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IFRS CREATES A TOUGHER WORLD FOR M&A

Accounting changes have dramatically altered the way are analysed. This is the first of two articles based on a report by Dimitris Karydas and Kenneth Lee of Citigroup.

By Dimitris Karydas and Kenneth Lee

The high level of M&A - or ‘ are not capable of being individually combinations’ - over the past two years has identified and separately recognised’. made analysis of deals vital for . This is a distinct change from the However, rules in this area have previous approach whereby was been subject to huge changes with the merely a residual difference between the transition to IFRS. The first changes, made purchase consideration and the in 2005 and known as phase 1, were of the net . The onus is on the significant but not controversial. Phase II, to split out any separately however, is causing a great deal of concern. identifiable intangible assets on future acquisitions. This should provide a more Let’s first look at what has already detailed and useful breakdown of these changed as this is what investors will have assets. However, this will reduce the to cope with when analysing 2006 deals. amount allocated to goodwill on future Elimination of merger accounting acquisitions. There is some initial It was already difficult for a combination evidence that are allocating to qualify as an accounting merger under very low levels of the purchase cost to IFRS due to the strict criteria. The other intangibles and goodwill is still elimination of this approach to M&A dominant. This is despite the clear accounting seemed a sensible bit of expectation in IFRS 3 that this would housekeeping. Having only one business change. combination accounting approach should No more goodwill amortisation also enhance inter-company comparability. There is no longer any systematic This change will apply prospectively: amortisation of goodwill. However, previous poolings will not have to be amortisation of other intangibles is ‘unpooled’. As merger accounting has required. Goodwill will instead be subject been eliminated, the attraction of using to an annual impairment test. Most share consideration has diminished. companies have applied this change Change in the definition of goodwill prospectively so that existing goodwill Goodwill is now defined as the ‘future has, in essence, been frozen at its current economic benefits arising from assets that value (see footnote 1) and then subject to impairment tests.

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Figure 1. Changed Definition of Goodwill

Source: Citigroup Investment Research.

Less opportunity to manipulate post- From a perspective goodwill acquisition results impairment should continue to be Restructuring provisions on acquisitions examined in a similar way to has been severely restricted. This should amortisation. This is because, unlike provide fewer opportunities for which relates to tangible to manipulate post- fixed assets that must be replaced, acquisition results. impairments relate to goodwill that need not be explicitly replaced. Therefore The verdict on these changes impairment charges would be expected to The headline change was the elimination have little discernible impact on of goodwill amortisation. We have always sentiment. Of course an unexpected seen this as a positive step. Given the impairment or an impairment that is larger ‘autopilot’ nature of goodwill than expected may indicate a problem. A amortisation it was largely ignored as reaction would then be no surprise (see having no economic relevance. footnote 2). Impairment testing is a more meaningful The introduction of an impairment regime approach under which management will does have two further possible be forced to think through the value of implications. First, it will make profits goodwill using a -flow-based less predictable. Second, it may well methodology. Also, the disaggregation of increase management discretion in intangibles should provide more useful relation to earnings. There may be little to information. stop management overestimating impairments to increase future profits and

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returns on book at the of volatile: the elimination of techniques -term earnings. such as restructure provisioning will make it more difficult to smooth earnings after Finally, in the absence of impairments, the acquisition. In most cases redundancy eliminating annual amortisation has and similar costs will be recognised as resulted in a step-up in earnings. As this is period . It will also be harder to likely to be relatively higher than the show a post-acquisition uplift: this increase in equity due to non- follows on from the restrictions on amortisation, returns on book equity provisioning. should increase. On a positive note, there should be Let’s look now at the proposed Phase II improved transparency. Extra disclosures changes and their likely effects. are required about the makeup of the Full, not partial, recognition of purchase price, the adjustments to goodwill values and the determination of the Currently goodwill is measured on a residual goodwill number. However, in partial basis. In essence we only recognise the UK the new disclosures appear more the part of goodwill that has been limited than UK GAAP. purchased. So if 60% of the business is Finally, troubled acquisitions will be acquired then only 60% of goodwill is revealed more quickly. recognised. This is inconsistent with the Investor Q&A on business treatment of other assets where, once combinations accounting is achieved, we consolidate 100% and back out the minority interests. Q. The elimination of goodwill amortisation will result in an Acquisition costs to be expensed increase in earnings per share The theory is that such costs are not assets (EPS). Has this caused higher so they should be expensed within valuations? goodwill, rather than subsumed as is It shouldn’t have. From an investment currently the case. perspective goodwill amortisation is not Contingent consideration relevant because companies do not have The new standard will distinguish to replace the goodwill. between contingencies that relate to This contrasts with depreciation which uncertainties existing at the acquisition relates to operating assets that must be date (for example, what is the fair value replaced. Many investors and sell-side of receivables?) and those uncertainties analysts have been using Ebitda that will only be resolved as the target (earnings before interest, , conducts its business (for example, earn depreciation and amortisation) as an out provisions). The standard suggests operating measure or a quasi cash- that the former are dealt with by adjusting based EPS number where the major the price and the latter are recognised as adjustment was to add back goodwill items unrelated to the original acquisition. amortisation. However, remember that So what are the implications for some investors do look at unadjusted EPS acquisitions of these proposed accounting numbers and not all investment houses changes? Earnings will certainly be more ignored goodwill amortisation.

