favourable private companies that trade at considerable discounts, and the consequences can be dire – ABC Learning is a classic example of the shortcomings of this approach.

At Montgomery Investment Management, we believe that value lies in a company’s ability to sustain a reasonable return on shareholder’s equity, and are thus attracted to the second motivation behind a roll-up. Companies should only be seeking to expand via acquisition if the combined entity is able to unlock synergies – these can arise by reducing costs through economies of scale or attracting more revenue through better branding and awareness.

With that being said, one consolidation play that we believe offers long-run value is 1300 Smiles (ASX: ONT). ONT provides the use of dental surgeries to self-employed dentists. Essentially, the dentists pay a management fee in return for the rooms, facilities and staff, while the head office takes care of the administration.

Management’s focus is delivering sustainable returns to shareholders by improving the dental health landscape in Australia. The company considers that the amount of Australians visiting the dentist each year is “a national embarrassment” (it is estimated that 70 per cent of Australians do not visit a dentist until they are in pain).

The company is firmly focused on increasing the number of people that visit the dentist through public initiatives. For instance, ONT has confirmed that it is involved in a public-private partnership with the Queensland government to reduce public dental waiting lists. It is also endeavouring to make dental health more affordable by providing a Dental Care Plan for $1 a day.
These initiatives will assist ONT in growing earnings organically through their existing and potential clinic network. What’s more, the company’s business model will provide additional benefits to society (this is also known as a positive externality).

ONT is seeking further growth with additional acquisitions. While its share price has the potential to re-rate on its ability to purchase private practices at a discount to public multiples, it is ONT’s potential to grow earnings organically that makes it such a desirable long-term value proposition. Unfortunately, its share price is not trading at a sufficient discount to our estimate of its intrinsic value to warrant investment, but it is a company that we are keeping a close eye on.