Frank Voisin writes about value investing topics at http://www.frankvoisin.com
Accretive is a term used to signify a transaction (often an acquisition, but not necessarily so) that is expected to increase a financial metric. The metric most often referred to is earnings per share. Companies often like to focus on how accretive their transactions are, putting the expected accretion up front in press releases, conference calls and investor presentations. The problem with accretion is that is glosses over far more relevant metrics and make bad deals look attractive.
Here’s an example. A company with a dominant market share in a stable industry trades at an earnings yield (earnings / market cap) of 8%. Furthermore, the company has no debt. The company has enjoyed relatively stable performance, but unfortunately, the share price has also been steady and range bound for years. A new management team wishes to boost the value of its stock options, and decides that it will achieve this only by showing above-average EPS growth for its industry. How can it accomplish this?
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The company can go the fundamental route, cutting costs or increasing revenues. Both of those are difficult and risky. Failure could lead to a loss of investor confidence and a collapse in the company’s share price (not to mention those executive bonuses). There’s another route, and that is to pursue an accretive transaction. As noted, the company has no debt. Thankfully (for management), interest rates are low, and this company can borrow around 4%. By issuing debt and repurchasing shares, the denominator in the EPS calculation (shares outstanding) declines, and because the rate of interest is below the earnings yield, the added interest expense will cause earnings to decline more slowly than the denominator, leading to an improving EPS metric. Thus, this was an accretive transaction.
But what has really happened here? The company’s operations are fundamentally the same, but now it is burdened with a high level of debt that limits its financial flexibility in the future. Furthermore, suppose interest rates rise and when the debt rolls over (or perhaps it was floating in the first case), the company doesn’t have the cash to repay it. Now interest rates have shot up above the previous earnings yield. Still accretive? No, but the initial boost was enough to support those stock options.
Now, the market is supposed to be smarter than this and take into account that a strictly financial transaction did not increase the value of the operations. The pie is the same size, just cut in fewer pieces. But there are plenty of transactions that are more difficult to assess. Consider the case of an acquisition. When a transaction is announced, managements have tremendous leeway in what assumptions they make about how the two companies will fit together in the future. Any number of wild assumptions can be made in order to show how accretive the transaction will be.
Consider Landauer, Inc (NYSE: LDR), a company focused on technical and analytical services for determining radiation exposure and for medical physics. The company has had tremendous returns, as the following chart shows.
Though returns have been on a downward trajectory since the beginning of the recession, its returns are still quite strong. Furthermore, the company has traditionally paid out almost all of its free cash flows; of the roughly $251 million in free cash flows over the period presented, it paid out a whopping $235 million! Also, over this period the company has traditionally eschewed debt.
A company that consistently generates exceptional (and unlevered!) returns and then pays out almost all of its free cash flow is often a good company to own. But things took a turn for the worse with this announcement in November (emphasis added)
Landauer, Inc. (NYSE: LDR), a recognized global leader in personal and environmental radiation monitoring and the leading domestic provider of outsourced medical physics services, today announced that it has acquired all of the outstanding equity interests of IZI Medical Products, LLC (IZI Medical Products) of Baltimore, MD, for a purchase price of approximately $93 million. IZI Medical Products is a leading provider of high quality medical consumable accessories used in radiology, radiation therapy, and image guided surgery procedures and was a portfolio company of Boston based Riverside Partners, a private equity firm with two decades of experience with middle market healthcare and technology companies. …
Saxelby added, “The acquisition is an excellent strategic fit and enhances our radiation safety continuum offering. There is significant synergy of customers between the companies and the combined brands of two market leaders allows for an expanded breadth of products and services to our healthcare clients. Sales for IZI Medical Products for the nine months ended September 30, 2011 were approximately $14 million.” …
IZI Medical Products was acquired for approximately $93 million in cash, subject to customary purchase price adjustments. The acquisition is expected to be approximately $0.12-$0.16 accretive to earnings per share in fiscal year 2012. The structure of the transaction also provides Landauer with a future tax benefit with a net present value of approximately $18.6 million.
For some context, a $93 million acquisition is large for this company which has (at the time of writing) a market cap of about $490 million. The company’s pre-transaction balance sheet had just $19.8 million in debt vs. $7.9 million in cash. According to the press release, the company obtained a $175 million revolving debt facility to refinance its existing debt, pay for IZI (including transaction costs) and still have $40 million available. So, we can expect that post acquisition, the company will have around $135 million in debt ($175 – $40m) plus some cash. Say $130 million net debt.
Another thing to note is that the company focuses on IZI’s sales and makes reference to a future tax benefit. This is a bad sign. It means that IZI is unprofitable (otherwise, management would be touting its earnings along with sales, rather than just sales) and has been for quite some time (losses such that the present value of the tax assets is greater than this year’s sales. Tax assets equal the loss times the tax rate less any valuation allowance, so to arrive at the minimum value of the losses, divide that tax asset by an assumed average tax rate, compare to the current revenues and you’ll get a handle for how long this company has been unprofitable).
So let’s clarify. LDR decided to make a tremendously large acquisition (relative to its own size) in order to pay ~5x peak revenues for an unprofitable company (that appears to have always been unprofitable). And in so doing, the company will take on the greatest debt burden in its history. But shareholders should cheer, because this will be an accretive transaction (in fact, according to this slide from the investor presentation, it will be accretive not only financially, but also operationally, whatever that means).
A further insult to shareholders is that the company provides little financial support for its assertion that the transaction will be accretive (the only way to avoid making an accretive 100% debt-funded transaction in this low interest rate environment is to buy an unprofitable company). There are two possibilities for supporting this assertion. One is that the company expects significant expense or revenue synergies. This is doubtful, because it usually takes more than a year to fully integrate two companies and costs tend to rise in the near term.
The second and more likely explanation is the future tax benefits. Earnings go up if the company pays less taxes. By utilizing IZI’s $18.6 million future tax benefit, the company will pay significantly less in taxes. Over the last three years, LDR has paid on average $11.5 million in taxes, so the $18.6 million tax asset will disappear sometime in the second year after the transaction. Will this transaction be accretive to fiscal 2012 earnings? Most certainly. But what about 2013 earnings? 2014? The only way this transaction is accretive in the long term is if management can execute on its strategy, and post-haste!
Let’s summarize: LDR’s recent transaction to buy IZI is an extremely risky proposition and investors would be wise to not focus on a transitory accretion to EPS, but rather the massive amount of debt that is being piled on to this historically formidable performer. Additionally, for investors reliant on that steady dividend payment, it might be worth questioning how safe that income is if management is unable to execute on its strategy and make IZI profitable before the acquired tax benefit disappears.
What do you think of LDR?
Author Disclosure: No position.
Talk to Frank about Landauer, Inc
Perhaps it would be better to look at a concrete example.
Frank Voisin writes about value investing topics at http://www.frankvoisin.com