(2008) Merger Model - Basic

Question 1

Walk me through a basic merger model.

Answer 1

“A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.

Step 1 is making assumptions about the acquisition - the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.

Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.”

Question 2

What’s the difference between a merger and an acquisition?

Answer 2

There’s always a buyer and a seller in any M&A deal - the difference between “merger” and “acquisition” is more semantic than anything. In a merger the companies are close to the same size, whereas in an acquisition the buyer is significantly larger.

Question 3

Why would a company want to acquire another company?

Answer 3

Several possible reasons:

The buyer wants to gain market share by buying a competitor.

The buyer needs to grow more quickly and sees an acquisition as a way to do that.

The buyer believes the seller is undervalued.

The buyer wants to acquire the seller’s customers so it can up-sell and cross-sell to them.

The buyer thinks the seller has a critical technology, intellectual property or some other “secret sauce” it can use to significantly enhance its business.

The buyer believes it can achieve significant synergies and therefore make the deal accretive for its shareholders.

Question 4

Why would an acquisition be dilutive?

Answer 4

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares. Acquisition effects - such as amortization of intangibles - can also make an acquisition dilutive.

Question 5

Is there a rule of thumb for calculating whether an acquisition will be accretive or dilutive?

Answer 5

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller’s Pre-Tax Income. And if it’s an all-stock deal you can use a shortcut to assess whether it is accretive. But if the deal involves cash, stock, and debt, there’s no quick rule-of-thumb you can use.

Question 6

A company with a higher P/E acquires one with a lower P/E - is this accretive or dilutive?

Answer 6

Trick question. You can’t tell unless you also know that it’s an all-stock deal. If it’s an all-cash or all-debt deal, the P/E multiples of the buyer and seller don’t matter because no stock is being issued.

Question 7

What is the rule of thumb for assessing whether an M&A deal will be accretive or dilutive?

Answer 7

In an all-stock deal, if the buyer has a higher P/E than the seller, it will be accretive; if the buyer has a lower P/E, it will be dilutive.

Question 8

What are the complete effects of an acquisition?

Answer 8

Foregone Interest on Cash

Additional Interest on Debt

Additional Shares Outstanding

Combined Financial Statements

Creation of Goodwill & Other Intangibles

Question 9

If a company were capable of paying 100% in cash for another company, why would it choose NOT to do so?

Answer 9

It might be saving its cash for something else or it might be concerned about running low if business takes a turn for the worst; its stock may also be trading at an all-time high and it might be eager to use that instead.

Question 10

Why would a strategic acquirer typically be willing to pay more for a company than a private equity firm would?

Answer 10

Because the strategic acquirer can realize revenue and cost synergies that the private equity firm cannot unless it combines the company with a complementary portfolio company. Those synergies boost the effective valuation for the target company.

Question 11

Why do Goodwill & Other Intangibles get created in an acquisition?

Answer 11

These represent the value over the “fair market value” of the seller that the buyer has paid. You calculate the number by subtracting the book value of a company from its equity purchase price. Goodwill and Other Intangibles represent things like the value of customer relationships, brand names and intellectual property.

Question 12

What is the difference between Goodwill and Other Intangible Assets?

Answer 12

Goodwill typically stays the same over many years and is not amortized. It changes only if there’s goodwill impairment. Other Intangible Assets, by contrast, are amortized over several years and affect the Income Statement by hitting the Pre-Tax Income line.

Question 13

Is there anything else “intangible” besides Goodwill & Other Intangibles that could also impact the combined company?

Answer 13

Yes. You could also have a Purchased In-Process R&D Write-off and a Deferred Revenue Write-off. The first refers to any Research & Development projects that were purchased in the acquisition but which have not been completed yet. The second refers to cases where the seller has collected cash for a service but not yet recorded it as revenue, and the buyer must write-down the value of the Deferred Revenue to avoid “double-counting” revenue.

