Today, a brief posting about shortcuts and practical rules of thumb for figuring out whether a prospective transaction might be accretive or not.

I’ll go ahead and give my caveat emptor right now — these shortcuts are only useful when there’s one type or source of consideration. Well, they can also be used to run sensitivity analysis to establish the relation between accretion/dilution and different types of consideration — but whenever a deal has a mix of consideration, you must follow the complete  analytical process I’ve already described in previous postings (and again summarized below).

So, recall that there are three major ways to pay for a target, each with its own effect on EPS:

• Cash: foregone interest
• Debt: new interest paid
• Stock: dilution due to new shares issued

An All Cash Deal is likely to be accretive if the foregone interest expense is less than the seller’s pre-tax income.  Foregone interest expense may be calculated by multiplying the cash investment rate times the purchase price.

An All Debt Deal is likely to be accretive if the new debt interest expense is less than the seller’s pre-tax income.  New debt interest expense may be calculated by multiplying the interest rate times the new debt (very much the same concept as the All Cash Deal).

An All Stock Deal is likely to be accretive if the buyer has a higher PE ratio than the seller. Here, the buyer is effectively buying “cheaper” earnings.

These methods use differences in consideration to project whether you’re likely to be getting more than you’re paying, all other things being equal.

Unfortunately, there is no shortcut for analyzing accretion if consideration is a mix. You must go through the whole process as described in previous postings:

• Calculate the EPS effect of each part of consideration (foregone interest, new interest paid, new shares issued);
• Combine the P&Ls and estimate revenue and cost synergies;
• Combine the balance sheets and allocate the purchase premium;
• Step up PPE and expense the projected new depreciation;
• Write up Intangibles and expense the projected new amortization;
• Calculate new DTLs.

Done carefully and correctly, this process provides a reasonable preliminary accretion analysis.

Next time, I’ll discuss some of the theory and accounting behind the acquisition of a minority interest.

Posted by: Mory Watkins

Last time I discussed how P&Ls are combined in M&A transactions and the effect of synergies, changes in the mix of consideration, and balance sheet write-ups on accretion (or dilution).

Today, I’m going to turn to the balance sheets. I’ve already mentioned two of the most important balance sheet changes last time – the write-ups for PPE and Intangibles. Here, I’ll tick down the key balance sheet accounts and touch on some of the combining adjustments.

In combining the balance sheets, I must also address purchase price allocation. I’m not going to go into mind-numbing detail; that’s beyond the scope of discussion here (and actual purchase price allocation should be left to CPAs, tax experts, etc.). In broad strokes, the amount of the purchase price paid in excess of the target company’s accounting value must be recorded on the acquirer’s balance sheet. Accounting conventions require that the purchaser first allocate to tangible assets and then to intangible assets. Any amount that cannot be allocated to identifiable assets is recognized as goodwill. Goodwill therefore represents the excess of purchase price over the fair market value (FMV).

Here is my time tested “quick & dirty” method for combining and allocating purchase price to the key balance sheet accounts. Using this process should give you enough rough approximations of opening combined balance sheet figures for preliminary analysis:

Cash: The combined cash balance of buyer and target is reduced by any cash used in the purchase price.

Short Term Assets/Liabilities: No initial adjustments needed; however, future write-off of A/R or changes in accruals may be necessary.

PPE: As previously discussed, the seller’s fixed assets (PPE) are revalued at the time of the deal and are almost always worth more than the carried book value. The incremental value is added to the balance sheet. The resulting incremental depreciation will lower book earnings and may result in the creation of a deferred tax liability (DTL).

Other Intangibles: Like PPE, intangibles are examined and revalued at the time of the transaction. In most cases the intangibles will go up, resulting in incremental amortization that will lower book earnings. This additional amortization is usually not tax-deductible, so a DTL is created. Regarding purchase price allocation, the purchaser must first allocate identifiable intangibles such as trademarks, patents, and other intellectual property. Any amount that cannot be allocated to identifiable assets is recognized as goodwill.

Goodwill: In merger models, the prevailing convention is to zero out existing goodwill on the target’s balance sheet (the new transaction refreshes goodwill and old goodwill is forgotten). New goodwill is calculated by taking the allocable purchase premium less the write-ups for PPE and Intangibles (mentioned above) and also subtracting the net of the write-off of existing DTL and new DTLs created by the PPE and Intangible write-ups.  Goodwill is assumed to last forever on the balance sheet unless there’s an impairment. There is no tax impact for goodwill unless there’s a write-down.

Long Term Debt: Add any new debt issued for the acquisition.

Deferred Tax Liability (DTL): In merger models, the common convention is that existing DTL on the seller’s Balance Sheet is written off at the time of the transaction regardless of the structure of the deal (stock, asset, or 338(h)(10)). Any new DTL will be calculated from the acquirer’s perspective in the future. As discussed above, write-ups for PPE and Intangibles may create new DTLs related to the transaction. The new DTL obligation may be estimated by applying the acquirer’s tax rate to the sum of the PPE and Intangibles write-ups.

