Accretion dilution slide from Lazard’s pitchbook to Tower Group.
Note: you can find a more recent version of this lesson by clicking here.
This post is part two of a two part series. Click here for part 1.
Major Income Statement Adjustments
When one company acquires 100% of another company, the net income generated by both companies, along with all line items, is consolidated (lumped together). Modeling the pro forma income statement impact of an acquisition requires that we take into account deal-related adjustments. Although these are not exhaustive, we outline the major deal-related adjustments below. For in-depth, step-by-step training on building and modeling complete accretion dilution models, please see our self study programs or participate in our upcoming 4-day financial and valuation modeling seminars.
A. Stock-For-Stock Acquisitions
New acquirer shares issued
Acquirers can acquire target by exchanging acquirer shares (stock-for-stock), by paying cash (cash-for-stock), or by using a combination of both forms of consideration – cash and stock. As we discussed in the previous newsletter, the major adjustment to EPS in a stock deal is the issuance of new acquirer stock (see illustration below). The acquirer will issue a certain amount of its own stock in exchange for target shares. In a complete (100%) stock-for-stock acquisition, the acquirer will issue enough of its own stock to purchase all of the target stock, reducing pro forma EPS. The ratio of acquirer shares issued per target share is called the exchange ratio. The exchange ratio taken from our example below is 2.4x.
B. Cash-For-Stock Acquisitions
New acquirer debt
When an acquirer purchases the stock of a target with cash (vs. acquirer stock), the acquirer typically raises the cash by borrowing debt. This new borrowing impacts the income statement in the form of incremental interest expense, reducing the pro forma net income and EPS. The major adjustment to EPS in a cash deal is the incremental interest expense arising from additional debt issued to finance the deal.
Excess cash
Acquirers also often use excess cash and liquid securities to help finance an acquisition. Since excess cash and liquid securities typically generate interest income on the income statement, the elimination of excess cash and securities also means that we need to eliminate the benefit of interest income from pro forma EPS.
Synergies: When 1+1=3
Synergies represent cost savings or incremental revenues that arise from an acquisition. If a hot dog chain merges with another hot dog chain, their scale allows them to negotiate better prices for hot dog buns and napkins – that’s the basic idea behind synergies. Synergies are often the rationale for a strategic acquisition – otherwise, what’s the point? Cost saving synergies: Merging companies can often make a significant cut in expenses by eliminating incompetent target CFOs, overlapping R&D efforts, closing down manufacturing plants, or trimming the workforce. Revenue synergies: As a result of combined technology/intellectual property, the combined firm may be able to bolster its revenue stream with new products and cross-selling opportunities. Don’t forget that any revenue synergies included here must be net of any costs associated with those incremental revenues. The impact is an increase in net income and EPS.
More Adjustments
Option proceeds
Typically in an acquisition, all outstanding target options vest. In-the-money options are assumed to be exercised and the acquirer receives option proceeds but must acquire more shares. When building an accretion dilution model, we can either assume that the acquirer will use all the cash from option proceeds to buy back as many target shares as possible (this approach is called the treasury stock method), or we can assume that the acquirer will simply keep these proceeds as cash. If we assume the treasury stock method, diluted shares outstanding will need to reflect the additional shares outstanding from options less the shares repurchased via option proceeds. If we assume that the acquirer keeps the option proceeds, we need to reflect the full impact of dilution. However, offsetting this is incremental interest income being generated by cash from options proceeds.
Deal-related fees
In an acquisition, there are investment banking advisory fees, legal fees, and accounting fees. Prior to 2009, these fees were included in the calculation of purchase price, and thus typically reflected within goodwill. Since goodwill is not amortized, there was no explicit EPS impact from these fees.* Starting in 2009, , instead of including deal fees in the calculation of purchase price, they began to be expensed as incurred on the income statement. In fact, several accounting issues related to M&A changed in 2009.
Underwriting fees
When a company borrows debt to finance an acquisition, the fees related to this borrowing are treated differently from advisory, legal, and accounting fees. Underwriting fees are capitalized and amortized over the life of the debt issuance. This creates an incremental amortization expense which reduces pro forma EPS.
Goodwill
Under GAAP, acquisitions are accounted for under the purchase method. Target assets and liabilities are written up / down to fair market value.** Any excess is allocated to goodwill. Subsequent to the landmark FASB decision in 2001, goodwill no longer gets amortized, and there is no explicit, systematic impact of goodwill on EPS anymore (goodwill is, however, subject to impairment tests).
Incremental D&A, asset write-ups, write-downs
Assets like PP&E and intangible assets are typically written-up to fair market value . Incremental D&A will be recorded thereby reducing EPS. Other assets and liabilities (inventories, accounts receivable, debt, etc.) are also adjusted to fair market value, and can either reduce or increase EPS depending on the nature of the adjustments.
Conclusion
This is a brief introduction to the concepts and adjustments underlying accretion/dilution analysis and modeling. These are, of course, just a few of the many issues that come into play when building an accretion/dilution analysis. Other adjustments that we did not include – they are typically minor, but may be significant for some transactions – involve the treatment of in-process research & development, registration fees, and refinancing target debt. In subsequent newsletters we will also address accretion dilution modeling issues such as calendarization challenges in Excel, and stub-year period calculations.
Learn More → Investment Banking Primer
Footnotes
* Since these fees are part of the purchase price, there is an implicit EPS impact – either in incremental interest expense or lost interest income). ** Since in most acquisitions the tax basis of assets and liabilities does not change, this write- up typically creates a deferred tax liability to reflect the difference between the book and tax basis of assets and liabilities. These issues are fully detailed in Wall Street Prep’s Self Study Program and seminars.