The acquirer

Performance Ade is one of the leading firms in the sports energy drink industry. It has been in existence for ten years and has grown from a small venture capital–financed company into an international company with a globally recognized brand name. It’s a stock market darling — it commands a high earnings multiple in the financial markets — and it’s considered a growth company in the mature beverage industry. Although Performance Ade is very successful in the sports energy drink niche, company management and the board of directors want to expand into other segments of the beverage industry, particularly the soft drink segment. They’re seeking to diversify in order to reduce their dependence upon the sports energy drink market and to capitalize on the existing Performance Ade brand and distribution channels.

Performance Ade produces a product that is viewed by the market as a high-quality product. The company has a high degree of marketing savvy and has positioned the Performance Ade drink as a premium product that captures a large portion of the high end of the market.

Performance Ade management is working with its investment bankers to determine how best to break into the more established (and much larger) soft drink industry. In consultation, company management and their investment bankers have determined that Performance Ade can either grow organically by developing its own products in the soft drink industry or acquire another soft drink manufacturer to jumpstart this growth. Management is open to either alternative and is looking for counsel on which path to take.

The target

The company’s investment bankers did a thorough industry analysis and came to the conclusion that the most likely company for potential acquisition was Yankee Beverages, a regional soft drink manufacturer in the Northeast. Yankee has been producing a product line of soft drinks that sell under both the Yankee name and various other private-label brands in stores throughout the region.

Yankee has been in business for nearly 95 years and, although the stock is publicly traded in the over-the-counter market, the company is still managed by members of the Gilmour family, who founded it. In fact, much of the stock is still held by members of the Gilmour family, and the family controls the majority of seats on the board of directors. The stock held outside the Gilmour family is thinly traded (there is not an active market for it) and is currently selling at a substantial discount to the typical firm in the industry (as measured by a price/earnings multiple).

The P/E ratio tells investment bankers how much investors are willing to pay for a claim to a dollar of a company’s earnings. The higher the P/E ratio, the more richly valued a company and its stock are. For more on P/E ratios, see Chapter 8.

The revenues of Yankee Beverages have been fairly stable in recent years; unit sales have been flat and total revenues have been expanding at roughly the rate of inflation. The company hasn’t actively been looking for ways to grow its product line, and in recent years, the free cash flow produced by the company has been used to virtually eliminate long-term debt and to provide robust dividend payments to the shareholders. The company has an extreme aversion to debt, because it barely survived the Great Depression, and debt financing is inconsistent with the very conservative philosophy of the Gilmour family. What little long-term debt there is left on the balance sheet is from a program from a few years ago in which Yankee modernized its plants, installing new state-of-the-art equipment.

The Gilmour family is in a transition phase with respect to involvement with Yankee. The grandchildren of the founder are all in their seventies, and their children and grandchildren show little interest in active involvement with the family business and are pursuing other interests.

Identifying the options

Performance Ade wants to grow and diversify its revenue stream and can basically take one of two paths: It can develop its own products and brands or it can acquire another existing firm (or firms). Both alternatives have their advantages and disadvantages.

Growing organically — that is, building its own product line — is advantageous because management can build the firm in its own image. Building or buying a firm is analogous to the decision to build or buy a home. When deciding to build a home, you can build it exactly to your own specifications — you get the floor plan, the kitchen countertops, and the exact lighting fixtures that you want. When you buy a home, you oftentimes must compromise by accepting limitations such as outdated bathrooms or kitchens that are smaller than you would like.

The flip side is that when you’re buying an existing home, you can generally occupy that home sooner than is possible in the typical construction scenario. In addition, you can often buy an existing home for less than it would cost you to build one. The same is true in the corporate world — some firms are selling for less than they’re “worth” to someone who can do the investment banking equivalent of painting walls, replacing countertops, and landscaping.

The buy or build decision has many factors, but it often comes down to a matter of both price and time to market (how long it takes for the company to have products ready to sell). Many companies lean toward the acquisition route for growth because they’re looking for immediate gratification. And why wouldn’t they? Most investors are very impatient and want to see growth in earnings and share value.

Looking at financing

Though it’s enormously successful, Performance Ade doesn’t have a great deal of free cash flow (the amount of cash flow from operations [CFO] remaining after paying for any needed capital expenditures; see Chapter 12). It’s a growing company and it has been using its prodigious cash flow to invest in more assets — particularly property, plant, and equipment — to support its robust sales growth. The firm does not pay a dividend to shareholders and has attracted an investor base that is growth oriented and not income oriented.

Companies typically have a particular dividend policy and stick to it. This is what is known as the clientele effect. That is, investors often choose to invest in companies that have dividend payout policies consistent with their own goals and objectives. For instance, because retired individuals often need to supplement their income, they often have portfolios comprised of companies that pay out a large portion of earnings as dividends. Individuals who aren’t looking to supplement current income, and are looking to minimize taxation, tend to invest in companies that don’t pay dividends or may pay minimal dividends. Firms generally adopt a certain dividend strategy — either a high-payout or low-payout strategy — and stick to it. They don’t want to alienate their dividend clientele.

