Acquisition stories seem to be a dime a dozen these days. The idea is that a company in a fragmented industry buys smaller players or competitors to increase their own size and scale. There are a few reasons why a company may do this. The most common reasons are: to expand their market presence, to increase their capabilities, or acquire strategic assets that would take years of capital expenditure to build.
The hope is generally for the company to increase shareholder value by acquiring the subsidiary on a lower price to earnings multiple than the parent is trading at. This is called an accretive acquisition, essentially increasing value by more than the sum of their parts.
The downside of this strategy is that most often a business is acquired for more than the net tangible assets of the business. In other words, they pay more for the physical assets (minus liabilities) than they are currently valued on the balance sheet. For example, let’s say a business has $500,000 of net assets on the balance sheet and the company might pay $2m for the business. While these numbers are made up, this illustrates a common transaction.
The reason for this disconnect is a combination of the value that is assigned to the brand name the company being acquired has established, and the expectation of future revenue from the business systems the company has developed.
The cash paid in excess of the net assets of the business is accounted for using a “goodwill” account on the parent company’s balance sheet. As the company makes more and more acquisitions, the balance in the goodwill account will grow. Goodwill is known as an intangible asset because it doesn’t actually exist, yet it is a large asset that they have paid for (being the business acquired).
To illustrate using an accounting example, the following is an indicative (and simplified) accounting transaction entered into the general ledger upon completion of an acquisition:
|DR Assets Acquired||10m|
|CR Liabilities acquired||7m|
|CR Cash paid||30m|
If the parent was only to pay for the value of the assets minus the liabilities, they would have only paid $3m in that example. But since the business was valued at $30m, the additional $27m of debits must go somewhere due to the laws of double entry accounting. Goodwill essentially represents the intangible aspects of the business being acquired such as brand names, and this brand name is now a recorded asset for the parent, albeit an intangible one.
Acquisition strategies can be great when the business is flying and the economy is booming. But what happens if an acquired business starts underperforming? The parent company has paid for an asset on the expectation that it will continue to produce a certain level of income, and has used this as the basis for calculating the amount paid for the business and in turn, the goodwill acquired. But if the company produces less than this, then the asset is worth less than the company initially thought and is therefore overstated on the balance sheet.
As a result, the accounts need to be changed to reflect the new value of the asset. This will have the effect of reducing the asset on the balance sheet but also reducing the amount of profit as the other side of this accounting entry must be an expense. Another way to think about it is that the company has simply overpaid for the business and are adjusting the accounts to reflect what they should have paid. The overpayment amount must be expensed because it was real cash that they paid, and because it no longer belongs on the balance sheet, it must belong on the Profit and Loss.
Using our accounting example above, if $15m of the asset acquired is impaired, the transaction will be as follows:
|DR Impairment Expense Account||$15m|
This all points to the importance of understanding that the acquisitions companies make come with real risk beyond the usual integration, execution, and combination risks. If the acquisition bombs then their profit will take a large hit, and they will be stuck with the debt or equity that they used to pay for it.
Slater and Gordon (ASX:SGH) are a prime example. The company was growing strongly in Australia, mostly by acquiring smaller legal firms, but this was not enough for them; they wanted to infiltrate the UK litigation industry as it appeared to be significantly more lucrative. In March 2015, they raised almost a billion dollars of capital and $600m of debt to pay for parts of a British company called Quindell, and in February 2016 they wrote off $824m of goodwill from the balance sheet in regard to this acquisition. This $824m went through the P&L leading to an incredibly large loss for the year, albeit a largely non-cash one. Still, the shareholders (both existing and new) are now stuck with an extra billion dollars of equity and more than $600m of debt, for which they have very little to show.
Another example is in the company Vocus (ASX:VOC). Vocus has experienced troubled times recently due to (among other reasons) significantly increased competition. The NBN rollout across the country has been reducing margins for all competitors in the telco industry. Vocus has spent the last 10 years rolling up small players in the telecoms industry, culminating last year in the multi-billion-dollar merger with M2. As a result of all these acquisitions the intangibles account on the Vocus balance sheet is almost $3.8 bn.
Unlike SGH, and despite relatively poor performance recently, Vocus have yet to announce any significant impairments to their goodwill, but with a market cap of only $2b I’d say this is at least a red flag.
Acquisition stories can be a great way to build shareholder value over an extended period of time. Farnam has in the past (and still does) own several such companies across our domestic portfolios, but we are constantly assessing whether we believe there is any likelihood of impairment against the expectation of future company outperformance.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.