M&A: CONCEPTS AND THEORIES

NEW YORK INSTITUTE OF FINANCE

Three ways M&A can increase a buyer’s value -

part two

So let's look at our first example of the motivation. We looked at these three,
synergy, change in multiple, arbitrage. Let's look at synergy first. So here we have a
deal where a company buys a competitor. Here are the numbers that the
competitor had, sales of 100 million. We bought it for 160 and the buyer paid cash
and stock for the transaction. So they gave the seller cash and some of the buyer
stock and here is the interest rate on the debt and the target price is eight times
EBITDA. So in this table, we're going to look at the before and after implications of
a transaction and this table is very common in regulatory filings and when
companies describe a transaction they will always have the before and after
picture.

So here's what the buyer looked like before, $250 million in revenue, net income of
18, 2 million shares outstanding in earnings per share of $9, stock was trading at 17
times earnings, so the price per share was 153. If you added the transaction to the
buyer, of course the sales go up and so do the earnings, but we have to put in the
extra interest and we have to put in the new shares that were issued and when you
do the mathematics, the earnings per share are now $10, so it's, of course,
accretive. And we're buying a company in the same industry so the PE multiple
doesn't change. Therefore the price is 170.

We threw in a few synergies of 5 million, ran the numbers through, new earnings
per share. The new price is now 189. So you can see just with this one transaction,
which was quite sizable, the share price of the buyer went up to 189, a 23% gain.

So do you see how the before and after picture looked? So all these M&A analyses
that the buyer uses have before and after.

Now, if this number was smaller, the deal wouldn't look so great. So often when
you're working on these things you run many scenarios of what price should we

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pay? And how much should we finance the deal with debt or stock, and so on?
We're going to actually go over some examples.

Jeff, is there some rule of thumb that you don’t do it unless it increases the value of
the share by some percentage?

No, I mean, dilution is considered bad. Accretive is good. So anything that's

accretive is good, assuming you don't take on too much debt as the buyer. But
dilution is tolerated for a publicly traded company if that dilution is, say, 2% or 3%
in the first year, that's OK. But it must be accretive in the second year.

Does the price of a share always go up during an M&A deal?

No. The question is does the share price always go up in M&A deal? No, sometimes
it doesn't. Sometimes you'll see the price fall, because the market thinks the buyer
paid too much. So you'll see that a lot. In there was just--

Well, the target, the price usually rises, because the buyer has to pay a premium. So
the average M&A premium in America is about 30%. So, yeah, you see a big jump
with the target stock price. That's why you see a lot of insider trading prosecutions
related takeovers, because someone wants to get that 30% premium.

So what about technique number two, where a low growth firm is buying a high
growth firm? I kind of call this the swan effect because of the fairy tale that some
of you may remember where the ugly duckling turned into a white swan. That's sort
of what we're talking about here. You have a low growth company buying a high
growth company, and it wants to get some of the reputation of the high growth
company.

So here you can look at a low growth company. I mean, it's not that low because it's
got a 10% growth rate and it has an 18 multiple, which isn't bad. But management
wants something more. So they buy a high growth company, and these are the new
numbers. They've got higher sales and higher net income.

However, as we just mentioned, here, they paid so much. Their earnings per share
are actually slightly lower, $0.98 versus $1. However, because they bought a high
growth company, they got some of the high growth reputation attached to their
own PE multiples. So their PE multiple actually went up. It went up on lower
earnings, which is a nice trick.

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So you have a higher PE multiple and slightly lower earnings. The stock price went
up. So you can see the stock price went from $18 before the deal to $21.50 after
that deal.

So here they were successful in changing the complexion of the company. So I like
to say it's a little bit like a woman walking into a beauty parlour. She goes in. She
gets her hair done. She gets her nails done. She gets new makeup. And she walks
out and she looks like a new person.

So that's what these companies are trying to do. They're trying to look like new
people, or new company.

