Acquisitions

Click here for a walk through a real company acquisition

In 2009, Kraft Foods launched
a takeover bid for UK firm Cadbury
Acquisitions (or takeovers) are relatively uncommon in the markets. In simple terms an acquisition is when one company bids for, and takes over another company which they then own. When an acquisition takes place, the board of the predator company will draw up and submit an offer to the shareholders (the owners) of the target company. It is then up to the shareholders of the target company to decide whether it is in their best interests or not.

For the predator to take over the target, it needs to receive 50% acceptances plus one extra acceptance. This means that the just over 50% of the shareholders of the target company must say "Yes" to the takeover. The board of the target company is also able to recommend that shareholders disregard or accept the big and this can sway the percentage achieved. If the directors of the target company own the majority of their company's shares and recommend a takeover should be accepted then the takeover is likely.

One point to look out for is as follows. Let's say the predator wants to take out the target company, but they want to start to do so by accumulating a stake in the target company so that when they make their move they have secured a large number of acceptances. Once the predator holds a 30% stake in the target, they are forced to make a bid for the target as per the UK takeover code. Therefore if the predator wants to takeover the target, but is not ready, they will hold a stake just below 30% to avoid being forced to do so.

Takeovers are not always successful either. Sometimes shareholders deem the takeover offer to not be good enough and on other occasions, once the predator has completed due diligence (background checks) they may back out of a potential deal. For example, in June 2013, Australian firm Billabong saw it's share price fall by over 50% when the predator walked away from the deal.

Why do Acquisitions occur?

- It is a fast way for a company to gain market share and thus generate higher revenues
- If the target company operates overseas, it can build the predators international awareness
- A firm may want to gain access to another company's assets, which may include patents or resource deposits
- The predator may benefit from lower costs due to Economies of Scale
- To diversify into another industry or to gain access to another stage of production (e.g. Yoghurt maker Muller took over Milk supplier Robert Wiseman Dairies which gave them control over their milk supply)

There are of course many other reasons, but these tend to be specific to the industry in question

What types of Acquisition are there?

There are two main types of takeover; cash and share based. Takeovers may take either or in some cases, a combination of these. In any case, for a takeover to be successful it it necessary for the predator to offer the target shareholders a premium. This is where the predator's offer values the target higher than their current market cap. Therefore they are paying a premium (which is expressed as a percentage). The percentage depends upon a variety of factors including the industry concerned. For example, in the oil and gas industry, the premium tends to be larger (at 40-70% typically) compared to the insurance industry where the premium typically lies between (20-50%).

An example of a cash takeover is as follows. Company A trades at 40p/share. The predator, Company B offers Company A's shareholders 56p/share equating to a 40% premium. Upon the next day of trading, Company A's shares will likely jump to 56p/share straight away. This is where the new market equilibrium lies. However, this may not always be the case. If the takeover is deemed unlikely by the market (for reasons such as a low premium), the share price may not jump to 56p but rather 50p. The 6p discount is the uncertainty over whether the offer will be accepted. Alternatively, as has been seen by Invensys (LSE:ISYS) recently, if a counter-offer is likely, the shares may rise over 56p in anticipation of a higher offer.

A share based takeover is more likely when a company feels its shares are overvalued or when a company wants to conserve cash. One example may be as follows. Company A has a share price of 36p and Company B has a share price of 60p. Company A offers Company B, 2 shares for each of Company's B's shares. Therefore Company A is effectively offering Company B 72p, which is a 20% premium. However, seeing as to do this Company A must issue new shares, it is likely Company A's share price will fall upon the announcement. Therefore Company B's share price will roughly track Company A's but may be less than 72p after the offer is announced. Considering the premium is only 20% and is likely to fall in tandem with Company A's share price, the takeover is less likely to be accepted.

Therefore it the offer initially values the target at the same share price, it is preferable for the target shareholders, to have the offer in cash as it provides a larger degree of certainty.

Takeovers can also include other proposals. Recently Afferro Mining (LSE:AFF) received a takeover bid that included 80p in cash plus a 40p/share loan note that matured after 2 years. The offer read: "The convertible loan notes will carry a coupon of 8%, which will be rolled up and paid at the end of the 24 month term. Upon maturity, the notes together with any accrued interest will be paid in either cash or converted to the equivalent value in [the predator's] shares at the time of conversion, at [the predators] discretion."

How can you value an Acquisition?

There are a number of ways to decide whether you should accept a takeover offer. These differ in complexity. Here are a few:

HP offered Autonomy investors a 78% premium
for their takeover. An offer too good to refuse
Measure the premium
A very simple way is to measure the premium that the predator is offering. Comparing it to successful past takeovers can be a good way to gauge whether the deal is acceptable. However, the easiest way to check whether the deal is even remotely good is to bring up a share chart for the target company. If the offer price is at the top end/higher than the highest traded share price then the offer is likely to be of better value. One example case is that of UK software firm Autonomy which was taken over by US firm Hewlett Packard (HP). HP offered a 78% premium in the deal which amounted to a share price above 2500p which was far higher than the share price had previously been at for well over 5 years. The result is that the deal was excellent value for Autonomy shareholders, and the takeover was accepted.

Using financial ratios
Once you have worked out the share price that is equivalent to the offer, you are able to start doing some calculations. For example, using the share price figure you can derive a new price/earnings ratio using the Earnings Per Share (EPS) value noted in the last full-year financial report for a company. Once you have derived the PE ratio, you can compare to other firms within the same sector and see whether it is reasonable. However, considering not every company generates revenues, this method cannot be used universally. Alternatively, you can compare the takeover price to a company's Net Asset Value (NAV). In an ideal situation where a takeover is good value, the difference between a company's NAV and takeover stock price will be small.

Valuation vs Cash & Assets/Liabilities
This method is more useful for smaller companies. Firstly you must locate the latest set of a companies financial results. This must contain the full financials of the company in tabulated form. First find the Cash and Cash Equivalents section. You can do this quickly through CTRL+F on your keyboard. As the name suggests that is the amount of cash a company had at the last set of results. From this, deduct any short term borrowings or other forms of debt shown under the liabilities section. Next you need to find the 'Trade Payables' and 'Trade Receivables'. Take the Payables away from the Receivables and you will be left with a figure that can be positive of negative. If negative, take this away from the cash minus debt (CDM) figure and if positive, add it to the CDM figure. This effectively is how much money the company has, or is owed. Now take the market cap of the company (post-bid) and subtract this figure from it. You now have a market cap minus the raw or owed cash. From this you can complete other valuations such as the resource valuation below. Basically, if a company has a large part of their market cap in cash, this helps see what the predator is actually paying for the assets.

Valuation Vs Resources (for Natural Resource Companies)
For companies that operate in the natural resource sector (e.g. oil, gas, gold), you can use the market cap of the company to work out whether a takeover values the company in the right sort of ballpark. Here's an example. OilExplorer has a market cap of $20m and has resources amounting to 6.5 million barrels equivalent. OilExplorer operates in the US. OilExplorer receives a takeover offer at $30m. Divide the market cap ($30m) by the number of barrels equivalent (6.5m). This retrieves a value per barrel of $4.61. Looking in the industry and at other takeovers or asset sales, the going rate (in the US) is between $3/barrel equivalent and $4.5/barrel equivalent. This rate fluctuates over time according to the US oil and gas prices so check that! Therefore the $4.61/barrel figure suggests that the deal is good value for OilExplorer.