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Before you buy a firm: Analyze

Welcome to class of International Merger and Acquisition (M & A) by Dr. Satyendra Singh www.uwinnipeg.ca/~ssingh5. Before you buy a firm: Analyze. Products of the firm Bottom up (daily use products), Top down (like a firm, sector…) Financial health of the firm

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Before you buy a firm: Analyze

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  1. Welcome to class ofInternationalMerger and Acquisition (M & A)byDr. Satyendra Singhwww.uwinnipeg.ca/~ssingh5

  2. Before you buy a firm: Analyze • Products of the firm • Bottom up (daily use products), Top down (like a firm, sector…) • Financial health of the firm • Earning, Balance sheet, LP account… • Management of the firm • Reputation, can they take it to the next level • Geographical exposure • Local vs. international • Stock market valuation of the firm • P/E over time, EPS over time

  3. Logic of M&A • Value creation through synergy • Economies of Scale • Economies of Scope • Transferring competencies • Sharing infrastructure • Access to patents, Growth potential, Risk sharing • ↑Debt capacity, ↓cash flow variability • Combined cash flow > individual • If Market value < true value • Needs restructuring; inefficient management • Where is the value coming from?

  4. Value Creation: Financial Perspective • Price per share (Market, not book) • Growth, risk, market speculation (based on P/E)… • Earning per share • TTM (Tailing 12 months), Sales side vs buy side • P/E Ratio • If too ↓, suspicious. If too ↑, why? Why buy a company with high P/E  must have reason • Capital structure impacts P/E ratio  Leveraged • Everything being identical in the same industry, P/E should be about same • Check P/E from industry sector, FTSE 100 • Obtain justifiable values based on the ratios.

  5. Value Creation: Example 1 Post-merger Price per share = $80 EPS = $7 P/E = 11.4 Pre-merger Price per share = $75 EPS = $5 P/E = 15 P/E dropped following merger, so the value of the merger is coming from the current projects rather than its future growth potential

  6. Value Creation: Example 2 P/E 2012 2013 2014 2015 2016 2017 $100/$1 100/2 100/3 100/4 100/5 100/6 100 50 33.3 25 20 16.7 P/E = Price to earning per share ratio P/E = 100 is too high  needs justification P/E match industry level everything being equal Expect growth  100% increase in EPS  must continue If P/E drastically different  merger arbitrage Value  from future growth potential on sustainable basis

  7. Why M&As Fail • Premium paid (shares) > synergy/value • Expensive: Bankers, accountant and lawyers • Competitive bidders appear • Arbitrageurs can buy outstanding stocks and force price concession • Lengthening the acquisition process • So more expensive • As such cash acquisition is more risky • Acquirer takes all the risks • Stock acquisition – risk is shared

  8. Can we create synergy/close the gap? Firm A B Combined P $60 $20 Earning $50m $10m $60m # shares 10m 10m 15 (10+5) EPS $5 $1 P/E 12 20 $60m/#15m = $4/share Loss of $1 per share ($5-$4) (+$10 x 10m = $100m premium) Can we close the gap? A agreed to buy B’s share for $30 (ie pay premium of $10/share) ie. Half share of A for every share of B (.5A = B) ie, B’s 10m share are equivalent to A’s 5m shares, total being 15m shares

  9. PEG Ratio • It is PE Ratio divided by the annual forecast EPS growth percentage • If a firm is growing at 30% a year and has a P/E of 30, PEG would be 1. • PEG > 1  Share cost is high relative to growth expectation • PEG < 1  Share cost is fair relative to growth expectation ***PEG is not scientific***

  10. PEG Ratio

  11. Managerial Motives to M&A • Conflict of Interest • Managers like running large firms due to additional pay and prestige • Overconfidence • Hubris Hypotheses (HH)  pursue merger even if low value because they believe their ability to manage is great enough to succeed. • Main difference: • Managers destroy shareholders value for personal gain • As per HH, managers believe they’re doing the right thing for shareholders.