So that's Part 2, Letter A, How about Part 2, Letter B? Here, you're doing, as I said,
the reverse. You're just trying to get a company that's lower risk than you are. So
you're trying to reduce your risk and therefore increase your value multiple.

So let's look at this company it's where an African company buys a Western
European company. So everybody knows Africa is riskier for business than Western
Europe, right? So here the African company is going to buy a Western European
company and decrease its earnings dependence in Africa.

So here, by the transaction, it made itself look less risky. And the market reacted
appropriately. It said, well, this was your risky PE ration. Now that you're partly in
Europe, we're going to increase your ratio.

So a little different psychology, but one that I think works. And I mean, let's take
CEMEX, which is the big Mexican cement company. It owned the Mexican market. It
had a 60% or 70% market share. It wasn't going anywhere. And Mexican market is a
little volatile.

So CEMEX took all the excess cash from its very profitable Mexican monopoly and
started buying cement companies in Spain, in the United States and other places.
So it diversified and lowered its risk.

Tactic number three, financial arbitrage. So we have, as is the case today, many
companies in the US, Western Europe, are trading around 10 times EBITDA. Their
enterprise value divided by EBITDA is 10 times. So a good technique for them is to

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buy smaller competitors at five times. Actually, smaller competitors these days are
trading around six or seven, but I"m using five in this example.

So as you can see, here's the big company. It's got $100 million EBITDA. And here,
it's trading at 10. So there's the enterprise value. We subtract the debt. And the
equity value is $700. $100 per share.

So this technique requires a little more maths than we're used to, but we'll go
through it. So here, the buyer is doing three deals, A, B, and C in one year. Each
deal has 20 of EBITDA, and they're paying five times. So you can see they're paying
100 for each one. They're taking on new debt, and they're also issuing shares to the
sellers.

So let's look at what happens at the end of the year. They've issued new shares.
They've taken on new debt. And they bought three companies.

After-- this is the after column-- we've got 160 of EBITDA. We're still trading at 10
time.

That’s always a given?

Yes. It better be, or the strategy won't work. I usually when I go over this example
to like business school students, and they say, wait a second, Mr. Hooke, our
professor of finance said that it's an efficient market out there and that the multiple
should now be instead of 10, should be 7 and 1/2 or something. But I tell him that's
really not the way the real world works.

The real world says you're going to transform A, B, and C into the big company. It's
going to be a seamless integration. So assuming that works, 10 times, this is year
new enterprise. Now you subtract the new debt, and we have some new shares. But
the price of the stock is now 135.

This is extremely popular in the US and Western Europe. General Electric does this,
20 or 30 deals a year like this. Many are small. You never hear about. And a lot of
private equity firms do this. Like I work at an investment bank as you know, and we
have private equity firms coming to see us every week and saying, show us deals.
We're trying to build up a big company in accounts receivable management or
something like that. It's fragmented. Show us a lot of small deals in that sector.

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Is there a lot of work involved in this in the long term? Do you need to form a new
team or you’re assuming that those companies will probably need to be run like the
big companies, and you’ll be spending some time cleaning it out?

Yeah. Yeah, I mean, you have a team of people for integration, because they're
basically integrating something every two or three month. So you got a whole team
of those people. And you've got a team of people like me running around the
country, or running around the globe, looking for similar deals, haggling with the
sellers, pricing it, financing it. That's a full-time effort by a team of people like
myself. You can't just have one or two people, because you can't close three or four
deals a year like that. You need a whole team of people.

So I mean I was working on a deal with Hewlett-Packard a couple of years ago. And
I met some people in their M&A team. It had like 30 people running around, literally
running around the country, or really the world in case of Hewlett-Packard, trying to
find deals and just do this. Now occasionally, we did a big deal, but they were
doing a lot of small stuff too. So if you like airplanes and you like staying in hotels,
work for a company that does this.

Now those techniques tend to be very popular in the developing world, the wealthy
parts of the world, US, Western Europe. So do investors understand these tactics,
people that buy the stocks and bonds of these companies? And the answer is, yes,
we do.

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