Beware of acquisition-driven earnings growth

Although increasing share prices can swell investors’ pockets, high earnings growth expectations and management incentive schemes related to share price performance can lead to company management behaving in a way that focuses on short-term strategies to

Going on an acquisition spree is one way of boosting a company’s earnings, often translating into an increased share price

According to Craig Butters, a portfolio manager at Prudential Portfolio Managers, ‘One of the common methods of boosting a company’s earnings is for a company with a high PE ratio to buy a company with a lower PE rating.’

Consider the example of two companies with the following financial metrics as shown in Table1. Assume that CompanyP (the purchaser) offers to acquire Company T (the target) by offering Tshareholders one P share for every two T shares they hold. The final column shows the impact on the combined entity after the acquisition:

Table 1: How a company can boost its EPS through acquisition

* Headline earnings per share (equal to headline earnings divided by shares in issue)

** Price-earnings ratio (equal to share price divided by HEPS)

*** 300m shares of company P, plus an additional 75m (150 ÷ 2) shares issued to acquire company T

In this example, by simply issuing more expensive shares (on a PE ratio of 10, compared to the shares of Company A on a PE ratio of 6.3), the earnings per share (‘EPS’) of the acquirer, CompanyP, increases from 50cps to 56cps. If the share continues to trade on its original PE ratio of 10, the share price would appreciate to 560cps, an increase of 11% due simply to the impact of the acquisition. Ignoring any synergies, the whole is simply the sum of the parts: the earnings of the combined entity of R210m is the sum of the individual companies’ earnings. Company P’s earnings per share however increases from 50cps to 56cps, through the effect of so-called “PE magic” rather than any fundamental or economic underpin.

In the current environment of lower interest rates, the funding of acquisitions through cheap debt has become widespread. This achieves a similar boost to earnings when considering the overall effect of the acquisition. Companies may however battle to justify the tax deductibility of the interest. Butters cautions that even earnings-enhancing acquisitions do not necessarily generate long-term shareholder value.

The gap created by illusory earnings growth becomes increasingly difficult to fill

For as long as the market continues to reward acquisitive earnings growth, this vicious circle can continue for some time, as a rising share price reflects an increased rating of a company and management remain well incentivised through an increase in the value of their shares and share options. This further raises earnings growth expectations, often placing increased pressure on management to pursue risky acquisitions to generate earnings growth. This may also lead to aggressive accounting practices, the manipulation of earnings and in extreme cases even fraudulent financial reporting. ‘Apart from the effect of “PE magic”, an acquisition provides an easy opportunity for earnings flexibility through the use of pre-acquisition provisions’ says Butters. ‘This is an often overlooked reality’.

Table 2: The vicious cycle of acquisition-driven earnings growth

History has shown however, that superficial acquisitive growth strategies often come back to haunt management, either through overpaying for a significant acquisition or through the acquired company not performing to expectation, or even worse, going horribly wrong. The expected benefits from an acquisition are very seldom realised to the extent envisaged.

Not all acquisitions are bad

Butters however emphasises that not all acquisitions are bad. ‘In fact, there are many examples where a sound strategic acquisition at a reasonable price has been a game changer for the acquirer, and a significant driver of longer term shareholder value.’ Some of the more highly acquisitive companies on the JSE have been Aspen, Steinhoff, SAB Miller, EOH, Imperial, BHP-Billiton, Investec, BCX and Redefine, with varying degrees of success and soundness in the underlying reasons for their acquisitions.

Investors do however need to be aware of the earnings flexibility and illusory growth an acquisition potentially provides. Rather than focusing on management’s ability to generate short-term earnings growth, investors should judge management on its ability to allocate capital wisely and effectively. ‘This is what ultimately generates returns to shareholders and drive shareholder value in the longer term.’