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Q. Many countries allowed companies Q. Can an acquirer recognise a to write goodwill off direct to restructuring provision which is reserves (equity) under local GAAP. dependent on the acquisition taking Has IFRS required reinstatement of place? this goodwill? This is crucial. According to the detail in There is no requirement to reinstate this IFRS 3 the possibility, or even near goodwill and it is unlikely that companies certainty, of an acquisition is an would choose to do so. insufficient recognition event. Therefore an acquiree cannot recognise such a This goodwill will not be recognised in provision in its financial statements. the as part of the calculation of any profit/loss on disposal. Q. Has amortisation disappeared as a This may well significantly increase concept altogether? profits on disposals for those companies We need to be careful here. The that have written off goodwill against prohibition on amortisation in IFRS 3 equity. relates solely to goodwill. Other Q. The standard includes rules about intangibles such as brands, , restructuring provisions. What will development costs and so on will continue be the impact of these rules? to be amortised. This ties in with the change in the definition of goodwill This is an area of major change by IFRS which means that other separable 3. Essentially the opportunity to make intangibles will be recognised and provisions on an acquisition is often amortised as normal. exploited by acquirers to manage the earnings profile of a combined entity after Footnotes acquisition. It allows companies to 1 For cross-border deals under IFRS, goodwill channel operating costs through goodwill, will have to be restated to take into account or at least to avoid recognition of certain shifting exchange rates. This is a departure expenses in the income statement. The from many other GAAPs that allowed rules have been tightened up so that many goodwill to be recorded at the historical rate. of the standard approaches to managing This may well cause much larger foreign exchange movements in equity on the re- earnings in an acquisition have been translation of foreign . eliminated. 2 There is some evidence that impairments do matter and are negatively correlated with the firm’s post-acquisition return performance (Li, Shroff and Venkataraman, 2004).

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REPORT DEBUNKS MYTHS ABOUT SUCCESSFUL MERGERS

In the second of two articles based on a report by Citigroup, Dimitris Karydas and Kenneth Lee propose a framework for analysing mergers and acquisitions

By Dimitris Karydas and Kenneth Lee

There are three areas of analysis that are • valuation issues: the common particularly important when it comes to valuation errors to avoid understanding merger and acquisition • empirical evidence: what factors have (M&A) deals. They are: historically indicated successful • financial analysis: what accounting M&As? issues/disclosures may be particularly Figure 3 below puts these into a interesting to examine? framework.

Figure 3. M&A analysis framework

Source: Citigroup Investment.

