Merger and acquisition (M&A) announcements regularly make the headlines.
These announcements make for exciting news and fire up investors’ imaginations.
With the desire to grow larger and get better, more and more companies are turning to acquisitions to turbocharge their growth.
However, investors owning companies that announce acquisitions should carefully scrutinise the deals as M&A do not always turn out well.
The devil, as they say, is in the details and we attempt to explain the good and the bad when it comes to M&A.
The lowdown on M&A
Companies undertake M&A for a variety of reasons.
These include, but are not limited to, the need to integrate a new product line or lines (buying instead of building one shortens the process), acquiring a new complementary set of customers, diversifying away from their core business or simply adding on to their existing capabilities.
Whatever the reasons, investors should look at several aspects to ascertain if the transactions are good or bad.
- Price paid and valuation – What was the total amount of money paid for the deal? Did the company over-pay or are they getting a good deal? It’s important to drill down into the valuation paid and not just look at the headline number. For example, if the acquisition costs S$100 million and the acquired company generates S$10 million in net profit each year, this means the acquisition was made at 10x earnings, which is considered cheap. The rule of thumb is anything above 15x earnings would be considered “expensive”, though of course, this varies according to the industry.
- Supposed benefits – Look at what management communicates to shareholders regarding the benefits of the M&A. Does it result in better earnings visibility, a wider customer base or product portfolio, or some other tangible benefit? Be careful of jargon such as “synergies” or a “new paradigm” that are full of fluff but short on details.
- Funding for the acquisition – How is the acquisition funded? Does the company rely on its cash resources and internally-generated cash flow? Or will it borrow to fund the purchase? The method of funding is important as it demonstrates if management may be biting off more than they can chew. The infamous leveraged buy-outs in the late 1990s in the US, where companies borrowed aggressively to fund expensive acquisitions, turned out to be a grave mistake as many of these M&A subsequently fared poorly. The acquirer was not only saddled with a ton of debt, but also had to deal with a lemon of an acquisition.
Assessing and monitoring M&A
Investors should continue to monitor and assess if the M&A performed well over time.
They can then decide on whether the company had made a good or poor acquisition.
Study the disclosures made of the new division or acquisition (assuming the company discloses such numbers) to determine if it is performing well or poorly.
The time horizon should be anything from one year to three years, so this can be a long-drawn process.
Get Smart: All that glitters is not gold
M&A can involve complex transactions, and it’s not always easy for the investor to assess if an M&A is good or bad.
One method of assessing them is to look at a company’s acquisitions track record.
If most have been successful, you can feel some measure of comfort.
Just remember that all that glitters is not gold.
Staying alert and keeping your eyes open will allow you to better analyse if M&A are, indeed, good for a business.
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Disclaimer: Royston Yang does not own any of the companies mentioned.