What's the most important thing for a listed company to focus on when considering an acquisition?
The following quotes from four different ASX listings in the past month indicates that there is almost a consensus that deals must be structured to increase Earnings Per Share (EPS):
"The acquisition is expected to be significantly EPS accretive in FY2020".
"Our business is expected to be EPS accretive in 2020 though once integration... is complete and the cost synergies are realised."
"Only transactions which are EPS accretive will be considered".
"The improved offer terms will be EPS accretive in the event the cost savings and synergies... are able to be realised".
In simple terms, in order for an acquisition to increase earnings per share, it must be acquired on a lower earnings multiple than the buyer. As some of the quotes above show, buyers will often factor cost savings and synergies into their estimate of the earnings per share contribution. Some are more conservative.
This view that earnings must be bought on lower multiples than the acquirer's current valuation metrics is also essentially the premise of the classic "roll-up" model where a company targets a fragmented industry and looks to buy small private businesses at, say, five times (5x) earnings then expects the market to value the consolidated group at, say, 10x earnings.
Earnings ain't Earnings
"Oils ain't Oils", Castrol used to tell us through the television set. It was talking about synthetic oils relative to natural oils. We're talking about lower quality earnings relative to higher quality earnings.
There's no fundamental reason why poor quality earnings worth 5x suddenly double in value just because they are now owned by an entity that also owns a business with higher quality earnings the market thinks are worth 10x.
There is some valuation support from being listed because investors are expected to value liquidity but the magnitude of the hoped-for re-rating requires a more substantial justification.
In the absence of some kind of special synergy, the market should continue to price the two earnings streams on roughly the same multiples they possessed before the combination. Given the risk that a buyer may have overpaid, one could even argue for a lower multiple on the target company's earnings.
In what circumstances would an acquisition result in an upward revaluation of the target's earnings? Smash repair leader AMA Group comes to mind as an example. It bought smash repair sites that it could then push additional work through from the insurance companies it had existing relationships with; and at the same time it benefited from increased buying power with its suppliers.
Adding to EPS but losing value almost half the time
A couple of years ago, Credit Suisse took a sample of 95 M&A deals, categorised them based on whether the buyer said the deal would be immediately accretive or dilutive to EPS, then reviewed the one-day abnormal return for the buyer on the day of the announcement.
The summary table from Credit Suisse, reproduced below, shows that:
- Roughly three-fourths of the deals had a neutral or negative impact on shareholder value.
- The bottom row reveals that 27 percent of the deals in this sample created shareholder value.
- The box in the upper right corner shows that almost half of the deals add to EPS but subtract from value!
This analysis is limited as it reflects the market's immediate reaction to a deal and not what happened over the longer term. But it clearly shows that investors are looking for something more than the phrase "EPS accretive" when an acquisition is announced.
Whilst not referenced, do you think a bit part of the lower 1 day return (or short term "value destruction") is a function of a lot of acquisitions being made in conjunction with relatively large placements?
In some cases that would definitely be correct - the issue of discounted stock to fund an M&A deal may immediately result in a weaker market price. But if the deal is perceived to be value creating, the discount should be small and the stock should be in demand when trading recommences. What the stats presented don't show is what happens to value creation over the longer term. I'm biased to what consultants AT Kearney wrote on the EPS accretion approach: "In the same way a Ponzi scheme must eventually fail due to the lack of underlying value creation, the P/E multiple of the acquiring company must fall as it becomes increasingly evident to the market that no value is created."
That makes sense. I agree with that quote. Many roll-ups are largely P/E arbs whilst some high growth business may use it to plug growth shortfalls if their runway comes forward a little early to investor expectations. A rule my former boss reiterated was if you do invest in a roll-up, always know when the the music stops.