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Four points of analysis based on anecdotal evidence, we believe it is rarely addressed in detail. For Last month’s article in Insight looked at example, the disclosures for un-amortised the accounting rules governing M&A goodwill would include: accounting. Here we examine four areas that may receive less attention but that are • key assumptions underpinning any worthy of analysis. value in calculation of use 1. Fair value adjustments • the period over which cash flows have been forecast The fair value exercise is a major component of any M&A analysis process • the discount rates used. and it can be revealing. Establishing an If a change to a particular assumption estimate for the fair value of an asset and causes an impairment to be recognised then any subsequent adjustment can have then a form of sensitivity analysis must be important implications for key disclosed. Many investors and analysts performance indicators (KPIs). For would find these audited disclosures of example, if an initial fair value estimate interest as another way to access for a property was conservatively biased management thinking. then depreciation would be understated with goodwill overstated (but no 4. Taxation amortisation under IFRS). Therefore Often the aspects of a deal are investors should be sensitive to the fair particularly important motivators. Indeed value exercise and especially to any an acquisition may open opportunities for changes from the initial estimates. acquirers to unlock tax value. In addition 2. Allocation of value to separable deferred taxation aspects can be most intangibles and subsequent confusing. The tax disclosures post- amortisation acquisition are well worth studying carefully: any recognition of previously The crucial questions here relate to: unrecognised deferred tax assets indicates • What separable intangibles have been the creation of value in the deal. It is recognised? Does this reveal extra likely that new deferred tax liabilities, value in the target? Are the recognised especially those on goodwill and other amounts unexpectedly high or low? intangibles, are actually instruments of ‘matching’ rather than true economic • What amortisation period has been liabilities. Therefore it may well be that chosen? How does this compare with most investors choose to ignore these. peer companies? Allocation of purchase price to goodwill • Are the separable intangibles maintained? versus intangibles - evidence from the UK If these assets do not have to be replaced, is amortisation a real economic cost or A recent report by Intangible Business merely double counting? examined the proportion of the purchase price that had been allocated to goodwill 3. Impairment disclosures as against intangible assets. The overall There is a huge amount of disclosure split is illustrated in Figure 4 below. required in this area that may have Clearly goodwill has maintained its significant relevance for value. However, dominance.

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Figure 4. FTSE 100 purchase price allocation

Source: Intangible Business. 2006/2007 will be the start of the acid The question is whether such a heavy test. allocation to goodwill is actually evidence of companies making biased decisions Valuation issues about the disaggregation. Why might There are certain valuation issues on companies be motivated to allocate more M&A deals that cause confusion when to goodwill? assessing what constitutes a successful or There may be a concern among corporates unsuccessful acquisition. that the amortisation of non-goodwill The most common include: intangibles will not be added back to earnings by the market in the same way 1. Earnings accretive deals are a that goodwill amortisation was. Therefore good thing. a large allocation to goodwill preserves It is not uncommon to read in the press earnings. that a company could afford to pay up to a Also, dividing up assets into smaller units particular amount for something ‘without can expose the company to a higher risk diluting its earnings per share’, as if this of an impairment. For example, when represented an economically meaningful assets are grouped together strong cash statement. The maths may well be right. It flows from one may offset weaker cash is just that the answer does not matter. flows from another. However, if assets are This is easiest to see if we think of an split out then this compensating offset acquisition financed by borrowing. may not happen and an impairment is Suppose that a company can borrow more likely. money at a gross interest cost of 6%, and If the assertion in the Intangible Business that it has a 33% marginal rate of tax. report is correct then IFRS 3 would Interest will cost it a net four cents in the appear to have failed to give investors euro. So if it buys an asset, or a company, materially enhanced information on on a multiple to earnings of less than 25 intangibles in the context of acquisitions. times [see footnote 1], the result will be However, we feel that more time is earnings accretive. Suppose it pays a required before a final verdict can be multiple of 20 times, then the earnings delivered. The quality of disclosures for on the acquisition will be an

