M&A Red Flags

It may be useful to review some M&A red flags as the M&A market continues to improve. These signals are frequently ignored once the deal process starts. My on-going list is as follows:

1)    Do you believe in magic? Aggressive revenue based synergies are always questionable. Failure to consider competitor response to revenue gains renders the estimates useless.

2)    It is a great target: It may be, but it is still a bad acquisition if you overpay. For me, premiums greater than 40% over the pre bid target stock price are delusional.

3)    Trust me: New CEOs still in their honeymoon period can get some strange deals approved.

4)    Trying to get my mo-jo back: Underperforming firms seeking to regain their old growth status usually violate the first law of holes-when you are in a hole-stop digging. Such firms are not the best owner of the target’s assets and make the acquisition for the wrong reasons i.e. weak strategic rationale.

5)    Bid’em up: Revising upward your pre bid walk away price once the bidding begins. Frequently based on some newly discovered synergy, but always fatal.

6)    Don’t worry about it: Large transformational trophy deals with high levels of shareholder value at risk (SVAR). SVAR is the premium expressed as a % of the acquirer’s pre bid market value. Sometimes known as the “bet your company” acquisition strategy.

7)    What- me worry?  Coupling a large high business risk acquisition with a highly leveraged capital structure is questionable. Flexibility is needed to successfully implement the acquisition and withstand possible competitor responses.

8)    All the other kids have one: Late cycle acquisitions to catch up with peers.

9)    It has to work: Vague existential integration plans.

10)  Don’t confuse me with the facts: Weak or ignored due diligence.

11)  Tunnel vision: Ignoring alternatives such as doing nothing or selling out.

12)  We can trust them: Dealing with sellers who have questionable motives is always dangerous. Make sure you listen to your lawyers by including risk mitigation clauses in your documentation. If the seller objects-ask why.

The presence of any one of the above should be a cause of concern for investors and directors. Two or more should be enough to reject the transaction.

Good hunting, but be careful-it is dangerous out there.

J

Something is happening here-what it is ain’t exactly clear…

(Buffalo Springfield-For What It’s Worth- 1966)

Another question raised at the Amsterdam Acquisition Finance course concerned the persistent muted level of M&A activity. Global 2013 M&A volume, despite a promising start, remains depressed at near 4 year lows.  U.S. volume is up 6% largely driven by the $124B Vodafone-Verizon transaction. Europe had its worst year since 2009. The U.K. market is at its lowest level in over a decade. This is surprising given the following ordinarily supportive factors: 

1)     Rising corporate cash balances and cash flow.

2)     Record private equity (PE) dry power and fund raising. PE firms have over $800B to invest of which $140B expires by YE 2014.

3)     Favorable financing environment.

4)     Positive shareholder responses to recent acquisition announcements.

5)     Limited organic growth opportunities and substantial industrial excess capacity.

6)     Robust stock market with strong buyer stock price performance-the S&P 500 is up over 22% thru early December this year and is trading at record levels.

The possible rationales for this puzzling state of events include:

1)     Buyers lack confidence to make substantial long term commitments due to their uncertainty about the economic recovery and our dysfunctional national government. This becomes less convincing given the steadily improving news about both the economy and the government.

2)     The substantial stock market recovery makes it difficult to find attractively priced targets. This makes some sense, and is reflected in current low premiums being offered. Usually, premiums over the pre-bid price are in the 30% range, whereas currently they are just under 20%. Given the 20%+ recent price increase for targets the effective premium could be viewed as closer to 40%.

3)     Stock repurchases rather than acquisitions have become the preferred corporate finance alternative for many firms. For the LTM stock repurchases have reached almost $450B-the highest level since 2008. Some of this is being driven by activists pressuring firms with bloated cash balances like Apple to use or return the cash.

As previously noted (see Repurchases) I believe stock repurchases are frequently misused. As Warren Buffett notes (see Price Matters) they should only be used if the firm’s stock price is priced below its conservatively determined intrinsic value. The current record stock price level makes it difficult to believe many firms are under priced. Thus, if they want to return excess cash to shareholders they should increase their dividend payout or declare a special dividend. Possible tax benefits of repurchases are probably a secondary consideration given the institutional ownership of most shares. To be fair, some firms like 3M, are using a combination of repurchases and a dividend increase (see 3M).

Many firms may be deferring acquisitions in favor of repurchases for incentive compensations purposes. A successful acquisition typically takes a few years before having positive earnings per share (EPS) impact. A repurchase, however, has an immediate positive EPS impact due to the immediate decline in outstanding shares. This is important as many senior management incentive programs are tied to EPS growth. Managers lacking confidence in EPS growth from acquisitions relative to repurchases will favor repurchases over acquisitions.

 This could be the reason for the depressed level of M&A activity. Researchers like Ralph will need to determine whether this is in fact the case. Perhaps they can see if firms with incentive programs tied to EPS growth are less likely to acquire. I welcome any comments you may have in helping resolve this open question.

Thanks, and I wish you all Happy Holidays.

j

Goodwill Hunting Revisited

An earlier Post focused on goodwill Impairments as a measure of M&A value destruction. Duff & Phelps has released a new Study which contains some interesting results:

1)   Goodwill impairment surged 76% from the prior year to $51B.They still remain below the peak 2008 crisis related levels which were centered in the financial services industry.

2)   Buyers paid the lowest premiums in nearly 20 years, less than 20% v a historical 30%+.

3)   Impairments were concentrated in industries and firms undergoing structural change. IT was the industry experiencing the largest share of impairments. Two firms in that industry, Hewlett Packard (HP) and Microsoft (MS) had the largest impairments at $13.7B and $6.2B respectively representing nearly 40% of total annual impairments. HP’s impairment concerned its Autonomy acquisition while MS’s related to aQuantive.

The biggest source of M&A value destruction is overpaying. No matter how good the fit, how good the target, how flawless the integration, or the amount of due diligence, if you overpay, reflected in the amount of goodwill created or earnings and book value dilution, your shareholders will suffer.

Conceptually, the target’s pre bid share price plus the premium equals price paid. The value received is the target’s standalone value (reflected in the pre bid price) plus any synergies. Thus, the acquirer’s net value received is synergies less the premium. Premiums are, however, a fact while synergies are an opinion subject to behavioral bias.

As a rule of thumb, premiums exceeding 40% are prima facie evidence of overpayment. Think about it, a 40%+ premiums means you have to improve the target’s performance by over 40% just to breakeven. Unless, the target was grossly mismanaged, this will be difficult in a low growth highly competitive market.

The HP and MS acquisitions were grossly overpriced with premiums of 64% and 85% respectively. Such actions reflect desperate buyers gambling for redemption (AKA Hail Mary pass). Both HP and MS are former growth stars experiencing slumping sales growth and eroding margins. Their management teams, both of which have or will be replaced following their disastrous acquisitions, believed large transformational acquisitions would serve as a growth elixir. Unfortunately their shareholders were forced to drink from the poisoned chalice of value destruction.

j

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.