Value of All-Stock Mergers Doesn't Always Add Up


It never fails with these corporate merger deals.

In an atmosphere of mutual congratulation, the selling company announces that its shareholders got a "full price" for their stock while the buyer diplomatically says it paid a "fair price."

Then advisors for both firms quietly put out the word that they took the other side to the cleaners.

But at least where all-stock mergers are concerned, the truth is invariably somewhere in the middle, according to Salomon Smith Barney analyst Phillip H. Gainey IV.

The post-merger returns to shareholders won't be as high as the buying firm predicts, but then the price won't really be as high as the seller often claims, Gainey says.

In a report titled "The Economic Cost of Stock-Based Acquisitions" and in interviews with The Times, Gainey shows how two popular ways of valuing such deals can lead investors astray.

Companies being acquired for stock tend to emphasize the market value of the shares to be delivered to them. This is the same approach generally used by The Times and other news organizations.

For example, Washington Mutual Inc. will pay 1.68 shares of its stock for each of the 115 million shares of H.F. Ahmanson & Co., parent of Home Savings of America. With Washington Mutual shares closing at $42.81 on Wednesday on the Nasdaq market, the current indicated value is $71.93 per Ahmanson share, or $8.3 billion total.

But when buyers want to justify their purchases, they often use a different method, particularly when the takeover is a "pooling-of-interest" deal, in which the balance sheets of the two companies are simply added together.

In such cases, a return on investment would be projected by dividing the combined firm's expected operating profits by the combined book value (assets minus liabilities).

Washington Mutual--post merger--expects operating profit of nearly $1.9 billion on combined book value of about $8.8 billion, for a whopping 21.3% return on investment, according to Gainey.

Sounds terrific, but there's a bit of computational sleight of hand there, Gainey says. The key is using combined book value as the denominator. It's like pretending that Washington Mutual paid only book value for Ahmanson, when in fact it paid more than twice that much.

If instead of adding Ahmanson's book value to Washington Mutual's you added the $8.3 billion in stock value that Ahmanson shareholders will receive, your return on investment would drop to 12.8%. Gainey contends this approach is also skewed, but in the opposite direction.

So how do you value this deal?

Gainey suggests that the buyer--and the buyer's shareholders--ask this question: "What am I really giving up?"

To complete the purchase, Washington Mutual will issue 136 million new shares on top of its current 253 million shares. Thus, when the deal closes, Washington Mutual's current holders will see their stake in the company watered down from 100% to about 65%.

Gainey calculates from publicly available figures that the present value of Washington Mutual's free cash flow as a stand-alone company will be $75.69 per share in the third quarter of this year, when the deal is expected to close.

(Free cash flow is net income adjusted for items such as depreciation, amortization, dividends and--in the case of banks--the amount of capital that regulators require the bank to keep on hand. Like many analysts, Gainey thinks free cash flow is a better measure of value than net income because it's less distorted by taxes and accounting rules.)

Again, by issuing the new shares, Washington Mutual holders will be giving up $26.55 a share worth of free cash flow. That $26.55 per share--or about $6.7 billion total--is the true economic cost of the deal from Washington Mutual's perspective, Gainey says.

Using that number produces a return on investment of 14.9%, which Gainey believes is the true figure.

How can Ahmanson shareholders be correct in believing that they're getting $8.3 billion, while Washington Mutual shareholders are only giving up $6.7 billion? Is this some kind of econometric free lunch?

Not really. According to Gainey, it's just one of the quirks of an all-stock deal. If Washington Mutual were paying cash, it would probably pay far less.

Ahmanson shareholders can tell themselves they're getting $8.3 billion, Gainey notes, but that number would drop like a rock if they tried to convert it into cash all at once, tossing 136 million shares on the market.

As a by-product of his inquiry into value, Gainey also found evidence to support the current prevailing wisdom that stock mergers are less risky--although potentially less lucrative--than the 1980s-style deals financed with bank loans, junk bonds and other debt.

By issuing new shares, the buying company is not only diluting its shareholders' ownership stake but diluting their risk in the combined enterprise as well, Gainey points out. Yes, the upside is reduced, but so is the downside.

In a debt-financed--or leveraged--acquisition, the number of shareholders stays the same while the size and risk of the enterprise increases, he says.

Gainey's advice for investors who want a quick-and-dirty way to size up an acquisition is to remember that the real cost will fall somewhere in between the low book-value estimate and the high stock-value estimate.

So, adjust your expectations accordingly.

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