When some company acquires another company we generally feel that it creates value for shareholders, but this doesn’t happens always.
Check the numbers of this company lets call it company X which is growing its sales by 5%. The tax rate is 34%. The current income statement numbers and projected numbers will be
| Company X | Year 1 | Year 2(Projected) |
|---|---|---|
| Sales | 5000 | 5250 |
| Cost and expenses | ||
| cost of goods sold | 3422.7 | 3591.4 |
| selling, general and administrative expenses | 1250 | 1315 |
| interest expenses | 100 | 105 |
| Total costs and expenses | 4772.7 | 5011.4 |
| Income before income taxes | 227.3 | 238.6 |
| Income taxes | 77.3 | 81.1 |
| Net Income | 150 | 157.5 |
| YoY sales increase | 5% | |
| Net income as % of sales | 3% | 3% |
| Shares outstanding(million) | 75 | 75 |
| EPS | 2 | 2.1 |
| PE | 14 | 14 |
| Price per shares | 28 | 29.4 |
Lets take another small size unlisted company and call it company Y which is growing its sales by 5%
| Company Y | Year 1 | Year 2(Projected) |
|---|---|---|
| Sales | 238.1 | 250 |
| Cost and expenses | ||
| cost of goods sold | 160.6 | 171.1 |
| selling, general and administrative expenses | 61.9 | 62.5 |
| interest expenses | 4.8 | 5.0 |
| Total costs and expenses | 227.3 | 238.6 |
| Income before income taxes | 10.8 | 11.4 |
| Income taxes | 3.7 | 3.9 |
| Net Income | 7.1 | 7.5 |
| YoY sales increase | 5% | |
| Net income as % of sales | 3% | 3% |
| Shares outstanding(million) | ||
| EPS | ||
| PE | ||
| Price per shares |
Case 1: Company X acquires company Y through equity funding
We are giving the PE of 14, so lets assume that the company will be acquired by paying 14 times the earnings. Which becomes 7.1 x 14 = 99.4 million . Company X will acquire company Y by paying 99.4 million. Company X share price is 28 , therefore for funding of 99.4 million company X has to issue 99.4/28 = 3.6 million additional shares. This will increase the number of shares outstanding to 78.6 million (75+3.6)
After the acquisition the sales of company Y will be added to sales of company X . Therefore the new income statement for year 2 will be as below
Note: We are adding the 2nd year projected numbers of Company X and Y
| Company X After Acquiring Company Y | Year 1 |
|---|---|
| Sales | 5500.1 |
| Cost and expenses | |
| cost of goods sold | 3762.5 |
| selling, general and administrative expenses | 1377.5 |
| interest expenses | 110 |
| Total costs and expenses | 5250 |
| Income before income taxes | 250 |
| Income taxes | 85 |
| Net Income | 165 |
| YoY sales increase | 10% |
| Net income as % of sales | 3% |
| Shares outstanding(million) | 78.6 |
| EPS | 2.1 |
| PE | 14 |
| Price per shares | 29.4 |
Notice that after adding the sales figures there is a year on year increase by 10% But this increase in sales is bringing no change in the EPS and Share price of the company because of increase in the number of shares. The EPS of the company is 2.1 with acquisition which is same as year 2 EPS of company X without acquisition. The 10% sales growth is not bringing any positive change , the things are same. In short annual sales growth from 5% to 10% has not benefited shareholders, whose shares increases in value by 5% whether Compay X acquires Company Y or not. Acquisition of another company through equity dilution doesn’t creates value for shareholders.
Case 2: Company X finances the acquisition of company Y with borrowed money
In this case lets assume the Company X will pay the amount of 99.4 million by borrowing money at the rate of interest of 8% this will result in increase in interest expenses. The new profit and loss statement will be like
below
| Company X After Acquiring Company Y | Year 1 |
|---|---|
| Sales | 5500.1 |
| Cost and expenses | |
| cost of goods sold | 3762.5 |
| selling, general and administrative expenses | 1377.5 |
| interest expenses | 118 |
| Total costs and expenses | 5258 |
| Income before income taxes | 242 |
| Income taxes | 85 |
| Net Income | 159.7 |
| YoY sales increase | 10% |
| Net income as % of sales | 3% |
| Shares outstanding(million) | 75 |
| EPS | 2.13 |
| PE | 14 |
| Price per shares | 29.82 |
Because of increased debt interest expense will increase to 118 from 100 million. Pretax income therefore falls from 250 million to 242 million, reducing net income from 165 million to 159.7 million. The number of shares outstanding will be 75 million only as funding is not through equity. This will result in increase in EPS to 2.13 from the previous case of 2.10 and the PE multiple of 14 the stock price will become 29.82 from the previous case of 29.4 There will be slight increase in the share price.
But in reality there won’t be increase in share price because a high debt company gets low PE multiple. If PE is reduced to 13 the stock price will become 27.69 that is reduction in the value.
So debt-funded acquisition also doesn’t increase the shareholders wealth and in fact it could reduce it. This is the reason why companies like Suzlon, 3i infotech, Opto circuits etc who did lot acquisition by taking debt were the wealth destroyer for shareholders.
Case 3 Acquisition takes place through surplus cash
In this case there won’t be equity dilution, there won’t be increase in interest expense, The PE multiple wont go down. The income statement in this case will be
| Company X After Acquiring Company Y | Year 1 |
|---|---|
| Sales | 5500.1 |
| Cost and expenses | |
| cost of goods sold | 3762.5 |
| selling, general and administrative expenses | 1377.5 |
| interest expenses | 110 |
| Total costs and expenses | 5250 |
| Income before income taxes | 250.1 |
| Income taxes | 85 |
| Net Income | 165.06 |
| YoY sales increase | 10% |
| Net income as % of sales | 3% |
| Shares outstanding(million) | 75 |
| EPS | 2.20 |
| PE | 14 |
| Price per shares | 30.08 |
You can see in this case there is rise in EPS and the share price. This will result in slight increase in value for shareholder.
In the next article I will write on the cases when acquisition actually benefits shareholders.