Welcome to class of

InternationalMerger and Acquisition (M & A)

byDr. Satyendra Singh

www.uwinnipeg.ca/~ssingh5

Before you buy a firm: Analyze• Products of the firm

– Bottom up (daily use products), Top down (like a firm, sector…)

• Financial health of the firm– Earning, Balance sheet, LP account…

• Management of the firm– Reputation, can they take it to the next level

• Geographical exposure– Local vs. international

• Stock market valuation of the firm– P/E over time, EPS over time

Logic of M&A• Value creation through synergy

– Economies of Scale– Economies of Scope

• Transferring competencies• Sharing infrastructure• Access to patents, Growth potential, Risk sharing• ↑Debt capacity, ↓cash flow variability

• Combined cash flow > individual• If Market value < true value

– Needs restructuring; inefficient management• Where is the value coming from?

Value Creation: Financial Perspective• Price per share (Market, not book)

– Growth, risk, market speculation (based on P/E)…• Earning per share

– TTM (Trailing 12 months), Sales side vs buy side• P/E Ratio

– If too ↓, suspicious. If too ↑, why? Why buy a company with high P/E must have reason

– Capital structure impacts P/E ratio Leveraged– Everything being identical in the same industry, P/E

should be about same– Check P/E from industry sector, FTSE 100– Obtain justifiable values based on the ratios.

Value Creation: Example 1

Pre-merger

Price per share = $75EPS = $5

P/E = 15

Post-merger

Price per share = $80EPS = $7

P/E = 11.4

P/E dropped following merger, so the value of the mergeris coming from the current projects rather than its futuregrowth potential

Value Creation: Example 2P/E 2012 2013 2014 2015 2016 2017

$100/$1 100/2 100/3 100/4 100/5 100/6

100 50 33.3 25 20 16.7

P/E = Price to earning per share ratio

P/E = 100 is too high needs justificationP/E match industry level everything being equalExpect growth 100% increase in EPS must continueIf P/E drastically different merger arbitrageValue from future growth potential on sustainable basis

Why M&As Fail• Premium paid (shares) > synergy/value• Expensive: Bankers, accountant and

lawyers• Competitive bidders appear• Arbitrageurs can buy outstanding stocks

and force price concession– Lengthening the acquisition process

• So more expensive

• As such cash acquisition is more risky– Acquirer takes all the risks

• Stock acquisition – risk is shared

Can we create synergy/close the gap?Firm A B CombinedP $60 $20Earning $50m $10m $60m# shares 10m 10m 15 (10+5)EPS $5 $1P/E 12 20

$60m/#15m = $4/shareLoss of $1 per share ($5-$4)

(+$10 x 10m = $100m premium)Can we close the gap?

A agreed to buy B’s share for $30 (ie pay premium of $10/share)ie. Half share of A for every share of B (.5A = B)ie, B’s 10m share are equivalent to A’s 5m shares, total being 15m shares

ie, $1 x 15m =$15m

PEG Ratio• It is PE Ratio divided by the annual forecast

EPS growth percentage– If a firm is growing at 30% a year and has

a P/E of 30, PEG would be 1.

• PEG > 1 Share cost is high relative to growth expectation

• PEG < 1 Share cost is fair relative to growth expectation

***PEG is not scientific***

PEG Ratio

Managerial Motives to M&A• Conflict of Interest

– Managers like running large firms due to additional pay and prestige

• Overconfidence – Hubris Hypothesis (HH) pursue merger even

if low value because they believe their ability to manage is great enough to succeed.

• Main difference– Managers destroy shareholders’ value for

personal gain– As per HH, managers believe they’re doing the

right thing for shareholders.

