Acquisitions often pose an analytical challenge for investors.
Should the fee be considered an operating expense, capital expense, or another sort of expense? What if part or all of the acquisition was financed using stock? How will the company’s financial standing be impacted? Is the acquisition fee too expensive? These are just some of the questions that shareholders need to answer.
The intricacies of each acquisition make analysing them a headache for investors. However, by breaking an acquisition assessment into parts, we can form a systematic approach to cover all angles.
Here is a short primer on the things to look out for in acquisitions.
Accounting for cash outlay
Free cash flow is often calculated as operating cash flow less capitalised expenses. On the cash flow statement, capitalised expenses are the purchase of property, plant, and equipment and other capitalised expenses such as capitalised software costs.
Acquisitions do not fall into these categories and investors may sometimes exclude cash outlays from acquisitions from the calculation of annual free cash flow.
I believe the right way to account for the acquisition fee is by deducting it as a capital expenditure. This is because when acquiring another company, you are effectively buying over the company’s assets such as customers, technology, infrastructure, and talent.
If you were to build all of this from the ground up, you would have to spend money buying properties, acquiring talent, and on marketing to acquire customers etc. These costs would be counted as either current expenses or capitalised expenses. Acquiring a company should, therefore, be given a similar treatment.
Let’s take Adobe’s acquisition of Figma as an example.
Adobe (NASDAQ: ADBE) announced last month that it would be buying Figma for US$20 billion at face value. US$10 billion of that is in cash, and the rest is in a fixed number of Adobe shares (at the time the deal was announced, the shares were worth US$10 billion). The $10 billion in cash is coming out of Adobe’s balance sheet and will have a very real impact on the cash on hand and the amount of cash that the company will be able to return to shareholders via buybacks or dividends.
As such, we need to account for it as capital expenses that reduce the company’s free cash flow. In the last twelve months, Adobe generated US$7 billion in free cash flow. If we deduct US$10 billion (the cash outlay for the acquisition of Figma), we see that Adobe has an adjusted free cash flow of negative US$3 billion.
But given that it is a one-off expense, does this mean anything? A resounding, yes.
When I assess free cash flow, I’m not scrutinising free cash flow over a single year. I’m examining the average free cash flow generated over multiple years. The acquisition cash outlay pulls down the long-term free cash flow average for Adobe, but it also paints a more complete picture of the cash flow that can be distributed to shareholders over time.
Consider dilution when looking at stock-based financing, instead of the current dollar amount
Many deals nowadays include some element of stock-based financing. Stock-based financing is a little bit more tricky to analyse than cash as stock prices can fluctuate.
Depending on the price of the stock, the dollar amount of stock that was used to finance the deal could be higher or lower. The Adobe-Figma deal is a good example. As mentioned earlier, the value of Adobe shares being offered to Figma shareholders was worth US$10 billion when the deal was revealed to the public. Today, with the steep fall in Adobe’s stock price, the value of those shares has declined by more than 20% to around US$7.7 billion.
Instead of worrying about the dollar value of the stock-based financing, I prefer to look at the number of shares that are being issued.
In the Adobe-Figma deal, Figma shareholders will receive about 27 million shares. In addition, employees and executives at Figma will receive an additional 6 million Adobe shares that will vest over the next four years. As of 23 September 2022, Adobe had 465 million shares outstanding. The Figma acquisition will increase the share count by 30 million, which represents dilution of around 6%.
In other words, all of Adobe’s future free cash flows will need to be shared with this new batch of shareholders, which will reduce Adobe’s cash flows per share by 6%.
This is the real cost of stock-based financing.
Is the acquirer overstretching its finances?
Now that we know the true cost of the acquisition, the next thing we need to consider is whether the acquirer has sufficient cash to finance the deal.
Ideally, the acquirer needs to have either cash on hand or sufficient cash flow generation ability to ensure that any debt incurred can be easily repaid.
Let’s take a look at the Adobe-Figma deal again.
Adobe ended its latest fiscal quarter with US$5.8 billion in cash and US$4.1 billion in debt. To fund the US$10 billion cash outlay for the Figma deal, Adobe would have to use some of its cash on hand and borrow at least US$5 billion. Whatever the ratio of debt to cash on hand used, the $10 billion cash outlay will leave Adobe with net debt of US$8.3 billion.
Although this is a historically high debt load for Adobe, I don’t see it as much of an issue. As mentioned earlier, Adobe generated US$7 billion in free cash flow in the last 12 months. If it can generate similar amounts of cash after the deal, it will be able to easily repay some or even most of the debt within a year, should management decide to.
Analysing the target company
Another important aspect of the deal is the quality of the company being acquired. Assessing the quality of a target company can be done in two parts. First, does the target possess a quality business?
As with assessing any company, we need to study aspects such as the quality of management, historical growth, ability to innovate etc.
Again, I will use the Adobe-Figma acquisition as an example. Figma strikes me as a solid and innovative business. Its annual recurring revenue is growing sharply and its product seems well-loved by customers. Other elements of Figma look good too, such as its product-release cadence, and management capability and innovativeness. For example: Figma was launched in 2012 as the world’s first design tool purpose-built for the web, and it has a net-dollar retention rate of more than 150%.
Second, will the combined entity work well together?
In the Adobe-Figma deal, it does seem that many possible integrations could happen when the two companies combine. Scott Belsky, Adobe’s Chief Product Officer, recently spoke at-length about the synergies he sees between the two companies’ products. Acquiring Figma will also be a good way for Adobe to tap into a different type of user base.
Another element of the deal that is often overlooked is the effect of removing a competitor. In the Adobe-Figma deal, Adobe is effectively removing a growing competitor.
Does the price match the value?
Now that we have identified both the cost and the benefits of the deal, we can then assess if the price matches the value gained from the acquisition. This requires an estimation of the net cash flow generated from the acquisition.
In the Adobe-Figma deal, we need to estimate the net future cash flow benefit from the deal. We then compare these cash flows with the cash flows that were given up, which includes the US$10 billion cash outlay and the 6% dilution. You can find an example of a financial model here.
Given the many intricacies of a deal, acquisitions can be tricky for investors to assess. Presentation slides offered by a company’s management will inevitably present a compelling case for an acquisition. But some acquisitions may not turn out to be positive for shareholders of the acquirers. As such, shareholders need to do their due diligence when assessing an acquisition.
With stock prices of many companies falling sharply in recent months, and some companies still generating healthy amounts of free cash flow even in this downturn, we could potentially see more deals being struck in the near future.
If you are a shareholder of a company making an acquisition, try to look at the deal from the perspective of how it will impact the cash flows paid to you by your company over the long term. This is the bedrock of all analysis and should be the foundation to build your assessment.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia owns shares of Adobe.