Welcome to class of International Merger and Acquisition (M & A) by Dr Welcome to class of International Merger and Acquisition (M & A) by Dr. Satyendra Singh http://abem.uwinnipeg.ca

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

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?

Value: Turn inefficiency to efficiency?

Value Creation: Financial Perspective Price per share (Market, not book) Growth, risk, market speculation (based on P/E)… Earning per share TTM (Trailing 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.

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

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

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

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 ie, $1 x 15m =$15m

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***

PEG Ratio

Managerial Motives to M&A Conflict of Interest Managers like running large firms due to additional pay and prestige Overconfidence Hubris Hypothesis (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.

Period: Major M & A Activities

Recent Mergers…

Recent Mergers

Types of Takeover… Takeover Merger 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

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

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

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

Friendly Acquisition Process

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

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/difficult 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

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

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

Government can interfere; for example,

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)

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

Leverage: Impact of Capital Structure on P/E, Assets Firm A Invested $100 K Not borrowed, so no liability # shares = 10,000 COGS (50%) = -$50 K Depreciation = -$20 K Operating Income (Pre-tax) = $30 K Tax (30%) = -$9 K 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 (ie mkt value of equity) = $210 K Firm B Invested only $10 K Borrowed $100 K @ 5% (ie $5 K) # shares = 10,000 COGS (50%) = -$50 K Depreciation = -$20 K Operation Income (Pre-tax) = $30 K Non-operating Income = $2 K Interest paid = -$5 K Total Operating Income = $27 K Tax (30%) = -$8.1 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. $279 K assets + $10 K cash = $289 K By borrowing you’ll ↑ assets

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