There are several factors that are considered when a company contemplates a transaction
Return on investment
Entrance into new market
Acquiring new product
Impact on shareholder value
“ Soft” factors
Cost and revenue synergies
Economics of scale
Transaction Considerations Note: Survey taken of executives of 150 companies across many industries and various sizes. Source: Deloitte & Touche LLP and The Deal Survey Top 3 Evaluation Criteria When Making M&A Evaluations (1 being most important) Source: Deloitte & Touche LLP and The Deal Survey Synergies in Decision Analysis
The acquisition of a company creates shareholder value (increases the value of shareholders’ stock) as long as the fundamental value of the Acquirer plus the present value of the synergies is greater than the purchase price.
Typically the Acquirer initiates the negotiations when it contacts the Target’s management to find out whether the Target is interested in a partial or total sale.
Once the Acquirer and Target reach agreeable terms and receive board approval, the deal is presented to shareholders for final approval.
Accretion / Dilution model is used to assess the impact of an acquisition on the Acquirer’s earnings per share (EPS).
An acquisition is accretive when the combined (pro forma) EPS is greater than the Acquirer’s standalone EPS.
Example: Lets say that the Acquirer’s EPS is projected to be $2.50 next year. You want to know the impact of the acquisition of a potential Target, and determine that the pro forma EPS next year would be $2.60, $0.10 higher than if the acquisition had not taken place. The deal would be $0.10 accretive next year.
An acquisition is dilutive if pro forma EPS would have been lower than $2.50.
A transaction would be considered breakeven if there is no impact to EPS.
Accretion / Dilution Defined Accretion: Pro forma EPS > Acquirer’s EPS Dilution: Pro forma EPS < Acquirer’s EPS Breakeven: No impact on Acquirer’s EPS
Introduction - - Accretion / Dilution Illustration: Dilution Assumptions: Acquirer purchases 100% of Target by issuing additional stock to purchase Target shares. No premium is offered above Target’s current share price.
Introduction - - Accretion / Dilution Illustration: Breakeven Assumptions: Acquirer purchases 100% of Target by issuing additional stock to purchase Target shares. No premium is offered above Target’s current share price.
Introduction - - Accretion / Dilution Illustration: Accretion Assumptions: Acquirer purchases 100% of Target by issuing additional stock to purchase Target shares. No premium is offered above Target’s current share price.
Adjustments to the Income Statement - - Stock-for-Stock Acquisition
When a company acquires 100% of its Target, the line items of both companies, including net income, are consolidated.
We must take into account transaction-related adjustments when modeling the pro forma income statement
The Acquirer can acquire a potential Target by exchanging its shares (stock-for-stock), paying cash (cash-for-stock), or using a combination of both (cash and stock).
The issuance of new Acquirer stock is a major adjustment to EPS in a stock deal.
In a 100% stock-for-stock acquisition, the Acquirer will issue enough shares to purchase all of the Target’s stock, thereby reducing pro forma EPS. The ratio of the Acquirer’s shares issued per Target share is called the exchange ratio.
Adjustments to the Income Statement - - Cash-for-Stock Acquisition
New Acquirer Debt
When the Acquirer purchases the stock of a Target with cash, it will typically do so through the raising of debt. This new financing impacts the income statement in the form of incremental interest expense, which is a major adjustment to net income and EPS.
When the Target has existing debt on its balance sheet, the Acquirer may refinance this debt. Interest expense from the existing debt must be eliminated and the new interest expense must be accounted for in the pro forma income statement.
Acquirers typically use excess cash and liquid securities to finance a transaction. Since this existing cash would typically earn interest income, we must eliminate the benefit of interest income in the pro forma income statement.
Adjustments to the Income Statement - - Synergies
Synergies represent cost savings or additional revenues that arise from an acquisition. The impact of synergies is to increase net income and EPS.
Cost Saving Synergies
Merging two companies can result in the elimination of overlap of workforces, PPE (plant, property, and equipment), and other unnecessary infrastructure.
If two companies combine similar technology/intellectual property, they may be able to significantly increase revenue with new products and cross-selling opportunities.
