In the current economic environment many companies are finding it difficult to grow earnings organically so they are turning to acquisitions more frequently. Adding further incentive for management teams to acquire businesses is the disparity between the valuation of an ASX-listed public company and a private company. This can create an opportunity for valuation arbitrage as a listed company is generally valued at a greater multiple. When earnings of a private company are added, they benefit from applying the public company multiple.
However, acquisitions are often unsuccessful, and worryingly we don’t see many management teams providing a track record of these in their annual reports. Here are some factors we look for when assessing the potential value of an acquisition:
1. Why is the company making the acquisition?
Too often we see only the strategic merits touted, but we need to discover the underlying motivation. If management is diluting earnings ratios in their existing business with a new one, then we need to know what benefits this new business will provide to the existing business. This is particularly important with larger acquisitions relative to the company’s existing size.
2. Is there organic growth in the existing business?
Always identify the organic earnings growth within the existing business. This is particularly pertinent where companies are making such frequent acquisitions that they are considered a ‘roll-up’. If the company is not growing organically, then inevitably all good things will come to an end when the acquisition pipeline dries up.
3. Are acquisition prices increasing?
Acquisition prices can tell you a lot about the opportunity available. If a company has made several acquisitions in the same industry and the prices for those acquisitions increase each time, this can be a sign of management becoming desperate to acquire when faced with a lack of opportunities.
4. Are accounting levers being pulled?
One benefit of an acquisition is the flexibility it provides management in relation to the accounts. There is opportunity to shift certain costs into what is called a ‘non-recurring’ item, but often these items are recurring. Acquisition accounting also gives companies a full 12 months to adjust the value of acquired assets and liabilities, meaning they can create certain provisions without dragging on the profitability of the business.
5. Is a contingent consideration in the price?
We often see a contingent consideration as part of an acquisition price, but this won’t be included in the headline price paid. Contingent considerations can be a great way to incentivise an existing management team, however, the details are not often disclosed. The accounting treatment for contingent consideration is also highly subjective as they are recognised at the present value of a likely future payment. Any adjustments to these figures are taken through the profit and loss which can result in a positive impact on profit and loss even if an acquisition is underperforming.
6. Where is the genuine value creation?
Finally, we need to look at how much value is being created by these acquisitions. Instead of simply looking at headline growth each year, we try to focus on the incremental profit growth in relation to the extra capital being employed by the business. This gives us a clearer view on whether the acquisition is actually working or if it is diminishing shareholder returns.
This is not an exhaustive list of items to consider, but rather some key considerations. There are numerous ways for a company to grow and in the current environment, acquisitions are proving popular. Not all acquisitions are bad, but more seem to go wrong than right. A management team which can allocate its capital effectively and continue to grow shareholder returns should see their share prices well rewarded over the longer term.
This article was originally published by Cuffelinks on November 28, 2018 and is authored by Ben Rundle, Portfolio Manager.
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