Every investor’s dream (especially mine) is you buy a stock, and then it gets taken out the next day, or shortly after. This has happened a few times in my career, and it always feels like hitting the jackpot. Okay, so it’s not like winning the Powerball jackpot. It’s more like hitting the all green lights on the way to work, jackpot. Now, if I was investing $100bn, it would feel pretty close to winning the Powerball:) Nonetheless, it’s still a good day when it happens.
Unfortunately, being on the right side of M&A doesn’t happen often enough. Because if it did, I’d be on some beach somewhere instead of at work. Although, maybe that’s a good thing because if it happened too often, the SEC would be knocking on my door.
Regardless of whether I own the acquirer or the target, the my first question, along with every other investor when a deal announced is, “Is this deal accretive or dilutive, and by how much?”
Importance of Accretion/Dilution
If you own stock of the acquirer, knowing the accretion from a deal is the most important question you need to answer because the stock MAY go up if a deal is dilutive, depending on the strategic fit. Investors will also consider the long-term benefits of a deal. However, the share price WILL almost always go up if the deal is accretive. That’s because if the EPS goes up and the multiple holds steady, then by definition the share price has to go up too.
If you own the target, understanding the accretion is especially important if you’re getting any stock in the deal. If you’re going to own a piece of the acquirer, you need to know how much numbers are going up. Even if the deal is all cash and you own the target, it’s still good to know how much accretion the acquirer is getting. Because if the accretion is too high, that means you just got shafted.
Below is my template for a basic accretion model. I know some analysts on the sell side that can’t properly compute accretion, so don’t feel bad if you’ve never done it before. It’s actually really easy once you have the template.
At the top of the template, I have a very generic income statement. On the right, I have the purchase price and breakdown between debt and equity to compute interest expense and share dilution. At the bottom, I have valuation metrics and margins, to see how these change with the new entity (NewCo).
There’s a reason that cell is blacked out. Revenue synergies are like fairies and unicorns – they’re don’t exist. You’re telling me a company needs to pay a 20-30% premium to acquire another company, just to get more cross-selling opportunities? You’re saying that this can’t be accomplished much more easily (and cheaper I might add) through a partnership?
Okay, so revenue synergies aren’t completely non-existent. But you certainly shouldn’t be baking any into estimates, since it’s impossible to verify.
I recently spoke with an analyst that brought up revenue synergies when we were discussing potential M&A for a company I cover. I told him that it would be like AAPL buyiing XOM so that they could sell iPhones at gas stations. His response was, “Why not?”
So if you’re looking to get into the sell side, the bar is apparently set VERY low.
It’s one thing to plug in numbers provided by management; it’s another to actually determine whether expected synergies are conservative or aggressive. Instead of looking at total costs, I like to break out COGS and SG&A. That’s because reducing COGS only comes with scale. For example, if one company is buying another and moving all that production onto one platform, I would expect substantial savings for COGS.
SG&A savings are generally straightforward. You fire some executives, consolidate headquarters, leverage an existing salesforce, reduce duplicate costs, etc.
I like to look at synergies as a % of NewCo expense to make sure estimates aren’t overly optimistic. It’s also good to compare to deals of similar size in the same industry to understand what can actually be accomplished. Some people like to look at the synergies as a % of what the target spends, but there can be some benefit to the acquirer as well, which is why I look at them as a % of the total company.
All deals will have an incremental interest expense component, unless the deal is all-stock. Sometimes, sell side analysts exclude this line when a company uses cash on hand. A company may not need to issue debt to do a deal, but that cash was generating income, however small. So if you’re looking at a deal that uses cash on hand, you should at least put in a nominal interest rate, like 1%.
It’s much harder to get tax synergies now that there are rules preventing inversions. That’s not to say that you can’t get any benefit, but I wouldn’t bake any benefit into estimates. Also, companies will be very reluctant to discuss tax synergies in an open forum, such as a press release or conference call, since that will invite scrutiny from regulators.
When calculating share dilution, it’s important to make sure you get the correct conversion ratio, the conversion price, and exactly how many shares will be issued as a result of the deal. If you’re off on the dilution, it can mess up your accretion analysis.
The proof is in the pudding. I usually focus on P/E, although there are some companies valued on EV/EBITDA. If the deal is accretive, valuation metrics will get cheaper. And remember, if the deal is accretive, the stock will almost always go up. And if it doesn’t at first, it will eventually.
Previously, I said that a stock will ALMOST always go up if a deal is accretive. Reasons why it won’t go up are if, a) the company is branching out into something completely different, or b) it’s putting on ridiculous amounts of leverage. Acceptable amounts of leverage vary by industry. I know some companies that have no issues levering up 7.0x, while others can only have 2.0x leverage.
In any deal, I always check the leverage in NewCo. isn’t ridiculously high, or else investors could be concerned about solvency issues.