Revenue Costs = Shareholders
Adjustments to the Income Statement - - Additional Adjustments
All outstanding Target options usually vest in an acquisition.
In-the-money options are assumed to be exercised and the Acquirer receives option proceeds and uses them to acquire more shares.
When building the pro forma model, we can assume that the Acquirer will use the proceeds to buy back as many Target shares as possible (treasury stock method), or we can assume that the Acquirer will keep the proceeds as cash.
If the treasury stock method is assumed, we would need to reflect the diluted shares outstanding [additional shares outstanding from options – shares repurchased from options proceeds]
If we assume that the Acquirer keeps the proceeds as cash, we need to take into consideration the incremental interest income that is generated by cash from the proceeds.
When an Acquirer uses debt to finance a transaction, the fees related to the raise are capitalized and amortized over the life of the debt issuance.
This creates an incremental amortization expense which reduces pro forma EPS.
Adjustments to the Income Statement - - Additional Adjustments
Incremental D&A, Asset Write-ups, Write-downs:
Assets, such as PP&E and intangible assets, are usually written-up to fair market value. Incremental D&A will be recorded thereby reducing EPS. Other assets and liabilities are also adjusted to fair market value and can also decrease/increase EPS depending on whether the assets or liabilities are written-up/written-down.
Include investment banking advisory fees, legal fees, and accounting fees.
Currently included in the calculation of purchase price (reflected in goodwill).
No explicit impact on EPS from these fees since they are part of purchase price.
New Rule – FASB has recently changed the rules on such fees. Instead of including them in the calculation of purchase price, they will be expensed as incurred on the income statement.
In-process research & development – companies must capitalize in-process R&D instead of expensing it on the income statement.
Registration fees – directly netted out of equity
Restructuring and merger-related costs – immediately recorded as a liability
Traditional Deal Structures - - Exchange Ratios
The period of time between the announcement date and the closing date of a transaction usually results in the movement in acquisition share price, and also introduces a level of uncertainty when an Acquirer pays for a Target with stock instead of cash.
Fixed exchange ratio or floating exchange ratio
The choice of a fixed exchange ratio as opposed to a floating exchange ratio (fixed value) mechanism determines whether the number of shares or the value of the shares fluctuates.
FIXED EXCHANGE RATIO Shares issued are known; value of transaction is unknown FLOATING EXCHANGE RATIO Value of transaction is known; shares issued are unknown
Traditional Deal Structures - - Fixed Exchange Ratio: Example
Fixed exchange ratio is used for converting each Target share into a set number of Acquirer shares upon closing:
Target has 30 million shares outstanding with shares trading at $10; Acquirer shares are trading at $20.
On February 5, 2008 (“Announcement Date”), Acquirer agrees that upon the completion of the deal (expected to be March 5, 2008), it will exchange 0.85 shares of its common stock for each of Target’s 30.0 million shares, totaling 25.5 million Acquirer shares.
Between the announcement date and the closing date, the ratio of shares will stay fixed.
On the announcement date, the deal is valued at 25.5 million shares * $20 per share = $510 million. Since there are 30.0 million Target shares, this implies a value per Target share of $510 million / 30.0 million = $17. That is a 70% premium over the current trading price of $10.
By March 5, 2008, Target’s share price jumps to $17 because Target’s shareholders know that they will receive 0.85 Acquirer shares (which are worth $20 * 0.85 = $17) for each Target share.
Traditional Deal Structures - - Floating Exchange Ratio (Fixed Value): Example
Fixed value is based on a fixed per share transaction price. Each Target share is converted into the Acquirer shares and is required to equate to the pre-determined per Target share price upon closing.
Target has 30 million shares outstanding with shares trading at $17; Acquirer shares are trading at $20.
On February 5, 2008, Target agrees to receive $17 from Acquirer for each of Target’s 30.0 million shares (1 : 0.85 exchange ratio) upon the completion of the deal, which is expected to be on March 5, 2008.
As previously described, the deal is valued at 30 million shares * $17 per share = $510 million.
