Mergers & Inquisitions: Merger Models

Walk me through a basic merger model

-Make assumptions about price and payment method (cash, stock, debt, combo)

-Determine valuations and shares outstanding of the 2 companies and project out Income Statements

-Combine Income Statements to get Combined Net Income and divide by the new share count to get the combined EPS

Why would a company want to acquire another company?

-Buyer wants to gain market share

-Buyer wants faster growth

-Buyer believes seller is undervalued

-Buyer wants to acquire seller's customers for up-selling and cross-selling

-Buyer thinks seller has a critical technology or IP

-Buyer thinks it can achieve synergies

Why would an acquisition be dilutive?

Dilutive if the Net Income contribution of the seller doesn't offset the buyer's forgone interest on cash, additional interest paid on debt, and effects of issuing additional shares.

How to calculate whether an acquisition is accretive or dilutive

Cash & Debt: Sum up interest expense for debt and forgone interest on cash, then compare it to the seller's pre-tax income

All-Stock: If buyer has higher P/E than seller, it will be accretive

Cash, Debt, and Stock: no rule of thumb. Do the math.

Intuition behind accretion and dilution

Accretive if you are paying less for earnings than what the market values your own earnings at.

Complete effects of an acquisition

1) Forgone Interest on Cash--buyer loses interest it would have otherwise earned on the cash used

2) Additional Interest on Debt--buyer pays additional interest expense if it uses debt

3) Additional Shares Outstanding--If buyer pays with stock, it must issue additional shares

4) Combined Financial Statements--Seller's financials are added to the buyer's post-acquisition

5) Creation of Goodwill & Other Intangibles--Balance Sheet items that represent the premium paid to the company's fair value

Why would a buyer decide not to use 100% cash even if they had the capability?

Might be saving cash for other purposes or might want it in case business takes a turn for the worse. Might want to use stock if stock is trading at a high price.

Why would a strategic acquirer be willing to pay more for a company than a PE firm (financial buyer)?

Because the strategic acquirer can realize revenue and cost synergies and PE can't.

What is the difference between Goodwill and Other Intangible Assets?

-Goodwill: Stays the same over years and isn't amortized. Only changes if there's a goodwill impairment.

-Other Intangible Assets: Amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line.

Any other intangible things besides Goodwill & Other Intangibles that could impact the combined company?

Purchased In-Process R&D Write-Off: R&D projects that were purchased in the acquisition but are incomplete

Deferred Revenue Write-Off: Seller has collected cash for a service but hasn't recorded it as revenue, so buyer must write-down value of Deferred Revenue to avoid double-counting revenue

What are Synergies and what are the 2 main types?

Synergies = buyer getting more value from acquisition than financials would predict

Revenue Synergies = Combined company can cross-sell or up-sell, potentially also expand into new geographies

Cost Synergies = Combined COGS or Operating Expenses are reduced, which boosts Net Income and raises EPS

Which type of synergy is more important?

Cost synergies are taken more seriously because they're easier to predict--it is straightforward to see how supply chain can be optimized

All else equal, which method would a company prefer to use when acquiring another company: cash, stock, or debt?

Would always prefer to use cash

-cheaper than debt because forgone interest is usually less than interest expense from debt

-cash is less risky than debt because there's no chance buyer will fail to raise sufficient funds from investors

-generally stock is a more expensive way of financing a transaction, plus stock price can fluctuate once the acquisition is announced

How would you determine the Purchase Price for the target company in an acquisition?

Use the regular valuation methodologies, than apply a premium (usually 15-30%) to win shareholder approval

What usually happens if a company overpays for another company?

High amount of Goodwill & Other Intangibles, sometimes followed by a large goodwill impairment if the buyer decides it overpaid

A buyer pays $100 for a seller in an all-stock deal, but the next day the market decides it's only worth $50 million. What happens?

Buyer's share price falls by whatever per-share dollar amount corresponds to the $50 million loss in value

How much debt could a company issue in a merger?

Look at Comps or Precedents.

Use combined company's Last Twelve Months (LTM) EBITDA and find the median Debt/EBITDA ratio and apply it to your own EBITDA. Also, look at Debt Comps for companies in the same industry and see what types of debt and how many tranches they've used.

Why do most mergers fail?

-Difficult to integrate companies

-Deals done for the wrong reason, i.e. CEO ego or shareholder pressure

What role does a merger model play in deal negotiation?

A company would never decide to do a deal based simply on the model output. It is a sanity check/rough guideline

What types of sensitivities and variables do you look at in a merger model?

Variables would be: Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies

Sensitivity tables would show EPS accretion/dilution at diff ranges for: Purchase Price vs. Cost Synergies, Purchase Price vs. Revenue Synergies, Purchase Price vs. % Cash, etc.