Last week on BNN during his call-in show, Bob McWhirter made an interesting point (15:58 mins, part two) that public Companies should take heed. He said that there is very limited liquidity for public Companies worth less than $100 million on the TSX/TSXV. I respect Bob's opinion very much, and I also happen to agree with him.
According to the TSX website, there were 312 technology companies listed on the combined TSX and TSXV exchanges. This is down 7% in one year from 334 listings as at the end of 2007. This trend should accelerate during 2009.
Of those 312 Companies, only 29 exited 2008 with market capitalization in excess of $100 million, with possibly another 5 listings within reasonable shooting distance to that benchmark.
Based on Bob's assertions regarding $100 million market cap, 283 Toronto-listed technology Companies, or 91% of the technology sector currently falls into the long-tail of the small cap market with market capitalization below $100 million. Even worse, 267 of those Companies are worth below $50 million and fall into a liquidity trap as capital flows to the relative safety of more liquid larger cap stocks. Will liquidity return to this part of the market? Not any time soon. The BMO Small Cap Index is down 46% from the previous year, and billions of dollars have left the market along with countless hedge funds that once traded small caps. It could be many years into a recovery before we see liquidity return to the long-tail of the small cap sector. However, we should see increasing liquidity among tech small caps with market capitalization above $100 million because of the horizontal nature of the sector, and the relative performance compared to other sectors during 2009.
As a CEO, what decisions could one make to get out of the liquidity trap? Here is a prescription (this could apply to other sectors such as media, too):
1. Reality Check: Too many CEOs are using pre-recession multiples to evaluate where their Company's stock should be trading. During the past few weeks I have heard it over and over again. My stock is trading at (insert nominal amount here), but it should be worth 10 times that. Well, maybe in 2007. But now profitable, cash generating, high growth tech Companies are being evaluated at 4x to 6x EV/EBITDA multiples. Earlier stage Companies with time to profits and weakening balance sheets are just not worth much because investors are no longer measuring investments on a revenue multiple basis. Bottom line, with few exceptions, current market capitalization reflects current value below $100 million. In the current market, very few Companies have the future earnings potential to grow profits organically to get to the $100 million market cap benchmark. As stated in previous posts, a lot of consolidation needs to occur in the sector, and among the 267 technology Companies worth under $100 million, its almost a binary decision...am I a buyer or a seller?
2. Options for profitable Companies worth below $100 million: There are some Companies worth below $100 million that are cashflow positive with strong balance sheets. It depends on where a Company is during its lifestage whether its Board should decide to become a buyer or a seller. A recently profitable Company ( with less than 4 quarters of consecutive profits) should be a buyer because its future earnings growth will be discounted by an acquirer. A strategic acquisition may be more easily accretive for a recently profitable Company if synergies are present. A consistently profitable Company with a decent balance sheet worth less than $100 million may think about becoming a seller because shareholders may realize more value from future profits on a relative basis. However, with cash in the bank, and consistent earnings, it may be worth buying or merging with a higher growth recently profitable Company to add some juice to future earnings. Notwithstanding, as a profitable Company, there are a lot more options with positive impacts on future earnings.
3. Options for near profitable Companies worth below $100 million and with strong balance sheets: An option for these Companies is to simply ride out the recession and hope that investors take notice when its all over and liquidity returns to the small cap sector. Shareholders are likely to suffer from this decision. Smart CEOs should look to become aggressive consolidators, picking off smaller, distressed strategic and competitive assets. Basically, put the balance sheet to work. A Company with a strong balance sheet that is nearly profitable likely raised capital prior to small cap decline. Gain more value by arbitraging on the multiples. Acquire for scale and for profitability.
4. Options for profitable Companies worth below $100 million and with weak balance sheets. Buy distressed competitors with stock. With limited market liquidity, dilution is likely not that impactful, but by taking out competitors, and creating operating synergies, cashflow could be accelerated. Buying distressed competitors could further weaken a balance sheet, however an effective roll-up strategy could attract investors to shore up balance sheets.
5. Options for unprofitable Companies worth below $100 million and with weak balance sheets (even with great potential). Investors are no longer interested in potential at this time. CEOs (and Boards) should look for strategic merger and sell opportunities. There is very little chance that these Companies will attract investor capital any time soon, and there is probably a "best before date" on the operation. Attempting to raise equity to fund working capital is probably a waste of management time. There is very little appetite among investors. Management should spend its time:
1) bridge financing operations until sold.
2) removing overheads and cleaning up balance sheets.
3) valuing assets and operations.
4) finding buyers that maximize shareholder value.
5) completing transaction.
6) assisting with integration (if required).
The public markets have been fractured, and for some reason the CEOs that operate within them seem to be the last ones to have gotten the message. The small-cap long tail is likely to be a lot shorter by 2011, and Management teams must find creative ways to improve liquidity. Right now, the magic point of liquidity may be $100 million market cap. CEOs buried in the long-tail of the small-cap markets should be asking every day, how can I get to $100 million market cap...soon?
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