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Analysis of Acquisitions

Chris Argyrople, CFA

Concentric

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What Happened to Neiderhoffer?

• Victor Niederhoffer, a famous trader who wrote a heavily promoted book on trading and the markets, lost all of his investors $130 million dollars in the summer of 1997.

• WHAT HAPPENED? He had a ten year track record of compounding capital at 35%

• He lost about 45% of his investors money in July, betting on the Thailand Baht

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Niederhoffer Didn’t Re-Evaluate

• Niederhoffer didn’t slow down• Instead, after losing 45%, he wrote puts on

the S&P !!• The press intimated that he wrote the puts

to generate cash to pay margin calls.• Writing the puts probably requires extra

margin, so the newspapers were probably wrong.

• Never try to gamble out of the casino.

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Long Term Capital Management

• Same problem as Neiderhoffer.

• Should have re-evaluated.

• They took on too much leverage.

• Risk is a good thing

• TOO MUCH RISK IS DEALDLY

• THERE IS A DIFFERENCE

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Investing Rule #1

• If you lose 50% of your capital, you must double your money JUST TO BREAK EVEN !!

• Thus, Preservation of Capital is RULE #1• A good rule is to SERIOUSLY EVALUATE

what is going on at each 10% interval.• Thus, slow down when you are

– Down 10% - Down 30%– Down 20% - Think about shutting down @ 40%

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Today in the Markets: BSX

• Boston Scientific stock was down $6 before being halted. (11/3/98)

• BSX announced accounting irregularities at its Japanese subsidiary that resulted in $40 - $50 million of improperly booked 1998 sales. WAS IT $40 or $50 ???

• On Oct 23rd, they announced that they were delaying Q3 financial reports because of accounting issues at a newly acquired unit purchased for $2.1 billion.

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Accounting and BSX

• On October 23rd, Joe Kernan, on CNBC, said something like : “usually announcements about accounting irregularities are never the end of the story.”

• I thought to myself: “Joe is right, BSX is a good short candidate, there are more accounting problems upcoming from BSX.”

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Disney, Barrons Accounting

• Barrons claimed Disney overstated EPS by creating $2.5 bil reserve for ABC Purchase

• CSFB Response: Bought ABC for $19 b

• Sold assets for $3 b

• 80% of ESPN is worth $12 b

• Thus, ABC Network, radio & tv bought for $4 billion, these 3 throw off $1.1 b EBITDA

• In a few years, ESPN will be worth $19 bil, thus making accounting irrelevant

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Acquisitions

• Two types of Acquisition Accounting:– Purchase Accounting– Pooling Accounting: Not allowed anymore BUT

effects are still in the market

• Goals of a Merger– Empire Building (usually a bad sign)– Strategic Fit (either horizontal or vertical)– Financial (breakup or cost-cutting)– Growth for acquirer

• Mergers are additive (accretive) or dilutive

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Anecdotes on Mergers

• Wall Street loves accretive deals.

• Wall Street hates dilutive deals more than it loves accretive deals.

• Acquisition of intellectual capital fails at a much higher rate than purchase of operational assets. Example: – Software firms: Employees often leave or can’t work

under the new culture. Thus, beware of software acquisitions, even if strategically the fit looks good.

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Bootstrapping

• Bootstrapping is when a high P/E firm takes over a low P/E firm. This creates EPS, but, financial theory says investors aren’t fooled. Why? You have 2 separate pies. By combining them, you do not get more pie.

• Does this work? What do you think?

• Do you agree with Financial Theory?

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Bootstrapping in Real Life

• Two industries I follow: Waste Disposal and Broadcasting appear to have created some intermediate value through bootstrapping. How?

• High P/E firms (commanding public multiples) take over privately held firms that do not have the liquidity premium of publicly held stock.

• Then, they integrate the operations cut duplicate overhead costs (adds real value)

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So, where is the Value Added?

• Value is Added by:• Elimination of Duplicate overhead• Better Market Position• Integrated Assets are more efficient than 2

competing firms. This is especially true in the waste industry: 2 trucks going down separate sides of the street.

• Professional Management running both firms (assuming acquirer is smarter)

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Is 1 + 1 = 3 ?? Pooling DealCase 1 Case 2

Parentco Targetco New Co New Co

Revenues 200 100 300 300EBITDA 30 30 60 60Depreciation -20 -10 -30 -30Interest -7.5 -3.5 -11 -11Taxes -1 -6.6 -7.6 -7.6NI 1.5 9.9 11.4 11.4Shares 30 10 40 40EPS 0.05 0.99 0.285 0.285

Share Price 15 15 15 17Shares 30 10 40 40Debt 75 35 110 110TEV 525 185 710 790

TEV / Revenue 2.63 1.85 2.37 2.63 TEV / EBITDA 17.50 6.17 11.83 13.17 EBITDA Margin% 15% 30% 20% 20%

Case 1: Market not Fooled, no Value Creation with BootstrappingCase 2: Market thinks Value is Created from the Combination

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Purchase Accounting

• Assumes a change of control, i.e. one firm buys another.

• Assets and Liabilities of the Target Firm are added to Parent

• Assets and Liabilities of Target Firm are written up to fair market value (usually based on acquisition purchase price)

• Usually a taxable event.

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Purchase Accounting Rules

• Income Statement is not historically adjusted or re-stated. Target firm’s results are included as of the purchase date (and forward)

• Goodwill is the amount that the purchase price exceeds the revised equity value (assets less liabilities). If the value of the target equity is greater than the purchase price, the equity (assets less liabilities) will be written down to equal the purchase price, and no goodwill is recorded.

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Pooling Accounting Outlawed

• Need to Recognize the Effects of Pooling, since it is in historical data

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Effects of Pooling Accounting

• Historical results are restated going three years back to account for the merger (this facilitates easy comparisons)

• Balance sheets are added at historical cost. No goodwill is recognized, and there are no writeups of assets and liabilities.

