Among the many murky issues financial analysts are expected to get to the bottom of, none are more frustrating or time-consuming than mergers and acquisitions (M&A) activity.
You wake up one fine morning to a press release informing you that a company you follow has decided to spend billions, if not tens of billions, of dollars of their shareholders’ money on acquiring a company you have never analysed in detail, and quite possibly have never heard of. You have about three minutes to get ready for a morning meeting where your sales force demands an authoritative answer to the question: “Do you like the deal?”. Since you have the benefit of financial expertise, you translate the question to, “Does the deal create shareholder value and if so, for whose shareholders?”.
Your first step is a cursory glance at consensus forecasts for the target company. They look a little sanguine to you, but even taken at face value, they certainly do not justify the price tag, even after adding industry-standard revenue synergies. But you don’t want to be seen as jumping to conclusions. You keep your comments appropriately vague initially and reserve full judgment until management have had a chance to present their case in the conference call conveniently scheduled just before market close.
Of course, you have no illusion about the nature of these calls. They tend to be so generic, that a simple search and replace of the names of the acquirer and target as well as the sums involved gives you an excellent template for any potential business combination under the sun. You don’t need your crystal ball to predict the three words that your specialist sales person will use to describe the call afterwards in his “initial take” e-mail: “a damp squib”.
The call holds no surprises. Management is waxing lyrical about the great strategic and cultural fit as well as the complementary products and skills and celebrates the creation of a champion. The drivers of future profits and cash flows remain predictably sketchy. The Q&A session starts.
As expected, management have been instructed by their lawyers to be as tight-lipped as possible, and they certainly follow this advice. Your more obsequious colleagues ask deeply philosophical questions about the entities’ cultural fit and get rewarded with answers of poetic beauty. The CEO commends them warmly for their “excellent” questions. His voice contrasts sharply with the hurt and slightly annoyed tone he adopts in response to your puny financial questions. The implication is clear: your bean counting exercises in the face of a marriage made in heaven are considered more than a little gauche. He reiterates impatiently that the deal is obviously not being done for the trivial cost synergies you keep harping on – it is a strategic deal. They won’t run through their 300 slides describing the amazing strategic fit again. Although scope for revenue synergies is strongly implied in every statement they have made, no revenue synergies have been baked into the forecasts of your very conservative management team. You gather that any revenue synergies would be considered icing on the cake, but you are at a loss to describe what exactly the cake is made of.
The purchase price accounting won’t be finalised for another 300 years or so (okay, make that a year or so), but it won’t tell you anything new anyway. Based on your wealth of experience, you can reliably estimate that 99.9999% of the purchase price will be allocated to that black box called “goodwill”. There is only one number that management is prepared to share: the accretion from the first full year post closing has been calculated to the nearest decimal place, even though vital inputs such as the phasing of cost synergies and the combined entity’s tax rate remain unquantifiable. They can afford to sound confident, because they can rest assured that nobody will ever throw any of these numbers back at them.
The financial industry is subject to constant rejuvenation, or whatever politically correct term you want to use in lieu of “juniorisation”. More than 12 months after the deal closes, the kids who will be covering the stock won’t even remember a time when TargetCo was a standalone business. Or, as Carl Sandburg put it: “I am the Grass. Let me work”.
At the end of the call, you are none the wiser. You are left to wonder whether management is not yet prepared to share their rationale for the deal with you, or if they really have no inkling why they signed the deal in the first place.
A horrible suspicion dawns on you. You harken back to the last Capital Markets Day, where a “new era of growth” had been ushered in. You vividly recall burning the midnight oil to fudge your spreadsheets until you had magically transformed that minus 1% compound annual growth rate (CAGR) to nearly plus 1%, dimly wondering somewhere in the darker recesses of your mind whether this really qualifies as “growth” from the perspective of the guy who gets paid millions to deliver that growth. You can’t help but wonder whether the latest deal was really just done in the name of P&L cosmetics.
You do the best you can. You produce a research note acknowledging the strategic logic of the deal while opining that it appears a tad pricey. Nobody will care, because on the next page, you publish the obligatory accretion analysis. As always, it is pure, unadulterated eye candy. Unless the target company is a unicorn that burns more cash than the world’s central banks are printing, it is not mathematically possible to do a deal that would be dilutive on any of the “alternative performance measures” (APMs) invented by management and widely accepted as a substitute for real earnings. They are typically free from the penalties that almost invariably come with M&A transactions, such as intangibles amortisation, and in a negative interest environment, there is not much of a financing charge that could have a sobering effect. Net-net, adjusted earnings forecasts nearly always rise in the wake of M&A, irrespective of the consideration paid. And since throwing random multiples at random earnings numbers has gained increasing acceptance as a valuation tool, you will inevitably end up rubbing your eyes as you watch the acquirer’s share price soar.
And so everybody is happy – for a while. But the story doesn’t end here. Rising scrutiny from antitrust authorities and other bodies who need to sign off on each deal notwithstanding, most M&A transactions do close eventually.
The day will come when the acquirer reports results for the first full quarter with TargetCo fully consolidated. You struggle for words to describe the combined result. Abysmal? Horrendous? Rock bottom? In any case, far worse than even sceptics like you could have imagined in their worst nightmares. No matter how you slice and dice the numbers, you come to the conclusion that either the legacy business or the newly acquired business must be falling off a cliff. Most likely the legacy business, you muse. It would explain why the acquirer was forced to do a deal you had always perceived as defensive.
