Business Acquisitions—Don’t Overlook Those Hidden Costs
The securities analyst must be aware of and take into consideration those “added” costs and expenses which can add significantly to the cost of a transaction. It is long been shown that most mergers, while strongly defended by management, fail, in good part because they fall short in delivering the intended result—higher cash flows and lower cost of capital.
Aug. 3, 2010, Journal Sentinel: Republic Airways Holdings Inc. reported an 81.6% drop in its second-quarter net income Tuesday, partly as a result of expenses tied to merging Midwest Airlines into Republic’s Frontier Airlines operation.
The financial press typically alludes to the cost of a business acquisition as the outstanding market value of a firm’s outstanding equity securities. However, the real cost to an acquirer is often substantially higher, and often makes for the difference between whether an acquisition is value-adding or value-destroying. When there is a large premium over the fair value of assets, the resulting goodwill is not deductable for tax purposes according to the IRS. Costs associated with a merger, such as legal and accounting, and fairness opinions become part of the purchase price and are not a tax-deductable item. However, analysis that took place prior to a target being isolated is deductible for tax purposes. Tax-losses of the target may be used; however, even that is compromised and takes place over an extended period.
Goodwill and other permanent tax timing differences, such as acquired in process research must be examined, for their affect on tax rate. For example , during 2007, Schering-Plough reported to shareholders its effective tax benefit based on the statutory rate of $425MM, but due to large in process research acquired in its combination with Merck, it showed a effective tax payment of $258 MM.
The demands on management and line employees can be difficult to estimate, especially if the deal was initiated by a very high-level executive. It is difficult enough to have large business combinations or acquisitions be successfully integrated without the myriads of problems that occur with every transaction weighing on the time that could be more effectively spent elsewhere, including important current clients. For example, it was estimated (Business Week, June 17, 2002) Hewlett-Packard spent over 1 million man-hours on the Compaq deal even prior to the actual merger even taking place, allowing a competitor, Dell, to increase its foothold in the PC business and enter the printer business. The cost to HPQ was therefore difficult to access.
November 10, 2009, LA Business: Live Nation Inc. and Ticketmaster Entertainment Inc. have reported third-quarter earnings that were impacted by costs related to the proposed merger of the two companies.
Perhaps the most important hidden cost is that many critical employees leave the firm—especially true for service and technology companies. Safeguards and incentives are important in retention but costly and must be considered as part of the purchase price. Also to be considered is potential customer loss and other business interruption or slowdowns related to manufacturing and supply chain integration. Loss of, or delivery slowdown, could also be costly, especially if a buyout entails that of a competitor of a supplier. If a deal is not successful and that supplier is again needed, failure to deliver the needed parts or other goods may result in lower margins or even inability to deliver orders.
Added to the purchase price must be the value of the vested and unvested options which, as a result of the offered share price or new employment terms, become of value to the holder. While there is an allowable tax deduction, the cost can still be significant.
If debt is assumed as part of the deal, the new capital structure may increase the firm’s’cost of capital, and as such, reduce its financial flexibility. Any change in credit rating could also impact the costs related to hedging activities. Any impact to debt covenants resulting from the new financial structure must be explored to determine remaining flexibility.
Other areas that would need to be explored include, but are certainly not limited to:
- All dilutive securities must also be considered including the vesting of incentive awards.
- Any hedges and swaps put in place in anticipation of the deal must be examined.
- Cost of product line exits, lease terminations, etc.
- Pension, post-retirement and health care costs often add greatly to potential costs. The terms of when employees become fully vested can differ from that of the acquirer. Multi-employer plans can be especially tricky.
In summary, the added costs must be taken into consideration when evaluating the prospects of any deal, and according to CT Capital research, often add anywhere between 1% to 10% (and more) to the initial cost. Thus, while executives stress the cost savings any deal is expected to create, it is imperative they also speak to the hidden expenses.
See additional original analysis at www.credittrends.com.
Disclosure: No positions
Related articles:
- Strategic Decisions Must Have Quantitative Backing For Success
- HPQ, Business Acquisitions, and Share Buybacks
- New Era of Buybacks, Dividends and Mergers?
- Taxes-A Large Issue Looming
Kenneth S. Hackel, CFA
President
CT Capital LLC
Subscribe to CreditTrends.com by Email
If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