Shareholder Equity: In merger models, the common convention is to zero out seller equity and add the APIC of the buyer’s stock. The shareholder’s equity section of the target’s balance sheet is not transferred; instead, goodwill is created on the consolidated balance sheet to represent the difference between the purchase price and book value of net assets acquired.

So that completes the merger of major balance sheet items. Using this method will provide good, quick insight into the combined entity’s opening balance sheet.

Next time, I’ll go over a couple useful shortcuts and rules of thumb for telling right away whether a prospective transaction will be accretive or not.

Posted by: Mory Watkins

Today I’m going to go into more detail about how P&Ls are combined in mergers — and how it’s analyzed in “real world” corporate M&A.  As I’ve already mentioned, how the P&Ls come together, and what the resulting accretion or dilution will be, drives strategic M&A more than any other factor.  It’s appropriate to drill down now and get more specific about what the combined income statement will look like.

Recall from last time that I addressed synergies and their relative importance. Considering synergies between buyer and seller led to the creation of several new line items on the newly combined P&L: Revenue Synergies (for revenues), COGS Synergies (for direct expenses), and OPEX Synergies (for fixed expenses).

But several other new line items are also needed. Changes to the mix of deal consideration must also flow through the combined P&L. Projected P&Ls include interest income and interest expense figures that assume a certain cash balance. When cash is used as part of the transaction consideration, however, interest income will be lower, so foregone interest on cash is a real cash deal expense that must be considered in accretion/dilution analyses. The potential for cash consideration in the deal means a line item called Foregone Interest is required. Also, a line item called New Debt Interest is necessary, of course, to cover situations where the buyer finances some of the purchase price with debt. Lastly, depending upon the P&L presentation, a line item called New Shares may be needed at the bottom of the combined P&L to show the effect of stock consideration in the deal when calculating accretion/dilution.

Balance sheet write-ups related to the transaction will also affect the combined P&L.  In M&A transactions, the seller’s fixed assets (PPE) is revalued and is almost always worth more than the carried book value.  The incremental increase in value means more depreciation will flow through the combined P&L, so a line item called Depreciation from PP&E Write-Up is necessary.

The other important balance sheet write-up of note concerns intangibles. The amount of the purchase price paid in excess of the target company’s book value is allocated and will usually be at least partially recorded as an Intangible Asset on the purchaser’s balance sheet. The purchaser must first allocate identifiable items (including trademarks, patents, and intellectual property), and then any amount that cannot be allocated to identifiable assets will be recognized as Goodwill. Amortization related to the newly created Intangible Assets will flow through the combined P&L, necessitating a line item called Amortization of New Intangibles. [When there is a relatively large amount of intangibles amortization, it is not unusual to show the accretion/dilution calculation two ways – one including the new intangibles amortization and a pro-forma without it. This is due in some part to the relative subjectivity in purchase price allocation when it comes to intangibles…]

That covers combining buyer and seller P&Ls.  The statements can be literally added together once synergies, changes related to mix of consideration, and balance sheet write-ups are accounted for.

Next time I’ll begin to discuss combining buyer and seller balance sheets in M&A transactions.

Posted by: Mory Watkins

Today, I’m going to briefly discuss one of the holy grails of corporate M&A, and the one that acquirers point to most often for justification in a strategic acquisition: synergies. Here’s how synergies are often considered and modeled in the real world.

Revenue Synergies: There are many reasons why one might think that 1+1 is going to equal 3 in an acquisition — maybe salesmen are going to cross-sell now, maybe one party has a stronger distribution channel, or maybe there will now simply be more manufacturing capacity – but how do you include this in the merger model and acquisition analysis? Very similar to what I’ve said before regarding projections, you should use a “bottom up” approach to calculate revenue synergies. Choose any of the most important metrics from the seller’s revenue model (such as average selling price, average customer value, or average units sold), goose it by a fixed percentage, and then add it to the buyer’s revenue model. You would include these calculations in a separate line item on the projected combined income statement called Revenue Synergies.

Expense Synergies: The thinking here, of course, is that 1+1 is presumably going to equal 1.5. Assumptions must be made regarding both variable and fixed expenses. The methodology will again be “bottom up”. The preferred technique is to estimate seller synergies as a percentage of seller revenues and then apply these to the combined entity. There are typically three main candidate categories for expense synergies — employees, facilities, and capital expenditures:

• For employees, a macro assumption (based on a more detailed analysis) may be made as to whether headcount falls or average expense per employee falls.

• For facilities, input from someone on the operating team should guide and inform assumptions as to when facilities will be combined and how much the resulting reduced overall facilities expense will be.

• For CAPEX, you will probably assume that the seller’s capital expenditures will fall as a result of the business combination. A percentage reduction in CAPEX should be reflected on the combined cash flow statement. Don’t forget that there will also be a corresponding reduction in related depreciation.

Add a COGS Synergies line to the model for variable expense reductions and an Operating Expense Synergies line to the model for fixed expense reductions.  Note that there may also be a need to model so-called “negative synergies” or scenarios where the combined expenses will actually go up.  Examples of this include existing customer overlap, differences in accounting, employee benefits, and conflicting suppliers.

Next time, I’ll discuss some methodology for combining the buyer and seller income statements.

Posted by: Mory Watkins