This value will be fixed regardless of what happens to the Target or Acquirer’s share prices. The amount of Acquirer shares that will have to be issued upon closing will change with the changing share prices to maintain a fixed deal value.
The floating exchange ratio is generally preferred by the Target because the issuance of a fixed value per share means the Target knows exactly how much it is being compensated.
Traditional Deal Structures - - Collars, Caps, and “Walk-aways”
Collars may be included with fixed or floating exchange ratios to limit potential variability that occurs due to changes in the Acquirer’s share price.
Fixed Exchange Ratio Collar
Sets a maximum and minimum value for fixed ratio transactions.
If an Acquirer’s share price goes up or down beyond a specified point, the transaction turns into a floating exchange ratio.
Collar establishes minimum and maximum price that will be paid per Target share.
When above the maximum Target price level, an increase in the Acquirer share price will result in a decreasing exchange ratio (fewer shares issued).
When below the minimum Target price level, a decrease in the Acquirer’s share price will result in an increasing exchange ratio (more Acquirer shares issued).
Traditional Deal Structures - - Collars, Caps, and “Walk-aways”
Floating Exchange Ratio Collar
Maximum and minimum shares issued for floating exchange ratio transactions. If Acquirer share price goes up or down beyond a specified point, the transaction will turn into a fixed exchange ratio.
Collar establishes minimum and maximum exchange ratio of shares that will be issued for a Target share price.
If below a certain Acquirer share price, exchange ratio will stop floating and will become fixed at a maximum ratio. Any decrease in Acquirer share will result in a decrease in value of each Target share.
If above a certain Acquirer share price, the exchange ratio will stop floating and become fixed at a minimum ratio. Any increases in Acquirer’s share price will result in an increase in the value per Target share, but a fixed number of Acquirer shares is issued.
“ Walk-away” Rights
This provision allows parties in a deal to walk away from the transaction if Acquirer’s stock falls below a certain predetermined minimum trading price.
Corporate M&A Conceptual Framework - - Sources and Uses of Funds To illustrate the dynamics of an M&A transaction, bankers will create a table that highlights the sources and uses of funds.
Stock Issued: Companies often finance acquisitions by issuing their own shares. (Acquirer Shares in Transaction) x (Acquirer Stock Price)
Acquisition debt: Companies usually raise debt to pay for acquisitions.
Debt raised =
Offer value – stock issued – excess cash used
Purchase of Equity: Equals Offer Value
Cash to Target
Stock to Target
Deal-related transaction costs
Debt-related financing fees
In addition to governing accounting rules, there are also important legal and tax issues that influence the corporate M&A framework. Corporate M&A Conceptual Framework - - Corporate M&A Components Corporate M&A Accounting Legal Tax
Allows parties to assess
Pro forma financial statements
HSR / Antitrust regulations
Structuring definitive agreements
Tax consequences when structuring a deal
Sale of assets
Sale of stock
Corporate M&A Conceptual Framework - - Types of Corporate Mergers Aerospace and Defense Aerospace Aftermarket Supply-chain Management Consumer Products Consumer Products Customers Suppliers Competitors No relationship Competitors No relationship Vertical Merger Horizontal Merger Conglomerate Merger
When a corporation chooses to sell off all its assets to another company, it becomes a corporate shell with cash and/or securities as its sole assets. The firm may decide to distribute the proceeds to its stockholders as a dividend and shut down completely.
The proceeds can also be distributed through a cash repurchase tender offer, meaning the firm makes a tender offer for its own shares using the proceeds of the asset sale to pay for shares.
The firm may also choose to continue to do business and use its liquid assets to repurchase other assets or companies.
A joint venture is another type of business combination.
A joint venture takes place when certain firms enter into an agreement to provide certain resources toward the achievement of a particular business goal.
A majority of shareholders must provide their approval before a transaction can be consummated.
A common threshold for common majority is 51%.
When a majority of shareholders approve the deal, minority shareholders are required to tender their shares, regardless of whether or not they approve of the deal.
Minority shareholders are said to be “frozen out” of their positions.
