Why Canadian tech stocks could see a surge of takeovers

You can almost see the tumbleweeds blowing through the tech sector these days.

The drubbing across the entire IT space in North America has investors largely ignoring the same startups they were obsessed with two years ago.

But there are opportunities growing where few are looking. With discounts of 50 to 75 per cent from previous highs not uncommon, lots of small-cap Canadian tech companies are priced to sell.

There are hints that a surge in tech acquisitions is coming. Waterloo, Ont.-based Magnet Forensics Inc. recently agreed to be sold to a U.S. private equity firm at a healthy premium. Other names also look like attractive takeout candidates for acquirers flush with cash.

“M&A will probably be a big driver for the next 12 to 18 months,” said David Barr, chief executive officer of Vancouver-based PenderFund Capital Management, which owns shares of Magnet. “There’s a lot of buyers out there.”

Many of them may just be waiting for interest rates to stabilize. The sharp upturn in rates has been the key catalyst in bringing about the worst selloff to hit the Canadian tech sector since the global financial crisis nearly 15 years ago.

After feasting on easy money and rampant investor demand for growth at all costs, technology was not well-suited for the sudden scarcity of capital of a high-rate, high-inflation era.

The widespread investor fixation with speculative tech plays that dominated markets through the heart of the pandemic vanished.

“We used to get so much pressure from clients saying, ‘you guys aren’t tech enough,’ ” said Bryden Teich, a partner and portfolio manager at Avenue Investment Management.

“That pressure has just been completely wiped away. It’s the most dramatic shift I’ve seen in my time doing this.”

Trading data speaks of an exodus from Canadian tech. For the Canadian market as a whole, average daily trading value was roughly flat in 2022 from the year before. That compares with a decline of more than 50 per cent in the broad Canadian tech sector, and roughly 80 per cent when looking at tech stocks with market capitalizations of less than $1-billion. Those numbers come from a recent RBC Capital Markets report looking specifically at the tech stocks its analysts cover.

The paltry valuations the market is assigning to smaller Canadian software names tell a similar story. The same RBC report pointed to “unjustifiably discounted” valuations across its top picks in the sector, including Copperleaf Technologies Inc., Coveo Solutions Inc. and D2L Inc. Those three names are trading at a discount of 42 per cent compared with the average across Canadian peers.

Even Magnet Forensics, a darling of the Canadian tech scene, dipped as low as four times when comparing its enterprise value to forward sales, which is less than half its average trading value since it went public in April, 2021. Ultimately, a deal was announced to acquire the software maker at a valuation of 10 times.

“Additional takeouts may help narrow the valuation gap … for all Canadian small-cap tech stocks,” the RBC report said.

There is certainly a lot of money on the sidelines. Private equity has stockpiled about US$800-billion of dry powder, according to figures from investment data company Preqin.

Corporate buyers, meanwhile, have added incentive to scale up by purchasing competitors. Many software companies have seen their prospects for organic growth shrink rapidly as rates have soared and sources of capital have dried up.

The industry will first need to clear a psychological hurdle before the deals really start to flow. “A lot of these CEOs and boards still think their company is worth what it was trading at when markets were crazy,” PenderFund’s Mr. Barr said. For management, it can take time to accept a diminished stature and start to engage potential buyers. “We’re starting to see that now,” Mr. Barr added.

Investors may also need to shift their perspective. An acquisition at a 20-per-cent premium to current trading value may be a disappointment to shareholders that saw their holding drop by 50 per cent in a year.

Looked at another way, that’s a nice little gain, if you can avoid dwelling on tech’s past glories.