Earnings accretion is not value creation

This morning’s announcement of a £1.6bn 403.5p per share bid for the speciality chemicals company AZ Electronic Materials by Merck KGaA illustrates another unintended consequence of quantitative easing – “earnings accretive” M&A1.

AZ’s business is the manufacture and sale of very niche chemicals critical to the manufacturing process of semi-conductor chips. The company makes very high margins, but has been struggling of late due to the appearance of some lower priced competitors. Merck is a huge diversified German pharmaceutical and chemical company. Why is Merck buying AZ? While there may a reasonable strategic rationale for the acquisition, two other important aspects are worth highlighting.

– Merck has lots of cash on its balance sheet. This cash is sitting in bank accounts earning next to nothing in interest. Even at 403.5p (52% premium to yesterday’s close), AZ offers Merck a 4% free cash flow yield. That may seem pretty low in absolute terms but it is a lot higher than any bank account.

– Because the acquisition is funded from Merck’s existing cash resources, it is immediately “earnings accretive”. This means the company will be able to show higher earnings per share after the deal than before. The cash that was producing no earnings is replaced by an asset that is producing some earnings.

At this point, we must ask: does “earnings accretion” always equal value creation? In this case, the stock market appears to be believe so. Merck shares have moved up 5% on the announcement of this deal.

However, I believe investors should be cautious about looking too much at “earnings accretion” from M&A deals. In the world of quantitative easing, where cash yields nothing, anyone with any money can create “earnings” simply by buying any income producing asset at any price they like. There must be a point at which the price paid is too high to be value creative. How can we assess when the price is too high?

The starting point is to recognise that all sources of capital have a cost associated with them. Owners of equity capital require a return on that capital to justify the risk. Similarly owners of debt capital also require a (usually lower) return to justify the (also usually lower) risk. Most companies’ employ a mix of equity and debt capital to fund their businesses, and as such their overall cost of capital is the average of these two sources.

For an M&A transaction to be value accretive, it must generate a return on the capital employed that is greater than the company’s overall cost capital. Whether the acquisition is funded from cash resources or elsewhere is not relevant.

In this specific example, we can see that Merck is getting an immediate 4% cash flow return on its investment. Merck’s cost of equity is almost certainly higher than 4%. Its cost of debt is probably lower than 4%, but as a predominantly pharmaceutical company debt does not account for a significant part of the capital structure2. Therefore, as of today, the return on the acquisition of AZ is unlikely to be above Merck’s cost of capital. Of course this may change in future if Merck is able to grow AZ’s sales and profits through a combination of revenue and cost synergies.

This example is illustrative of a wider problem with ultra-low interest rate and quantitative easing policies. With money so freely available and cheap, there is a huge temptation to spend it too freely (especially when senior managers’ incentive packages are based on earnings per share growth!). Almost any acquisition is “earnings accretive”. But if the prices are too high, the end result will be to reduce the economy’s overall return on capital, and ultimately destroy, rather than create stock market value. The best managed companies will benchmark the returns from M&A against the returns from other uses of capital such as buying back shares or organic capital investments, but sadly not all do this.

M&A has always been a dangerous area for equity investors, with most studies showing that in aggregate M&A creates no value for the acquiring companies. Investors should be especially careful in today’s environment.

Matthew Tillett

 

1. This is no recommendation to buy or sell any particular security.
2. Pharmaceutical companies typically avoid high debt levels due to their dependence on a small number of high margin product with limited patent lives.

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Author - Matthew Tillett

Matthew Tillett

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