Question 14

What are synergies, and can you provide a few examples?

Answer 14

Synergies refer to cases where 2+2=5 (or 6, or 7…) in an acquisition. There are 2 types: revenue synergies and cost synergies.

Revenue Synergies: The combined company can cross-sell products to new customers or up-sell new products to existing customers. It might also be able to expand into new geographies.

Cost Synergies: The combined company can consolidate buildings and administrative staff and can lay off redundant employees. It might also be able to shut down redundant stores or locations.

Question 15

How are synergies used in merger models?

Answer 15

Revenue Synergies: Normally you add these to the Revenue figure for the combined company and then assume a certain margin on the Revenue - this additional Revenue then flows through the rest of the combined Income Statement.

Cost Synergies: Normally you reduce the combined COGS or Operating Expenses by this amount, which in turn boosts the combined Pre-Tax Income and thus Net Income, raising the EPS and making the deal more accretive.

Question 16

Are revenue or cost synergies more important?

Answer 16

No one in M&A takes revenue synergies seriously because they’re so hard to predict. Cost synergies are taken a bit more seriously because it’s more straightforward to see how buildings and locations might be consolidated and how many redundant employees might be eliminated.

Question 17

All else being equal, which method would a company prefer to use when acquiring another company - cash, stock, or debt?

Answer 17

Assuming the buyer had unlimited resources, it would always prefer to use cash. Why?

Cash is “cheaper” than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher.

Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds.

Stock is the most “expensive” way to finance a transaction. Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.

Question 18

How much debt could a company issue in a merger or acquisition?

Answer 18

Generally you would look at Comparable Companies/ Precedent Transactions to determine this. You would use the combined company’s LTM EBITDA figure, find the median Debt/EBITDA ratio of whatever companies you’re looking at, and apply that to your own EBITDA figure to get a rough idea of how much debt you could raise.

Question 19

How do you determine the Purchase Price for the target company in an acquisition?

Answer 19

You use the same Valuation methodologies we already discussed. If the seller is a public company, you would pay more attention to the premium paid over the current share price to make sure it’s “sufficient” (generally in the 15-30% range) to win shareholder approval. For private sellers, more weight is placed on the traditional methodologies.

Question 20

Let’s say a company overpays for another company - what typically happens afterwards and can you give any recent examples?

Answer 20

There would be an incredibly high amount of Goodwill & Other Intangibles created if the price is far above the fair market value of the company. Depending on how the acquisition goes, there might be a large goodwill impairment charge later on if the company decides it overpaid. A recent example is the eBay / Skype deal, in which eBay paid a huge premium and later ended up writing down much of the value.

Question 21

A buyer pays $100 million for the seller in an all-stock deal, but a day later the market decides it’s only worth $50 million. What happens?

Answer 21

The buyer’s share price would fall by whatever per-share dollar amount corresponds to the $50 million loss in value. Depending on how the deal was structured, the seller would effectively only be receiving half of what it had originally negotiated. This illustrates one of the major risks of all-stock deals.

Question 22

Why do most mergers and acquisitions fail?

Answer 22

In practice it’s very difficult to acquire and integrate a different company, actually realize synergies and also turn the acquired company into a profitable division. Many deals are also done for the wrong reasons, such as CEO ego or pressure from shareholders.

Question 23

What role does a merger model play in deal negotiations?

Answer 23

The model is used as a sanity check and is used to test various assumptions. A company would never decide to do a deal based on the output of a model. Emotions, ego and personalities play a far bigger role in M&A than numbers do.

Question 24

What types of sensitivities would you look at in a merger model? What variables would you look at?

Answer 24

The most common variables to look at are Purchase Price, % Stock/Cash/Debt, Revenue Synergies, and Expense Synergies. You might look at sensitivity tables showing the EPS accretion/dilution at different ranges for the Purchase Price vs. Cost Synergies, Purchase Price vs. Revenue Synergies, or Purchase Price vs. % Cash.