This requirement is designed to prevent a holdout problem, which sometimes occurs when a minority shareholder holds up the completion of a transaction unless they are compensated over and above the acquisition stock price.
Closing the deal is often only the first step in the battle. To capture all of the projected post-deal synergies, public companies spend significant time executing the integration of the operations. If the integration is not done correctly, the acquisition can very well be dilutive to the company. Oftentimes, it takes two to five years (or longer) for an Acquirer to realize the synergies in combining with a Target. Management, shareholders and board members recognize the difficulties involved in integration. What is acquisition integration? Why is acquisition integration so important? When does the process occur? What are the necessary steps to complete a successful integration? - - The Deal is Closed. What now? Acquisition Integration Topics
Acquisition integration can be defined as the combining of two companies, through changes of ownership such as mergers, acquisitions and takeovers, to include their customers, organizations, processes, products and employees to form a larger, more powerful organization.
In simplified terms, it means making 1 + 1 = 3.
How is that achieved? By identifying synergies.
Common synergies include:
Headcount reduction in departments with parallel capabilities (i.e. admin, it support, etc.)
Successful integration enables clients to achieve their business case objectives for doing the acquisition.
Enables a company to grow more rapidly.
However, in reality it is difficult and often unsuccessful. Common consequences of failed integration are:
Lost focus on core business
Lost image in the market place
All of these may result in hesitancy to do M&A deals in the future.
- - Acquisition Integration
Acquisition Integration – When does it Occur? Announcement - - Acquisition Integration Closing Final Negotiations “ Quiet Period” Regulatory Due Diligence Post-Acquisition Execution Right Here and… Right Here Integration Planning
Acquisition Integration – How to Get it Right The process used for post-merger integration often differentiates experienced, successful Acquirers from value destroyers. The key is to find the right balance between speed and thoroughness. Although it is important to realize the potential synergies quickly, ideally in the first 12 to 18 months, executives often declare victory too quickly and rush to return to “business as usual,” leaving synergies unexploited. A disciplined and well-structured integration plan is vital to success. Communicate the vision and business logic of the deal – Employees and other pivotal stakeholders, including investors, must understand the strategic rationale, business objectives, and post-merger integration milestones and targets. Senior management should lead the implementation. Separate the post-merger integration from the core business – Post-merger integration needs its own organization, with a dedicated team of executives and faster than usual governance and decision-making processes. Correct allocation of resources is especially important where there are mission-critical functions. Monitor core business performance – Establish early warning systems to alert management to any falloff in revenue or profitability in the core business. - - Acquisition Integration
Acquisition Integration – How to Get it Right (Continued) Proactively manage the soft issues – Post-merger integration isn’t just a numbers game. The process involves complex organizational and cultural changes. Identify key staff and design strategies to keep them on board as they are the value of the franchise. Handle new appointments with care. Move before the close of the deal – There are a lot of actions that can be taken in advance (prior to the close), that enable you to realize the benefits of the transaction immediately after it is finalized. Challenge decisions and assess progress after completion – During a post-merger integration, companies often make decisions on pragmatic or political grounds, resulting in inflated costs. Revisit those decisions and question their contribution to the company’s value-creation potential. When a post-merger integration is successful, the payoff can be striking. A rigorous approach may enable an Acquirer to even exceed its synergy demands and earn the shareholder’s respect and confidence in the company. - - Acquisition Integration