The reason I say “slice and dice” is that the combined entity’s profit is obviously not obtained by simply adding up the profits of LegacyBusiness and TargetCo. Oh no, there are many more moving parts than that in an M&A transaction! Within the legacy business, you are typically dealing with lost profits associated with divestments that were mandated by anti-trust authorities, exacerbated by the dys-synergies that arise from having to carve out and sell off an integral part of the business, mitigated to only a very limited extent by the profits associated with the related transitional manufacturing agreements the company entered into, not to mention the numerous confounding effects from all the bolt-on acquisitions made in the same time frame (in some sectors, any transaction with a value of less than $10 billion is considered a “bolt-on”).
None of these effects are quantifiable on a quarterly basis. And of course, the segment reporting won’t give you any clue as to the performance of the newly acquired business. The second the deal closed, the company’s segment reporting was re-jigged and reshuffled in much the same way that mother nature randomly recombines chromosome segments before a child is conceived. Just like babies will have a little bit of Mommy and a little bit of Daddy, post acquisition, every single segment and product group will have an element of LegacyBusiness and an element of TargetCo. And management will of course take the line that the integration has been such a resounding success that you can no longer separate the businesses, any more than you can separate Siamese twins.
You make another valiant effort in the earnings call. You run your range of assumptions for all of the aforementioned moving parts by management in an effort to force them to admit that the only possible explanation for the massive earnings miss is that either the legacy business or the acquired business is underperforming. They tell you rather predictably that they are unable to follow your complicated math over the phone, but Investor Relations (IR) will be delighted to take your questions off-line. Three minutes after the call, you send all your calculations to IR, along with detailed explanation and reconciliations, only to get an out-of-office reply. Your IR contacts will be on annual leave for the next 8 weeks. (Can you blame them?).
I won’t describe the rigmaroles required to force management to admit in the next earnings call that their legacy business is facing a few headwinds. Suffice to say that with hard work and perseverance, it can be done.
A word of advice, please don’t take it personally if they insinuate that any self-respecting analyst should have seen these headwinds coming years ago. You breathe a sigh of relief. You effectively have confirmation that the acquisition was done in order to plug the holes in the legacy business. It still doesn’t justify the price tag, but from a technical perspective, there is no reason for the company to impair goodwill. It rarely happens anyway, and if it does, it’s usually long after all the investors have scrambled for the exit door, occasionally turning a former Blue Chip into a penny stock in the process.
The impairment tests strike me as being a tad subjective, and maybe even a wee bit political. No CEO can live down a $50 billion dollar goodwill impairment. You’d have to fire the CEO first. I am not an expert on the technical aspects of goodwill impairment, but I am skilled in the art of spreadsheet gimmickry. Excel does not have a built-in plausibility check for the assumptions that are being fed into DCF models (at least officially – I have always suspected that whenever Excel sheets crash, it’s because they have had more than they can take, from a moral and ethical perspective).
While most of my colleagues typically shrug off goodwill impairments as “too little, too late”, I personally like to see the impairments happen. It is the only way to remove that eyesore called goodwill from the balance sheet.
I am a purist. I do not ever wish to see the amount of money corporates spent on future synergies and cash flows double-counted, but it’s invariably what happens if the goodwill isn’t impaired at some point. If the expected synergies and future cash flows are actually realised, they will eventually be recognised in the P&L and flow through to shareholders’ equity. The company has effectively recouped its original investment, but because goodwill is not amortised, the outlay that was needed to generate the profits in the first place is forever treated as some sort of a value in its own right.
I am hopeful that the International Accounting Standards Boards’s (IASB) new Discussion Paper on Goodwill and Impairment will address some of these issues. Not that I’m very hopeful for the balance sheet. Unfortunately, few users share my views that goodwill should be amortised quickly or, better yet, taken against equity on the day the deal closes.
The latter solution would best reflect the reality that management has just taken billions of dollars of shareholders’ equity and only time will tell whether any of that money will ever come back to them.
The main problem with this approach is that it would mess up just about every ratio. In the acquisitive world we live in, most companies would be wiping out most of their equity most of the time, so that even the most dismal operating performance would translate to something like a 10,000% return on equity. But there is always the P&L.
Maybe we can get some sort of an inkling how the acquired business is performing in the initial years. For example, there is such a thing as separately identifiable brands. If, say, a consumer health business specialising in vitamins acquires a maker of sun tan lotions, kindly split out the sun tan lotion revenues until the day when you will inevitably divest them again and thank you.
Institutional investors are expected to hold management to account. For regulatory as well as practical reasons, they can’t just vote with their feet every time a company makes a dubious acquisition. It is the investor’s fiduciary duty, in order to get the best possible performance out of an investment, to engage with management and to challenge them on any plans that may not create much shareholder value.
If you were a tad cynical and world-weary – traits found with surprising frequency among battle-hardened veteran analysts and investors – you might wonder, is there any point in holding management to account for value-destroying M&A? It is a valid question. Ultimately, the company will just replace the CEO and the successor will in due course pass through all the stages that his predecessor did, namely 1) enthusiastically unveiling a new strategy, 2) proudly proclaiming the dawn of a new era of growth and 3) jumping headfirst into some foolish M&A transaction in a bid to deliver that growth. I have a feeling that my preferred universal answer (It depends”) won’t do. For once, I am lost for words. So I just say: Touché.
Marietta Miemietz, CFA is a CRUF UK participant and former CRUF co-chair, as well as a member of the International Accounting Standards Board’s (IASB) Capital Markets Advisory Committee (CMAC) and vice chair of CFA UK’s Professionalism Steering Committee (PSC). She is the founder and director of the research boutique Primavenue. Marietta has more than twenty years’ experience as a sell-side and independent analyst covering the pharmaceutical & healthcare sector.
Disclaimer: The views expressed in the blog are those of the author and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.