Mergers and acquisitions are back on the menu. Global markets appear to be scenting a rebound following news of a handful of huge mergers by cash-rich companies, including chipmaker Intel’s purchase of McAfee and mining giant BHP Billiton’s hostile takeover bid for Canada’s Potash Corporation.
According to research published by Bloomberg, August was one of the most active months for global M&A activity since the financial crisis struck in 2008, with the value of deals done exceeding $175bn (£113bn) by the middle of the month. And the deals keep getting bigger: in September, fast food chain Burger King was sold to 3G Capital, a private equity firm backed by three prominent Brazilian businessmen, for £2.6bn, while in August, UK oil explorer Dana Petroleum received a hostile £1.9bn takeover bid from South Korea’s state-owned KNOC. BHP Billiton’s summer bid for Potash is worth a cool £35bn.
Activity has also picked up in the UK. According to the Office of National Statistics, expenditure on acquisitions in the UK by UK companies increased from £1.3bn in the first quarter of 2010 to £1.9bn in Q2, in which 66 UK companies made acquisitions of other UK businesses with a value of over £1m per deal. So, as companies start dipping their toes back into the M&A pool, how can FDs ensure they don’t overpay in a buyer’s market?
Negotiating a purchase price is challenging at the best of times, but negotiations are even more fraught when the prospect of a double-dip recession looms. Nick Rea, partner in the valuations team at PricewaterhouseCoopers (PwC), says finance directors face a difficult task in accurately valuing potential takeover targets because there is more temptation for struggling businesses to be more positive about the strength of recovery in their own prospects than is really the case, pushing up the value they see in their business and the cost for the buyer.
It is particularly challenging for both target and acquirer to agree on value when the target business is in transition, either on the way up or on the way down. There are often striking differences between buyer and seller views as to how and when the target business will pick up.
“In the past two years it has become more difficult to make valuations because there is less certainty than normal operating conditions,” Rea tells Financial Director.
Allan Gasson, consulting partner and M&A strategy team leader in the strategy practice at Deloitte UK, says the question FDs need to ask is how deep and how long the recession will be. Buyers expect a gradual improvement in the economy and businesses over the next few years, while many sellers expect to bounce back with a V-shaped recovery and to achieve the kind of shareholder value they demonstrated immediately prior to the recession.
Uncertainty about the shape of the economic recovery has made it harder for FDs to value a company’s current and forecasted earnings, its cashflow and underlying management strength and its competitive position in the market.
Gasson points FDs to the valuation trends coming off the back of previous recessions. After the 1992 recession, for example, the automotive components industry took five years to recover valuations, giving bidders ample room to move.
“Automotive sales were down 38 percent in August 2010 versus August 2009. You have got to put those thoughts into sellers’ heads,” he says. Gasson believes the UK economy will take another seven years to recover ground lost during the current recession. That means opportunities for depressed valuations and the length of the recovery period to be leveraged in the valuation.
“Buyers and sellers are amazed by how long that cycle takes,” he says. “The automotive cycle took five years, but this recession is going to drive that particular industry much deeper. What we are finding now is that people have a very naive approach to current expectations, typically drawing up a business plan that carries a very steep V-shape recovery, coming out in 2010 very strongly. We think this will be much more of an L-shaped recovery.”
The dearth of recent transactions is proving problematic to the valuation process.
“We rely heavily on transactions as data points that are situation specific,” says PwC’s Rea. “The intelligent use of market multiples from similar deals allow FDs to estimate target values. That is difficult now because of a lack of reliable market data.”
As a result of this, there has been a move towards a greater use of discounted cashflow models to evaluate potential targets, which assumes that predictions will come to fruition exactly as planned and on time. This is evidently problematic to impose on the current economic reality. Because of volatility in the markets, the ability to meet what in a lot of situations are very aggressive and overly optimistic forecasts is at great risk.
The inherent unreliability of the discounted cashflow approach is that you have to rely on forecasts that can be influenced afterwards by management decisions, says Rea. This in turn is pushing some to look to other valuation models giving a far more detailed level of information about underlying trends than what is behind deal valuations in the last year or so. Probabilistic modelling – taking an event and modelling the probable outcomes – decision analysis, understanding the complex reasons behind a series of decisions, and finally micro-simulation – a mind-bending econometric method involving analysing how behaviours change over time – have all crept into the analytical toolkit companies are now using to make more complicated business decisions where there is a much higher degree of risk and uncertainty.
“There is more of an appetite to look at different situations and scenario models now. People run due diligence scenarios to look at what the worst outcome could be
as well as where the upside is,” says Rea.
Many companies have recently slashed production, closed facilities, made more redundancies and implemented a number of cost-cutting strategies designed to weather the downturn. These actions may improve operating results in the short term but may not be sustainable in the long term. They may also have damaged, at least temporarily, the company’s market position and customer loyalty.
A finance director looking to acquire a company that has done this needs to carefully consider how much of those moves are sustainable after purchase and whether some cost-cutting moves may even need to be reversed if, for example, they are found to be undermining growth prospects.
“What are the cuts? What is sustainable? In an environment of cost cutting to survive, what will the earnings look like going forward?” asks Rea. “What could happen is that people expect a fantastic growth story. FDs need to be careful to build in the investment needed in support infrastructure to meet earnings targets.”
With acquisition targets slashing costs by deferring maintenance or repair projects, or foregoing the necessary capital expenditures required to be competitive, Gasson says FDs must be wary about taking one-off financial hits. He thinks such deferrals will only require future investments from the acquirer to meet existing forecasts and any additional ambitions needed to justify the acquisition.
“In the hotel industry, refurbishments take place every six years,” Gasson says. “During a downturn it is easy to let that slip to seven or eight years. If you then buy a hotel business in that environment, you inherit a major investment hit.”
Gasson adds that FDs must now be willing to hit the phone and speak to their prospective customers. A customer under cost pressure may change something internally to overcome the cost pressures they are under. Often when conditions improve, they will not return to the same level of purchasing.
With such uncertainty surrounding the variables that must be identified and factored into a valuation model, FDs need to be more diligent than ever – involving their own teams, not just those of their anointed advisers – when acquiring what at face value appears to be a bargain. Those not doing so risk paying dearly down the road.
“The overall message is that the uncertainty factor has gone up,” says Rea. “It makes life difficult from a valuation point of view. FDs must do everything they can to grapple with that.”
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