• Generally not a taxable event

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How do we guage the deal?

• Number one concern -- is it accretive?

• Accretive on: – Prior / Historical, Current Year, Forward

Numbers?

• Is the deal accretive day #1 ?

• What cost reductions are necessary? Are they identified?

• Philosophical / employee issues?

• Who are the surviving managers?

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My thoughts on Mergers

• Sometimes the stock crashes when it shouldn’t:– USA / Western Waste (market didn’t believe /

understand cost cuts, thought growth was over

• Sometimes the market is way too exuberant:– Software & tech firms are particularly dangerous– The Learning Company was a disaster

• Key: Listen to the market, THEN DECIDE TO AGREE OR DISAGREE

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My thoughts on Mergers

• There are many deals, thus you must know how to analyze. Today’s mergers are often tomorrows spinoffs

• Accretive Deals are good. Qualifiers:– FIRM’S GROWTH RATE STAYS INTACT– COST CUTS REFLECT REALITY– REVENUES ARE NOT HURT BY COST CUTTING

• Dilutive deals are bad, BUT:– STRATEGIC DEALS CAN INCREASE MARKET

POSITION, EXAMPLE: NEWPARK’S MONOPOLY

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My thoughts on Mergers

• Huge value was created in many industries:– Waste Disposal– Broadcasting– Funeral Homes– Temporary Staffing– Haircuts (Regis / Supercuts merger was

interesting)

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Beware of Software Mergers

• Mergers based on “Human Capital” often do not work.

• Software cultures are difficult to integrate

• Which product survives after the merger?

• Who will run the combined firm?

• Will physical distance make it hard for the 2 employee bases to work together?

• Once people are rich, will they work hard?

• Cost cuts can destroy morale

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UW / WMX Merger (Mar 1998)USA Waste / WMX Merger

Combined(Pooled)

USA Waste WMX Company 2000E

Revenue 4,720 9,400 14,120 15,000 COGS (2,400) (5,700) (8,100) (8,250) SG&A (485) (985) (1,470) (1,500) Synergies 800 900 EBITDA 1,835 2,715 5,350 6,150 D&A (540) (1,200) (1,740) (1,800) EBIT 1,295 1,515 3,610 4,350 Interest Expense (200) (450) (650) (450) PBT 1,095 1,065 2,960 3,900 Taxes (438) (426) (864) (1,560) NI 657 639 2,096 2,340

Shares 258 455 587.9 587.9 EPS 2.55 1.40 3.57 3.98

Free Cash Flow

NI 657 639 1,296 1,935 D&A 540 1,200 1,740 2,940 Capex (500) (1,200) (1,400) (1,400)

Free Cash Flow 697 639 1,636 3,475

Synergies/Share 1.36 1.53

Assumptions

Synergies Easily MetAsset Sales Pay Down DebtFree Cash for Acquisitions or Debt Paydown

Calendar Year 1999

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USA Waste Deal -- Assumptions

• 800 million of synergies considered to be conservative. Here is the breakout:– Corp Overhead $225 million– Internalize Waste $175 million– Consolid Field Ops $400 million

• Internal Growth > 5%

• $600 million / year of tuck-in acquisitions

• Some Asset Sales (pooling prevents a lot)

• Sold the deal on “Operating EPS” :-)

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MOST ACQUISITIONS DON’T WORK

• Failed deals:

• AOL / Time Warner

• Daimler / Chrysler

• AT&T / NCR, AT&T / Media One

• Disney / ABC

• TYCO ( all of them ?? )

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The “Denominator” Problem

• Acquisition stories are called “Rollups”

• Management has “rolled up” many industries: Waste Mgt, Funeral Homes, Radio, etc.

• Rollup stocks ALWAYS crash

• You just don’t know if they crash in year 2 or year 10

• The problem is the denominator

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The “Denominator” Problem• In Year 5, YOU find out about it because it is now

big enough for Wall Street & the Media• By year 5, it is a “proven” 30% grower (all through

acquisitions by the way)• Then, it does 1 huge acquisition: a megadeal• Then, it can’t to grow anymore (barely 10% !!)

Year1 Year2 Year3 Year4 Year5 Year6 Year7 Year8

Revenue $50 $250 $450 $650 $850 $1850 $2050 $2250

Growth Rate 400% 80% 44% 31% 118% 11% 10%

Acquisition $$$ $200 $200 $200 $200 $1000 $200 $200

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The Denominator Problem

• So, after the megadeal & “proven” growth & management, the company’s P/E multiple gets slammed as there are fewer & fewer companies to buy

• Remember, at the beginning, they buy all the “low hanging fruit”

• At the end, the due diligence gets lax as they try to hit their acquisition targets

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Beware of Financial Deals

• Late 80s: the size of the Japanese Banks scared everyone. They were supposed to have lower cost of capital due to their size.

• Naturally, size does not lower the cost of capital.

• CREATIVITY DRIVES FINANCIAL FIRMS• SIZE STIFLES CREATIVITY. Too many

rules etc.• Deutche Bank’s $$$: Failed on WallStreet

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Mergers in Financial Services• Culture clash between high paying Wall Street

types and Insurance types -- no visible synergies there.

• As bureaucracy increases, good people will leave while incompetents stay.

• Cross Selling: Nobody wants to buy all their financial products from one place. Thus cross selling wont materialize.

• As population ages: insurance is a tough business, less premium, more claims

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Some Financial Deals

• Conseco / Green Tree Financial

• Citicorp / Travelers, Smith Barney, Salomon

• JP Morgan / Chase

• Bank deals seem to work, cross deals like Sears & Dean Witter don’t