Case Study - Introduction Consolidated Communications Acquires North Pittsburgh Systems, Inc. for $375.1 Million Announcement Date: July 1 st , 2007 183 days Closing Date: December 31 st , 2007 Acquirer: Consolidated Communications provides communications services to residential and business customers in Illinois and Texas. It offers a range of telecommunications services, including local and long distance service, custom calling features, private line services, dial-up and high-speed Internet access, digital television, carrier access services, network capacity services over its regional fiber optic network, and directory publishing. Target: North Pittsburgh Systems, Inc. is a local network services, including local dial tone service, custom calling features, and local private line services to residential and business customers; and network access services, which comprise access to its switched access facilities for the completion of interstate and intrastate long distance toll calls and extended area service calls, as well as access to private line network facilities for use in transporting voice and data services to interexchange carriers, cellular mobile radio service providers, and other local exchange carriers. - - Acquisition Integration
Case Study – Acquisition Rationale - - Acquisition Integration Source: Consolidated Communication 7/2/2007 8-K SEC Filing Pennsylvania market 357 employees 63,000 access lines Superior broadband technologies Video service Local brand name equity Illinois and Texas market 1,100 employees 232,000 access lines 64,000 broadband connections IPTV technology Telemarketing services Business services
Case Study – The Transaction - - Acquisition Integration Advisors Consolidated Communications Legal – Schiff Hardin Financial – Wells Fargo North Pittsburgh Systems, Inc. Legal – Hughes Hubbard & Reed Thomas, Thomas, Armstrong & Niesen Financial – Evercore Partners Source: Capital IQ Transaction Values Total Consideration to Shareholders ($ mm) 375.13 Total Transaction Size ($ mm) 395.38 Implied Equity Value ($ mm) 375.13 Implied Enterprise Value ($ mm) 347.97 Implied Equity Value/LTM Net Income 25.0x Implied Enterprise Value/Revenues 3.5x Implied Equity Value/Book Value 3.8x Implied Enterprise Value/EBITDA 7.6x Exchange Rate 1.000 Offer Per Share ($) 25.00 Consideration to Shareholders ($ mm) 375.13 Total Cash ($ mm) 300.10 Premium (1 week Prior) 21.1% Total Stock ($ mm) 75.03
Case Study – The Transaction (Cont.) - - Acquisition Integration 17.6% premium over market trading price on day of Definitive Agreement Not subject to collars $11.25 million break-up fee Source: Capital IQ North Pittsburgh 7/2/2007 8-K SEC Filing The Purchase Other Terms Financing Cash on hand and debt financing from Wachovia Synergies Operating synergies $7 million in 2008, $11 million in 2009 and beyond 6.0% accretive to cash flow after first full year of operations
Case Study – Results - - Acquisition Integration
Operating synergies exceeded the projected $7 million for the first year
On track to exceed $11 million in projected synergies for the second year
10% lower capital expenditures over previous year (2008 compared to 2007)
Rolled out most successful IPTV launch in history in Pennsylvania
Growth of 6.6% in Pennsylvania access lines exceeded the projected 5.0% growth
Management believes there are still significant opportunities to cut costs within the combined company
Building cash balance, considering another acquisition
“ We'd love to do another North Pittsburgh” - Robert Curry, CEO on Nov 05, 2009 Earnings Call
Case Study – Stock Performance - - Acquisition Integration Consolidated Communications outperformed the S&P 500 by 50% over this time period Relative Stock Performance 1-year after Acquisition to Today (January 1, 2009 -April 23, 2010) SPX closed 34.6% higher on April 23, 2010 compared to January 1, 2009 price CNSL closed 84.6% higher than January 1, 2009 price on April 23, 2010
- - Appendix Note: The companies used as targets in these examples are fictitious and presented for illustrative purposes. Any resemblance to actual companies is unintended and purely coincidental.
Valuation of Target Co. Valuation Methodologies
Comparable Company Analysis
Similar operating/industry characteristics
Apply relevant valuation multiples
Precedent Transaction Analysis
Similar operating/industry characteristics
Apply relevant valuation multiples
Discounted Cash Flow (“DCF”) Analysis
Develop five-year projections
Exit multiple and cost of capital methodology
Sensitivity analysis for key assumptions
Valuation Analysis - -
Develop projections for Target and Acquiror
Determine combined company synergies
Analyze transaction with respect to earnings
*The companies used as targets in these examples are fictitious and presented for illustrative purposes only. Any resemblance to actual companies is unintended and purely coincidental.
Implied Valuation of Target 2 *The companies used as targets in these examples are fictitious and presented for illustrative purposes only. Any resemblance to actual companies is unintended and purely coincidental. Valuation Analysis Valuation Methodologies - -