Earnings Dilution - A Real or Imagined Problem?

A good deal is one that is expected to produce a positive net present value.  That is, it is worth more than it costs.  But what about a deal that has a positive net present value and results in earnings dilution next year?  Is this possible?  If so, is this still a good deal?  Are there any ways to avoid dilution?  In a share for share exchange, how can we tell the maximum number of shares that an acquirer could issue without causing dilution?

Can a deal with a positive net present value cause immediate dilution of earnings?  Absolutely.  If we issue enough shares to acquire a target and the shares are not offset by an appropriate increase in next year's earnings, dilution will occur.  By NPV terms, the deal is still a good one if the expected net present value is positive.  It is just that the value and cash flows appear later in time.  Nevertheless, the dilution in eps creates a very real perception that the firm is declining.  Shareholders without privy to the stream of expected cash flows or NPV calculations can assume that the acquiring firm is in a downward trend.  Hence, dilution creates a very real problem.

How to avoid it?  A first solution is not satisfying: don't acquire targets where dilution would occur.  This results in missing great opportunities if the deal is indeed a positive NPV.  A better approach is to structure the deal so that dilution does not occur.  This is done by issuing fewer shares and substituting cash or debt to complete the payment.  Deferred or contingent payouts can also help in this regard.  

How can we know if dilution will occur?

1.  Estimate projected eps without the deal
2.  Estimate projected total earnings with the deal
3. Divide the projected total earnings by projected eps in step 1.  This tells you the maximum number of shares you can have outstanding without dilution
4. From this maximum number of shares, subtract the current shares outstanding of the acquiring firm.  This tells you the maximum number of shares you could give the target without dilution.
5. Divide the number in item 4 by the number of target shares currently outstanding.  This gives you the maximum exchange ratio without dilution.  

As an advanced concept, you could expand this maximum using free cash flow generated by the target in the first year after acquisition although you'd be giving away some value.  To do this:

6. Calculate how many shares of the acquiring firm you could acquire using the target's first year free cash flow.  Add this to the maximum number in item 4 and recalculate item 5.

All the best,

Ralph

Acquisition Risk, Collars and the Comcast Time Warner Deal

An article in yesterday’s Wall Street Journal illustrates one of the risks in stock swap acquisitions – by the time the deal closes the stock price of either target or bidder could change, sometimes dramatically.  What once looked like a good deal could now fall apart.  In this case, the article notes that Comcast’s stock price has dropped nearly 10% since the deal was announced, reducing the value to Time Warner shareholders from $159 per share to $144 per share.  The deal is set to close in the summer.   By that time Comcast’s price could recover – or it could drop further.  Meanwhile Charter Communications waits in the wings with threats to renew its own bids for Time Warner.

One of the topics that always draws considerable interest in our Acquisition Course in Amsterdam is how to mitigate risk in acquisitions.  In the case of the Comcast – Time Warner deal, the risk associated with the change in stock prices could be mitigated through the use of collars.   A collar, comes in various forms, but basically outlines how the value of an offer must change with variations in stock price at deal completion.

The two basic forms of a collar are illustrated below in a chart from an article by Micah Officer.   The formal names of Fixed Exchange Collar and Fixed Price Collar are illustrated graphically by the diagrams and humorously by Micah’s nicknames of Travolta’s and Egyptian’s, respectively.  (Presumably, one can imagine John Travolta striking a similar pose as panel A in Saturday Night Fever.)

Panel A shows the fixed exchange-ratio collar.  This is the most basic collar, setting a minimum and maximum share price at which a deal would be completed.  Imagine striking a deal somewhere in the middle of the chart on the sloped portion of the payoff line.  Small deviations in the bidders stock price produce deviations in the value received (paid) by target (bidding) shareholders at deal completion.  Both sets of shareholders receive some protection from extreme swings in stock price, however. If the bidder’s stock price has increased at deal completion, target shareholders gain and bidding shareholders pay more, but only up to a pre-determined threshold.  Beyond that threshold, the maximum price is reached, illustrated by the upper, horizontal line.   

Conversely, a drop in the bidder’s stock price at deal completion results in target shareholders receiving less and bidding shareholders paying less, but again, only to the point of a pre-determined threshold.  In this case, the lower barrier identifies the minimum value that target shareholders would receive.  Thus, bidders are protected on the upside and target shareholders are protected on the downside.

Perhaps more difficult to understand is the fixed price collar.  In this case the amount received and paid is fixed within a given middle range but varies at the extremes.  Thus, target and bidder are certain of the deal price in some (perhaps plausible) range.   Beyond the thresholds, however, target and bidding stockholders share upside gains and downside losses in response to changes in the bidder’s stock price at closing.   (Still, it is hard to imagine target shareholders suffering extreme losses on the downside without at least trying to walk away from the deal.)

In the case of Time Warner shareholders, there is currently no collar in place.  It will be interesting to watch the vote for approval in the summer if Comcast’s stock price remains low.

All the best,

Ralph