Period: Major M & A Activities

Recent Merger

Types of Takeover…• Takeover

– Transfer of ownership from 1 firm to another• Merger

– Combination of 2 firms into 1 legal entity– Similar-sized firms are combined– So are their names

• One may be of the parents’ or a combination• DaimerChrysler• SIRIUS XM

– Both shareholders approve the transaction

Types of Takeover• Acquisitions

– Purchase of 1 firm by another– Larger firm buys smaller firmer, which becomes

a subsidiary• Kraft foods buys Cadbury

• Amalgamation– Merger that requires fair opinion by an

independent expert on the value of the firm’s shares when public minority exists

• Consolidation– An entirely new form is created

Types of M&A Activities• Related

– Vertical• Supplier or customers

– Horizontal• Competitors

– Product extension• Complementary products

– Market extension• Complimentary markets

• Unrelated– Conglomerate

• Everything else

Friendly Takeover• Target firm is willing to be taken over• Investment bank prepares tender offer

for the management• Can be initiated by acquirer• Both parties structure the deal to their

mutual satisfaction; e.g.,– Capital gain– Acquirer uses target as asset for tax deductions– Graceful exit environmental, lawsuits…– Agree on initial purchase price; pay later

Friendly Acquisition Process

Hostile Takeover• Transactions bypass the management• Management is opposed to the deal• Acquirer already accumulated 20% of

Target’s stock

• So, tender offer is made directly to shareholders

Hostile Takeover: Defense Tactics• Shareholders Rights Plan

– Poison Pills – Dilute the share by offering more shares and by

giving discount (50%) to Target’s shareholders, making it expensive/difficult for Acquirer

• Selling Key Assets– Sell the assets that Acquiring firm is interested– Pay large dividends to remove excess cash

from Target’s balance sheet• White Knight

– Seek out friendly acquirer

Critical Shareholder %• 10% early warning

– Acquisitor is accumulating a position-- toehold• 20% takeover bid

– Not allowed further, must tender bid, open to all• 50.1% control (Simple majority)

– Can replace board and control management• 66.7% amalgamation

– Shareholders approve amalgamation proposal• 90% minority squeeze out

– Minority shareholders are forced to tender their shares to avoid frustration

Regulatory approval…• All mergers must be approved by

regulators– In the USA, all mergers over $60m must be

approved by the government before the proposed takeover occurs

• EU Commission has similar process

• Emerging markets– More strict due to colonization

Government can interfere; for example,

Merger Arbitrage• Once a tender offer is announced, the

uncertainty about whether the takeover will succeed adds volatility to the stock price– This uncertainty creates an opportunity for

investors to speculate on the outcome of the deal• It creates volatility

– Market share price > offer price (may be more bid)– Market share price = offer price (deal is likely)– Little trade in shares (deal may not go through)– Significant trade in shares (deal is likely)

Merger Arbitrage ExampleFirm A Price per share = $30# shares = 10mMarket Capital = $300m

Firm B (Target) Price per share = $50# Share = 1mMarket Capital = $50m

A is acquiring B for $60m in A’s Share(A needs 2m more shares @ $30/share $60m)ie. 2 shares of A for every share of B (2A = B)

Suppose due to volatility, share for B is trading at $55So buy 1 share of B $55 (exchange it for $60)Short sell 2 share of A $60 Net gain $5

Leverage: Impact of Capital Structure on P/E, AssetsFirm A Invested $100 KNot borrowed, so no liability# shares = 10,000COGS (50%) = -$50KDepreciation = -$20KOperating Income (Pre-tax) = $30K Tax (30%) = -$9KInterest = 0Earning after tax = $21 KEPS = $2.10

Analyst P/E should be 10So, market share price = $21

Market capitalization = $210 KBut A put $100 KEquity + Liability = $210 K + $0Total Assets (ie mkt value of equity) = $210 K

Firm B Invested only $10 KBorrowed $100 K @ 5% (ie $5K)# shares = 10,000COGS (50%) = -$50KDepreciation = -$20Operation Income (Pre-tax) = $30KNon-operating Income = $2KTotal Operating Income = $32KTax (30%) = -$8.1KInterest paid = $5 KEarning after tax = $18.9 KEPS = $1.89

Analyst P/E should be 10So, market share price = $18.90

Market capitalization = $189 KBut B put only $10 KEquity + Liability = $189 K + $100KTotal Assets = $289 KIe. $279K assets + $10K cash = $289KBy borrowing you’ll ↑ assets

Impact of M&A on Goodwill

Goodwill = Price paid – MV of Target firm Equity

= $1,250 – (MV of target assets – MV of target Liabilities)

= $1,250 – ($2,200 - $1,050) = $100