In simple terms, synergy occurs when 2 + 2 = 5. That is, when the sum of the value of the Buyer and the Target as a combined company is greater than the two companies valued apart. Most mergers and large acquisitions are justified by the amount of projected synergies. There are two categories of synergies: cost synergies and revenue synergies. Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations. For example, closing one corporate headquarters, laying off one set of management, shutting redundant stores, etc. Revenue synergies refer to the ability to sell more products/services or raise prices due to the merger. For example, increasing sales due to cross-marketing, co-branding, etc. The concept of economies of scale can apply to both cost and revenue synergies.
In practice, synergies are “easier said than done.” While cost synergies are difficult to achieve, revenue synergies are even harder. The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it. Of course, this last fact never finds its way into a banker’s M&A pitch.
There are a variety of reasons why companies do acquisitions. Some common reasons include:
- – The Buyer views the Target as undervalued.
- – The Buyer’s own organic growth has slowed or stalled and needs to grow in other ways (via acquiring other companies) in order to satisfy the growth expectations of Wall Street.
- – The Buyer expects the deal to result in significant synergies (see the next post for a discussion of synergies).
- – The CEO of the Buyer wants to be CEO of a larger company, either because of ego, legacy or because he/she will get paid more.
Goodwill, a type of intangible asset, is created in an acquisition and reflects the value (from an accounting standpoint) of a company that is not attributed to its other assets and liabilities. Goodwill is calculated by subtracting the target’s book value (written up to fair market value) from the equity purchase price paid for the company. This equation is sometimes referred to as the “excess purchase price.” Accounting rules state that goodwill no longer should be amortized each period, but must be tested once per year for impairment. Absent impairment, goodwill can remain on a company’s balance sheet indefinitely.
Other things being equal, if the Price to Earnings ratio (P/E) of the acquiring company is lower than the P/E of the target, then the deal will be dilutive to the acquiror’s Earnings Per Share (EPS). This is because the acquiror has to pay more for each dollar of earnings than the market values its own earnings. Hence, the acquiror will have to issue proportionally more shares in the transaction. Mechanically, proforma earnings, which equals the acquiror’s earnings plus the target’s earnings (the numerator in EPS) will increase less than the proforma share count (the denominator), causing EPS to decline.
A number of factors can cause an acquisition to be dilutive to the acquiror’s earnings per share (EPS), including: (1) the target has negative net income, (2) the target’s Price/Earnings ratio is greater than the acquiror’s, (3) the transaction creates a significant amount of intangible assets that must be amortized going forward, (4) increased interest expense due to new debt used to finance the transaction, (5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction and (6) low or negative synergies.
The purpose of an accretion/dilution analysis (sometimes also referred to as a quick-and-dirty merger analysis) is to project the impact of an acquisition to the acquiror’s Earnings Per Share (EPS) and compare how the new EPS (“proforma EPS”) compares to what the company’s EPS would have been had it not executed the transaction.
In order to do the accretion/dilution analysis, we need to project the combined company’s net income (“proforma net income”) and the combined company’s new share count. The proforma net income will be the sum of the buyer’s and target’s projected net income plus/minus certain transaction adjustments. Such adjustments to proforma net income (on a post-tax basis) include synergies (positive or negative), increased interest expense (if debt is used to finance the purchase), decreased interest income (if cash is used to finance the purchase) and any new intangible asset amortization resulting from the transaction.
The proforma share count reflects the acquiror’s share count plus the number of shares to be created and used to finance the purchase (in a stock deal). Dividing proforma net income by proforma shares gives us proforma EPS which we can then compare to the acquiror’s original EPS to see if the transaction results in an increase to EPS (accretion) or a decline in EPS (dilution). Note also that we typically will perform this analysis using 1-year and 2-year projected net income and also sometimes last twelve months (LTM) proforma net income.