April 2021 - Assessing the merits of an acquisition
The recent news that Scales Corporation has emerged as a front runner to acquire Villa Maria Estates brought to mind a checklist that investors would be advised to run through when gauging the merits of an acquisition.
This checklist is in no particular order as each factor will vary in importance for each different deal, however the size of a deal will always rank up there. Very few acquisitions will tick off every item on this checklist, but it is amazing how often you will see a deal that fails to conclusively tick off any item on the list.
Size. This is an element of the Goldilocks Effect; not too small and not too big. Too small an acquisition and it just will not move the dial while too big can blow the dial up. A rule of thumb for a potentially too big acquisition would be 40% or more of the market capitalisation of the acquiring business. Crossing this threshold is moving into “transformational” acquisition territory. The problem here can be that the company transformation is not chrysalis to butterfly but rather the rapid development of gangrene. New Zealand corporate history is littered with bad “transformational” deals. Telecom (AAPT), Air New Zealand (Ansett) and the Warehouse (Clint’s Crazy Bargains) all ended up losing limbs in their bold transformational moves into Australia.
A better size is a bolt-on acquisition of around 5-15% of the market capitalisation of the acquiring business. If this acquisition is integrated well, made at a sensible price, and has some synergies with the current business then an incremental increase of 1-3% in the overall business earnings per share could be achievable. While this is by no means shooting the lights out, if it is on top of solid organic growth from the core business then good progress is being made. And if it turns out to be a bad deal, then not too much damage is sustained. Freightways has been a prolific and successful bolt on acquiror. Since listing in 2003 it has been involved in 44 transactions, the majority of which fall into that 5-15% size.
At this point it should be noted that there is always, always the risk that a deal, even one that ticks most boxes on this checklist and appears to be a really sensible bolt-on acquisition, turns out be a bad one. For example, even Port of Tauranga, under the stewardship of arguably New Zealand’s best ever management team who made a string of great acquisitions, suffered a bloody nose with their purchase of Quality Marshalling which was ultimately written off.
Acquisition history. If the acquiring management team have a good track record of acquiring and then successfully integrating it is a definite tick in the box. Port of Tauranga and Freightways would be good examples of management teams that get it right nearly every time.
Geography. If any body of water other than the Cook Strait is between the acquirer and the acquisition then extreme caution should be taken. There are exceptions but not many. New Zealand corporates tend to struggle with global expansion and even Australia has proven a dangerous minefield (see the examples above). A somewhat cynical view is that the driver for overseas expansion has at times been management teams wanting to get stamps on their passports. Fletcher executives at one time could visit operations in over 30 countries!
Vendor motivations. The ideal scenario is one where the founder is the seller but takes shares in the acquiror as part of their sell-down and that an earnout is also part of the deal. The less preferred seller is a private equity firm completely selling out in a pure cash deal, such as Fletcher Building’s purchase of Formica which, while far from the worst Fletcher Building acquisition, was a disappointment from almost day one.
Source of funds. A concern here is that a company with net cash on the balance sheet acquires because it feels it has to spend the money rather than give the cash back to shareholders. In this scenario the concern has to be that the hurdle to make a good acquisition is not at the level it should be. Investors may feel that a greater level of governance and accountability is at play when the company has to go to shareholders to raise equity to complete an acquisition, however this is far from a failsafe, for example Fletcher Building raised new equity to buy Formica.
Complementary business. If an acquisition has a high degree of overlap with the rest of a business you can be pretty confident that the management team have the expertise to run it successfully. This should also signal the potential for synergies and the likelihood that the acquiring management team can realise those benefits. Where there little or no synergy benefits alarm bells should be ringing.
Other buyers. This check covers off a couple of facets of deal making. Sometimes no one else is a logical buyer of the business except the acquiror, which gives some confidence that a sensible price is being paid. Or was it a formal and public sale process that investment bankers hawked around the world trying to get the best possible price? This effectively rules out the chance of picking up a bargain.
Returning to Scales Corporation potentially acquiring Villa Maria Estates and applying this check list does not garner many clear ticks. If successful they will be the highest bidder in a global sale process run by UBS investment bankers, outbidding, amongst others, Pernod Ricard and Constellation Brands. Unlike those potential buyers Scales Corporation, as an apple exporter, will have little in the way of synergies to realise or expertise to deploy. Additionally, there has to be the concern that their circa $100m net cash position, due to the 2018 sale of their division, was starting to burn a hole in their pocket and partly triggered this move. And finally, the size of the deal means it is likely to be over that 40% of market capitalisation threshold, which makes it one of those “transformational” deals.