  12. Period: Major M & A Activities

  13. Types of Takeover… • Takeover • Transfer of ownership from 1 firm to another • Merger • Combination of 2 firms into 1 legal entity • Similar-sized firms are combined • So are their names • One may be of the parents’ or a combination • DaimerChrysler • SIRIUS XM • Both shareholders approve the transaction

  14. Types of Takeover • Acquisitions • Purchase of 1 firm by another • Larger firm buys smaller firmer, which becomes a subsidiary • Kraft foods buys Cadbury • Amalgamation • Merger that requires a fairness opinion by an independent expert on the value of the firm’s shares when public minority exists • Consolidation • An entirely new form is created

  15. Types of M&A Activities • Related • Vertical • Supplier or customers • Horizontal • Competitors • Product extension • Complementary products • Market extension • Complimentary markets • Unrelated • Conglomerate • Everything else

  16. Friendly Takeover • Target firm is willing to be taken over • Investment bank to prepare tender offer to management • Can be initiated by acquirer • Both parties structure the deal to their mutual satisfaction; eg, • Capital gain • Acquirer use target as asset for tax deductions • Graceful exit  environmental lawsuits • Agree on initial purchase price; pay later

  17. Friendly Acquisition Process

  18. Hostile Takeover • Transactions bypass the management • Management is opposed to the deal • Acquirer already accumulated 20% of Target’s stock • So, tender offer is made directly to shareholders

  19. Hostile Takeover: Defense Tactics • Shareholders Rights Plan • Poison Pills • Dilute the share by offering more shares and by giving discount (50%) to Target’s shareholders, making it expensive for Acquirer • Selling Key Assets • Sell the assets that Acquiring firm is interested • Pay large dividends to remove excess cash from Target’s balance sheet • White Knight • Seek out friendly acquirer

  20. Critical Shareholder % • 10% early warning • Acquisitor is accumulating a position-- toehold • 20% takeover bid • Not allowed further, must tender bid, open to all • 50.1% control (Simple majority) • Can replace board and control management • 66.7% amalgamation • Shareholders approve amalgamation proposal • 90% minority squeeze out • Minority shareholders are forced to tender their shares  to avoid frustration

  21. Regulatory approval • All mergers must be approved by regulators • In the USA, all mergers over $60m must be approved by the government before the proposed takeover occurs • EU Commission has similar process • Emerging markets • More strict due to colonization

  22. Merger Arbitrage • Once a tender offer is announced, the uncertainty about whether the takeover will succeed adds volatility to the stock price • This uncertainty creates an opportunity for investors to speculate on the outcome of the deal • It creates volatility • Market share price > offer price (may be more bid) • Market share price = offer price (deal is likely) • Little trade in shares (deal may not go through) • Significant trade in shares (deal is likely)

  23. Merger Arbitrage Example Firm A Price per share = $30 # shares = 10m Market Capital = $300m Firm B (Target) Price per share = $50 # Share = 1m Market Capital = $50m A is acquiring B for $60m in A’s Share (A needs 2m more shares @ $30/share  $60m) ie. 2 shares of A for every share of B (2A = B) Suppose due to volatility, share for B is trading at $55 So buy 1 share of B  $55 (exchange it for $60) Short sell 2 share of A  $60 Net gain $5

  24. Leverage: Impact of Capital Structure on P/E, Assets Firm A Invested $100 K Not borrowed, so no liability # shares = 10,000 COGS (50%) = -$50K Depreciation = -$20K Operating Income (Pre-tax) = $30K Tax (30%) = -$9K Interest = 0 Earning after tax = $21 K EPS = $2.10 Analyst  P/E should be 10 So, market share price = $21 Market capitalization = $210 K But A put $100 K Equity + Liability = $210 K + $0 Total Assets (iemkt value of equity) = $210 K Firm B Invested only $10 K Borrowed $100 K @ 5% (ie $5K) # shares = 10,000 COGS (50%) = -$50K Depreciation = -$20 Operation Income (Pre-tax) = $30K Non-operating Income = $2K Total Operating Income = $32K Tax (30%) = -$8.1K Interest paid = $5 K Earning after tax = $18.9 K EPS = $1.89 Analyst  P/E should be 10 So, market share price = $18.90 Market capitalization = $189 K But B put only $10 K Equity + Liability = $189 K + $100K Total Assets = $289 K Ie. $279K assets + $10K cash = $289K By borrowing you’ll ↑ assets

  25. Impact of M&A on Goodwill Goodwill = Price paid – MV of Target firm Equity = $1,250 – (MV of target assets – MV of target Liabilities) = $1,250 – ($2,200 - $1,050) = $100

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