How does an investor begin to assess the real value of a merger or acquisition made by a company in which they own shares?

When chip design champion ARM (ARM) agreed to a £24.3 billion takeover by Japan’s Softbank (9984:T) on 18 July 2016, the fundamental gravy for shareholders in the UK company was glaringly obvious. They were being offered £17.00 per share, equal to 43% more than the market value of the stock before the news. You can debate whether this is good or bad value, but the monetary gain is self-evident.

But being on the flipside of that takeover equation is harder to judge and remains a salient issue for private investors.

They often struggle to understand the terminology that usually accompanies an acquisition. There’s typically talk of expanding a geographic footprint, bolstering the product suite and cross-selling opportunities, sometimes used as euphemisms for
cost-cutting.

There is no magic formula to make acquisitions successful. Like any other business process, they are not inherently good or bad, just as marketing or research and development are not. Each deal must have its own strategic logic.

‘In our experience, acquirers in the most successful deals have specific, well-articulated value creation ideas going in,’ write McKinsey analysts Marc Goedhart, Tim Koller and David Wessels in a study on M&A. ‘The strategic rationale for less successful deals, such as pursuing international scale, filling portfolio gaps, or building a third leg of the portfolio, tend to be vague.’

Every acquisition is different and each comes with its own set of challenges. The principle is the same: two companies with separate ownership unite and operate under the same roof to obtain some strategic or financial goal. But with so many potential deal structures out there, and the valuation of a target company often tricky to establish, some have argued that buying another business is less of a science and more of an art.

Clear vision

Some of the business chiefs with the better reputations for successful M&A try to keep things relatively simple. ‘Almost without exception we only look at businesses with long track records of profitability,’ says John McArthur, CEO of transport software and services specialist Tracsis (TRCS:AIM).

When push comes to shove, in McArthur’s eyes it is all about a company’s ability to increase profit and generate the cash flow needed to pay shareholders their dividends. ‘It is about how we can use existing cash or debt facilities to make more money.’

John McArthur, CEO Tracsis

McArthur’s view chimes with many other M&A industry experts. ‘M&A should be the means to an end, not an end in itself,’ says Mostyn Goodwin, a partner at OC&C Strategy Consultants.

There are no end of bad reasons to strike out on the acquisition trail, from financial engineering to disguising looming internal operational problems, a management team’s sheer thrill of the chase to its reluctance to hand surplus cash back to investors.

Though not guaranteed, the chances of generating long-run sustainable value is greatly increased when M&A is executed as part of a clearly defined strategy. ‘In our experience,’ says Goodwin, ‘companies wishing to generate real long-term value should make M&A an enabler of strategy, not a pseudo-strategy in itself.’

According to Tracsis’ McArthur, companies, analysts and investors can get carried away talking about strategic acquisitions and new market opportunities. ‘That’s more complex than what I typically look at,’ he says. ‘We are specifically interested in niche businesses.’

To McArthur, it is not so much about what a target company might do, instead it is more about what that target can contribute and how much did Tracsis pay versus what has been added, the ‘relative value’ as he calls it.

At the simplest level, economic M&A is all about natural arbitrage. ‘If my company’s stock is trading on a 20-times price to earnings (PE) multiple, and we buy a company at a PE of below 10, hopefully much less, suddenly those new earnings are worth a lot more,’ explains the Tracsis CEO, a reaction to those new earnings getting re-rated to match Tracsis’ own.

The thinking is that the acquired company is now part of a bigger entity with more resources, improved contacts and opportunities and, not least, more liquid and easier to trade stock being part of a listed business, hence a higher value placed on its future earnings.

According to the CEO, Tracsis has historically bought companies on less than five times earnings across its nine acquisitions to date. ‘(Price paid) is probably the biggest litmus test for us, more important than geography or management chemistry, although there are other boxes to tick,’ he admits.

Image issue

Acquisitions generally have a bad reputation. Alliance Bernstein produced an M&A report in June 2016 looking specifically at the 54 technology sector mega deals, or those valued in excess of $5 billion, over the last decade. The study concluded that ‘historically, the majority of very large tech acquisitions have been failures.’

Yet the overall appetite for M&A remains stronger than ever. In 2015 the value of global M&A activity set a new record of $4.2 trillion, according to Thomson Reuters, beating the previous high set eight years earlier.

‘In 2007 an average of about one deal of $10 billion or more would get announced each week, but last year it averaged at about 1.5 a week,’ said David Lomer, JP Morgan’s co-head of mergers and acquisitions for Europe, the Middle East and Africa (EMEA) at the start of 2016.

At the time he also remarked that the pipeline of deals for 2016 was ‘markedly up year-on-year,’ but stressed that whatever the bid environment, companies should never underestimate the importance of discipline, particularly when it comes to valuation.

At the start of 2016 global consultant EY said its research showed that 42% of all UK executives were aggressively focused on growth and planned to acquire assets in the next 12 months, driven by a need to accelerate earnings.