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immediate 5%, with an uplift of 1% on its opportunities. Why shouldn’t corporate return on capital. bidders do the same? Readers should not have difficulty This point is illustrated in Figure 5 below. thinking of acquisitions that would be While the acquirer achieves a Return on very poor value on a multiple of 20 times Invested Capital (ROIC) lower than the current earnings. Now take an acquisition Weighted Average funded with new shares. If the earnings (WACC) in the early years of the post- multiple of the acquirer is higher than that merger integration, it generates returns over of the target then the result will be and above the cost of capital in later years. earnings accretion. If you do deals on this Any transaction judged on the basis of any basis regularly enough you will sustain a single year’s comparison of return and cost high rate of growth in earnings per share, of capital would give the wrong conclusion apparently justifying the high multiple — about the value creation potential. until you run out of large enough targets Instead, a holistic approach is required to maintain the pretence. that explores whether the value creation in There is some evidence that in fact it is the later stages of the transaction dilutive deals that do best. Why? Perhaps integration (ROIC > WACC) outweighs because they are the ones that get thought the initial value loss. about more carefully before management 3. Acquirers’ share prices takes them to the market. underperform because promised 2. Return on capital employed must synergies don’t happen. exceed the cost of capital for a deal to be a good thing. Not so. It is true that historically the share prices of most bidders underperform the How many times have we read in the market for a long time after the transaction, financial press that ‘if you take the and the bigger the transaction, the worse the projected synergies, tax them, and add damage. It is not true that the profitability them to the ongoing earnings of the target of merged companies is lower than that of company, then the implied return on the their competitors who have not made transaction value — the price paid for the acquisitions - rather the reverse. equity and the that is being So how do we square this circle? Because assumed - is less than the cost of capital, when companies make acquisitions the so it is a bad deal’? price that they pay generally includes an Most acquisitions destroy value for the element that relates to expected synergies. bidder’s shareholders, but this calculation The problem is not that the synergies simply does not work. By this logic if you don’t happen. It’s just that they are not want a return on your equity investment generally large enough to justify what was of 8% or more then you would never buy paid for them. If a company pays for 150 a share on a multiple to earnings of more per cent of the achievable upside from a than 12.5 times. Investors happily pay deal, the target’s shareholders will be very more than that because they are happy. The acquirers will not and may capitalising upside from future growth come to regret the deal.

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Figure 5. M&A value creation profile

Source: Citigroup Investment Research. financed , the target did not, 4. Whose cost of capital? and the refinancing element of the bid A company that has paid what seems to was part of the addition of value created observers to be a relatively high price for by the deal - but probably not outside the an acquisition often justifies it by saying world of . If a bidder funds ‘we have a very low cost of capital so can an acquisition with cash then it is clearly pay more’, to which the unkind response not justifiable to value the target using a might be ‘not any more, you don’t!’ cost of debt. The first and most basic rule relating to Why? Because the bidder is only able to the application of discount rates to fund the acquisition by virtue of having acquisitions is that the discount rate equity in its balance sheet. What is applies to the target, not the acquirer. But happening is a cross-subsidy of the target there are more subtle issues. What if the by the previously owned assets, which target has an inefficient balance sheet and clearly does not in itself add value. So the acquirer argues that by funding the most of the time the prudent course is to acquisition more effectively, it can cut the allocate no value to the effect of cost of capital? And how much of this refinancing. upside should it be prepared to pay for? 5. Analyst models that have steadily One starting point is to question whether rising returns on capital employed the tax shelter could have been created by in them are overly optimistic. the acquirer through the purchase of its own shares, rather than by borrowing Usually, but not when the company being money to pay for someone else’s. If the analysed has lots of goodwill in its answer to this question is ‘yes’ then that balance sheet. This is an extension of the in no way justifies paying up for the point made under item 2. When target. One could imagine a situation in companies make new investments they do which the bidder already had an optimally not install a pile of goodwill on top of

78 REPORT DEBUNKS MYTHS ABOUT SUCCESSFUL MERGERS them. It is the return that the company ability to achieve a higher value from the makes on its existing capital — excluding existing assets. This is either by managing goodwill — that presumably provides the them better or by financing them more best indication of the returns that can be efficiently, or both. This is what private expected on new capital. This explains equity funds are designed to exploit. Figure 5 under item 2 above. As the The second relates to the possibility that balance between existing assets and new putting two operations together will result ones shifts towards the new, so the in either lower costs or higher . weighted return on capital shifts upwards Here the benefit is not stand-alone. It is towards the underlying level, excluding the direct consequence of economies of the goodwill. scale, cross-marketing, technology 6. Control premiums and synergies transfer, and so on. ─ avoiding double counting. Clearly when assessing deals it is essential to differentiate between the Acquirers generally pay a premium over expected justifications for the control the previously prevailing market price. premium. It is also essential not to pay a This is what is generally known as a over and above the premium for control. It is justified by expected synergies. synergies of one sort or another, and these should be carefully divided into two Footnotes: categories. 1 A price-to-earnings multiple of 25 implies an The first relates to the possibility that the earnings yield (the reciprocal) of 4%. Any PE of less than 25 would have a larger earnings market value of the company was yield and so the increase in earnings would be depressed — perhaps because of a greater than the incremental borrowing cost of perception of poor management. In this 4% in our example. So by earnings per case, the uplift in value that the acquirer share would rise. expects derives entirely from its expected

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