Can an EPS-accretive deal be value-dillutive?

[roark1211]

We are seeing a lot of this in Europe at the moment.

 

With 10 year sovereign bond yields hoovering around 1-2%, companies are loading up medium-term debts (5-7 years) at less than 1% to do acquisitions; hence, almost anything they can buy these days will be immediate EPS-accretive. Private-market deals are now happening at double-digit EV/EBITDA multiples, especially with assets that have bond-like characteristics, like infrastructures, utilities.

 

Most recently, Vinci (DG FP) - the largest infrastructure operator in Europe, has talked about buying Aeroport de Paris (ADP FP), at almost 18x EV/EBITDA.

 

We are having an internal debate on this. These deals, by traditional metrics, are super expensive, but they also boost EPS immediately, thanks to the simple interest rate arbitrage.

 

It would be great to hear your thought on this.

[rolling]

I am no specialist, but my major holding (Ibersol), has done something similar (but at a low multiple) very recently, so here is my opinion:

- if debt is low cost (1-2-3%)

- if it is a debt fueled acquisition

- debt is non callable and

- if cash flows will pay the totality of the debt in those 5-7 years you mention

 

Then it is a no brainer. In the end you have a cash generating asset for free.

 

However:

- if you cannot pay the totality of the debt in those 5-7 years, then nothing guarantees that you will be able to roll over that debt in the end at a similar cost.

 

So, the following make all the difference:

- multiples

- safety of cash flows

 

But:

Aquisitions are more probably value accretive if you can get medium term very low cost debt. You basically get the first 5-7 years earnings for free and basically you are programming an aquisition for a much lower multiple in 5-7 years.

[Broeb22]

I think one good example of this would be the radio roll-ups of the past few years.

 

I'm sure the PE buyers who put together radio broadcasters at 11x EBITDA saw a deal accretive to equity. However, as it became clearer that radio faced some secular headwinds, these deals became value-destructive.

 

To generalize that, I guess buying a business that quickly turns south can both be EPS-accretive in the short-term and value destructive long-term.

 

This is clear in the rationale Greg Maffei has given for why he would not combine iHeartMedia with SiriusXM or Pandora with SiriusXM at this point. Each company is valued somewhat differently (1, as a secularly declining cash flow machine, another as a growing cash flow machine, and a third based on its strategic value as a potentially viable business once turned around).

 

It would clearly be negative for SIRI to combine with IHRT at this point in time because it would negatively impact SIRI's cash flow growth, and would likely cause the multiple to be depressed in the short- and medium-term.

[Cigarbutt]

My answer is yes and I submit that many acquisitions, when reassessed years after the fact, reveal that value creation was over-estimated and this phenomenon may be in large part related to the EPS accretion mindset.

 

With interest rates where they are (risk free rates and spreads), relative opportunity mindset with debt-financed acquisition can justify pretty much any acquisition since "stocks are cheap" because of gravity. This applies also to buy-backs these days.

 

Not saying that we should go back in time but there was a period, not long ago, when goodwill resulting from acquisition was amortized, raising the hurdle at least to some degree for EPS accretion.

 

The companies I look at and what is shown in the aggregate point to the possibility that firms have loaded up on debt in the last 10 years and this marked rise has not really resulted in adverse coverage ratios so far.

 

I would say that using a normalized cost of capital analysis would result in a better assessment for the potential economic profit arising from an acquisition. However, many compensation packages are tied to the EPS number.

 

I recently heard Mr. Buffett in an interview saying that, when evaluating "deals", he would do so as if he would finance the deal entirely with equity which is either conservative and/or a way to say that the rule gravity should not be applied using a simple rule of three. I understand that the hurdle rate that Mr. Buffett uses results in his bids being not competitive to others who use cheap leverage to finance acquisitions.

 

And then there is always optimism about synergies.

[Spekulatius]

I agree that an earnings accretive deal can be can be value destructive. With the current low interest rates, almost any deal can be constructed earnings accretive. The real question is, if he Capital invested in the deal earns a decent return in investment. If not, doing share buybacks should be lower risk, can be scaled as needed and that is what a deal should be measured against.

[LC]

Sure. Imagine someone acquiring any profitable company with a major contingent liability.

[CorpRaider]

Hell yes.  As you probably know.  See, The Money Game (or any of the books about the conglomeration game of the Go-Go years).

[gjangal]

one example is if the acquired company is capital intensive ie has low roic , it’s can result in value destruction even if the deal is eps accretive

[Cigarbutt]

Hell yes.  As you probably know.  See, The Money Game (or any of the books about the conglomeration game of the Go-Go years).

 

Mergers and consolidations come in waves.

 

The Money Game was a great book originally written during the conglomerate phase (edition 1968) when the PE bootstrap game was playing full swing. The name of the game was to use the (overvalued) stock of the acquirer as a currency hoping to catch synergy between technology, sports equipment and toilet paper.

 

No waves are exactly the same and here’s a quote from the 1976 preface dealing with the passing phases of capitalism, taken from the otherwise exact version of the book:

 

“Great rewards accrue to the successful, and even though, he said {Keynes} there will be (paraphrasing Chuck Prince) some without chairs when the music stops, all the players can still play with zest and enjoyment”.

 

When you look at what Tom Murphy did at ABC/Capital Cities or Alain Bouchard at Couche-Tard, in terms of financing acquisitions, debt was used and over time debt levels rose but remained within restraints as the bump in debt levels after acquisitions was repaid within 2-3 years. Debt repayment is not an institutional priority in the relative opportunity EPS-accretion arena.

 

Another book I like that deals with the historical aspects of M&A activity is from Bruce Wallerstein: Big Deal: Mergers and Acquisitions in the Digital Age.

 

[LongHaul]

We are seeing a lot of this in Europe at the moment.

 

With 10 year sovereign bond yields hoovering around 1-2%, companies are loading up medium-term debts (5-7 years) at less than 1% to do acquisitions; hence, almost anything they can buy these days will be immediate EPS-accretive. Private-market deals are now happening at double-digit EV/EBITDA multiples, especially with assets that have bond-like characteristics, like infrastructures, utilities.

 

Most recently, Vinci (DG FP) - the largest infrastructure operator in Europe, has talked about buying Aeroport de Paris (ADP FP), at almost 18x EV/EBITDA.

 

We are having an internal debate on this. These deals, by traditional metrics, are super expensive, but they also boost EPS immediately, thanks to the simple interest rate arbitrage.

 

It would be great to hear your thought on this.

 

Interesting Question:

 

I think you can separate out the 2 components.

1.  The value of the business on an unlevered basis vs the price.

2.  The benefit of below normal interest rates.

 

If you pay 2x for a business but then save .2x for the next 5 years in low interest rates the purchase is still net negative -.8x, so it is a dumb deal probably.  It is impossible to predict interest rates but the current period is the outlier for recorded history.  Probably a dumb bond bubble. 

 

The CEO's probably just want to do deals and justify things on an accretive basis in the short term.  But the overpaying and debt binges generally end badly.  Investors generally don't know any better either and seem to encourage them.  If the debt matures in 5 years and the world changes - lower prices, higher interest rates, cautious lenders they may even file for bankruptcy.