That deal optimism is far from being fulfilled so far this year, according to most recent data from the Office of National Statistics. In its first quarter report there were 114 successfully completed domestic and cross-border acquisitions and disposals involving UK companies. That puts the volume of deals struck by UK companies towards the historically low end of activity, although there are obvious volatility fluctuations in long-run quarterly data. Interestingly, the overall value of those deals was at the higher end of long-run averages.

No one size fits all

Engineering turnaround specialist Melrose (MRO) is an M&A specialist with an enviable track record. Its modus operandi involves buying what it considers to be good manufacturing businesses with strong fundamentals in order to improve performance.

Financing its acquisitions using low level debt leverage, it improves a target business by a mixture of investment and changing the internal management focus. When it feels it has added all it can, Melrose flips the business via a sale and hands the money back to shareholders. The company has delivered an average shareholder return of 22% per year since its first deal in 2005.

Melrose’s experience shows that the philosophy of Tracsis’ McArthur is not a one size fits all M&A blueprint per se, but it is what he thinks is best for his company, and it works.

Since 2008 Tracsis has completed eight full acquisitions plus bought a minority stake in human and motor traffic analytics designer Citi Logik, for a combined cost of approximately £40 million in cash and shares. In the last five years alone the share price has soared more than 650% to the current 440.5p, adding at least £105 million to the market value.

A last vital point for all investors to understand is the way companies pay for acquisitions. Often a deal is accompanied by a share placing to raise cash to aid the funding. Not necessarily bad, but this does add extra dilution risk to existing shareholders, especially private investors who are usually excluded from the cash call.

That’s not (typically) the Tracsis way, which almost entirely funds its own M&A from existing cash or debt resources, mainly using earn-outs and issuing only a small number of new shares to provide incoming management with the right kind of performance incentives going forward.

‘It’s a really important point,’ he says and it remains one that even City analysts often overlook when it comes to assessing future growth performance of the combined business.

The fund manager’s view

Ali Unwin

Fund manager, Neptune Global Technology Fund

(GB00BYXZ5N79)

Assessing the value created or destroyed by M&A deals is extremely difficult as a fund manager. Even in retrospect, apart from the obvious blow-ups or home runs, you don’t know how things would have looked had a deal taken place (or not).

We consider deals in the context of the long-term outlook for the companies involved. To look at a deal being undertaken by a company in which we invest we consider four main things:

Underlying rationale or real motivation

This may not always be quite the same as management claim. Deals in the technology space usually fall under:

1. Tuck-ins. These are a small ticket price which add a new product or feature, new distribution capabilities, or some other advantage to the acquirer. Lower risk from a monetary point of view but must be considered in terms of overall acquirer company strategy - these deals use up management time, divert resources from other projects and can act as a cover for management to be slow to address issues in their ‘core’ business. In general we trust management teams to undertake these deals efficiently but would be concerned if they did not fit in with the overall strategy.

2. Market consolidation. These can be small or large but rely on synergies in both cost (remove duplicate cost centres) and revenues (improved products, better R&D, cross sell to each other’s customers). These are most interesting when there is a change in the bargaining power between the combined entity and their customers as the market consolidates as this can allow more pricing power.

3. Transformational. This might be a deal that takes the acquirer into a new line of business and normally quite significant in monetary terms. Risky given the size and scale and historically not often been successful. We tend to be sceptical of companies making very large deals or acquisitions outside of their normal market as it can sometimes signal weakness in the core business (management are ‘acquiring growth’).

Price

Closely linked to the deal rationale - a company may be of higher strategic value to one buyer than another - but here we would look at comparable deal multiples, likely potential synergies (revenue and cost), and the impact the deal would likely have on market dynamics.

Some deals may be of limited strategic value but still represent a good use of shareholders’ capital - for example buying a small competitor that has become a forced seller at a rock bottom price. Other deals may look ‘optically’ expensive (ie at a high multiple of earnings) but prove very successful - for example a large company paying for an exciting new company whose products it can then distribute though its superior distribution channels.

In some more cyclical industries (e.g. semiconductors) we would also look at the point in the cycle. A lower multiple on peak cycle earnings may not be as attractive as a high multiple on earnings when the cycle is bombed out.

Regulatory hurdles

We have seen intensifying regulatory scrutiny in the technology space with the emergence of Chinese tech M&A, in particular. The main concern as a fund manager is that the acquirer’s share price moves on the news of the deal as if it will automatically be permitted, which has not always been the case.

Management incentives

Some management teams will have a ‘change of control’ provision over some or all of their share options, which might give them an incentive to take a weak offer in order to crystalilse their options today rather than risk not meeting their performance criteria in coming years.

Some companies on the acquirer side have M&A as a core part of their strategy, and this can be effective if a management team is experienced and well-regarded in the space (e.g. Micro Focus (MCRO)). The discipline on price and ability to ‘walk away’ from deals is the key thing we would look for here.