Performance Ade, however, is in the unenviable position of needing to satisfy investors’ ever-increasing growth expectations. The company has been able to grow largely through increasing its share of existing domestic markets and by expanding globally. However, it’s becoming increasingly more difficult to capture market share because Performance Ade is already an industry leader in the niche market of sports energy drinks.

Performance Ade isn’t saddled with a great deal of debt, because the firm was financed in its venture capital stage largely through convertible bonds that, as a result of the success of the company, have been converted into equity at the option of the original bondholders. This provides Performance Ade with a great deal of unused borrowing capacity, which is a terrific option for a firm to have. This is akin to an individual being virtually debt-free when seeking a mortgage loan, car loan, or money to fund a child’s education. The less debt on an individual’s balance sheet — or on a firm’s balance sheet — the more willing lenders are to provide them with loans because the lenders have a large margin of safety.

An analysis of the financial statements

We’ve talked about our two companies. Now let’s take a look at their financial statements, and see if we can make a deal!

Note: These financial statements are being presented in terms of thousands of dollars. There is simply no reason to get bogged down with a bunch of extraneous zeros. Doing the analysis is easier with fewer zeros, and the implications are the same. So, other than any per-share information, all the numbers are presented in thousands of dollars.

Form of acquisition

Given the lack of debt in the capital structure of both Performance Ade and Yankee, issuing debt to purchase Yankee makes the most sense. Performance Ade has tremendous unused debt capacity and has a very steady revenue stream. The consistent and growing revenue stream and operating income provides creditors with the margin of safety they need in order to feel comfortable loaning Performance Ade the money at reasonable terms. In fact, with the help of their investment bankers, Performance Ade management has been able to secure bank financing at the rate of 8 percent in order to do the deal.

The shareholders of Yankee would also likely not be very interested in receiving stock of Performance Ade in lieu of cash. Remember: Yankee currently has a high dividend payout. Its shareholders would likely not want to receive stock of Performance Ade, a company that currently doesn’t pay a dividend. So Yankee shareholders would likely value the flexibility to reinvest their cash proceeds in a company with a high dividend payout. Now, these shareholders will incur tax consequences and be responsible for paying capital gains on their holdings, but the premium above market price will likely placate them.

Creating pro forma statements

What will the reorganized Performance Ade firm look like following the acquisition of Yankee? Investment bankers put together pro forma statements in order to model the new structure. The pro forma balance sheet is shown in Table 18-4.

Notice that there is a new account on the balance sheet called goodwill. One way that goodwill comes into existence is when a company buys another company for more than the aggregate current value of that company’s specifically identifiable assets (see Chapter 7). The accounting treatment for goodwill can become somewhat complicated, but the essence is in the case of Performance Ade purchasing Yankee, the total cost was $1,312,500. Performance Ade is buying the entire Yankee company with the book value of equity of $700,000. Typically, the company must determine how much the assets listed on the balance sheet are currently worth, but let’s assume here that the current book value of these assets approximates each of their market values. The difference between the purchase price and the net book value of equity of $612,500 is listed on the balance sheet as goodwill. As you can see, unlike inventories or property, plant, and equipment, goodwill is not a tangible asset. A company can’t raise cash by selling its goodwill.

Most investors are less concerned with what the balance sheet will look like than the earning power of the reconstituted company. The pro forma income statement is shown in Table 18-5.

As you can see, the newly constituted Performance Ade is more profitable and more highly leveraged than it was before it acquired Yankee. It’s more profitable because its return on equity has gone from 26.1 percent ($304,500 ÷ $1,135,530) to a robust 38.5 percent ($437,500 ÷ $1,135,530). It’s more highly leveraged because its total debt–to–total equity ratio has gone from 1.30 ($1,479,630 ÷ $1,135,530) to 2.81 ($3,192,130 ÷ $1,135,530). What this means is that the firm has been able to increase its profitability because it’s earning more on its borrowed funds than those funds cost the firm.

But Performance Ade hasn’t leveraged itself to a dangerous level. The pro forma times interest earned ratio (computed by dividing operating income by interest expense) is still a healthy 4.88 times. That gives lenders a fairly large margin of safety, especially given the stable revenues of the firm. It appears that the firm even has more unused debt capacity.

The new Performance Ade would also have higher earnings per share of $4.375 ($437,500 ÷ 100,000) than it did before the acquisition of $3.045 ($304,500 ÷ 100,000). This will generally be very well received by investors, because one of the most common valuation methods is to multiply earnings per share by a price/earnings multiple to obtain an estimate of firm value.

Before you assume the market will simply apply the same P/E multiple of 17 to the new Performance Ade that existed before the acquisition, a word of caution is in order. The financial markets are populated by some very sophisticated and knowledgeable investors and analysts. They’ll recognize that the increase in earnings is the result of acquiring a lower-growth soft drink business by the higher-growth sports energy drink business. The P/E multiple applied by the market will likely be somewhere between the 10.5 applied to Yankee and the 17 applied to Performance Ade. The key will be how that market assesses the chances that Performance Ade will be able to successfully grow the revenues of Yankee beyond that under the current management.