As a firm begins to explore M&A activity prudent investors can learn a lot about the company they have, or plan to, invest in. First, and possibly most important, it is a great opportunity for the investor to observe how management views the value of their own company and where the synergies are expected to be realized. The biggest clue for this is the payment method chosen. The payment method, which can be cash, stock, or a mix of the two, provides a candid assessment of the buyer’s perspective on the relative value of a company’s stock price and future growth assumptions. Second, the type of M&A transaction can also leave clues that paint a picture of future goals and perceived strengths and weaknesses of both the buyer and the target.
Before we get into the specific payment methods, I will cover a few types of transactions as they somewhat impact the payment method. A merger can be classified as:
• Statutory – the target is fully integrated into the acquirer;
• Consolidation – the two entities join to become a new company; and
• Subsidiary – target becomes a subsidiary of the acquirer.
The key thing to remember is that M&A is not always a welcomed event. The acquirer might try to purchase the target in a friendly takeover or force a sale in a hostile takeover. A hostile takeover is generally accomplished by going directly to the company’s shareholders and fighting to replace management to get the acquisition approved. There are several strategies to protect against this, but I will cover those in a separate article.
Investors can assess the payment an acquirer offers a potential target as an indication of the management’s view of the stocks value. The key thing to remember here is that both buyer and seller need to agree on the payment method, and both will have different objectives they want to achieve.
a) Cash, securities or a mix
Firms have to take many factors into consideration when an offer is put together. These include, but are not limited to:
• The potential presence of other bidders
• The target’s willingness to sell and payment preference
• Tax implications
• Transaction costs if the stock is issued
• The impact on the capital structure
A company can be purchased using cash, stock or a mix of the two. Stock purchases are the most common form of acquisition, and although they may provide less liquidity, they are generally favored by both parties.
• Cash – The more confident management is that they will be able to benefit from the acquisition, the more they will want to pay with cash. This is because they believe the shares of company stock will eventually be worth more after the merger, generally due to achieving the desired synergies.
• Stock – The alternative stands for the target company using the same assumptions. If paid in stock, they become a partial owner of the acquirer and will be able to realize the benefits of the expected synergies. The less confident an acquirer is about the firm’s relative valuation, the more they will want to share some of the risks of the acquisition with the seller. Thus, the acquirer will want to pay in stock. If a company you have invested in is getting offered a lot of cash, consult with management as to why they think the buyer prefers cash over stock.
b) Stock as a currency
Market conditions play a significant role in M&A deals. Stock-for-stock deals are where a firm acquires some stock in a firm with its own stock. This can give an investor insight as to how the buyer’s management views the current stock price. When the buyer’s shares are considered overvalued by management, they may prefer to pay for the acquisition with an exchange of stock-for-stock. Shares are essentially considered a form of currency, and if one of the companies is listed, fairly liquid. Since the shares are deemed to be priced higher than what they are actually worth, swapping stock gives the management team more bang for their buck. With just a simple calculation, this can actually provide insight into where the management thinks the current market value of the stock is.
If the acquirer’s shares are considered undervalued, however, management may prefer to pay for the acquisition with cash. By thinking of the stock as equivalent to currency, it would take more stock trading at a discount to intrinsic value to pay for the purchase.
There are also several types of mergers; each providing investors with insight as to the purpose of the acquisition.
• A horizontal merger is an acquisition of a competitor or related business. The buyer is generally looking to achieve cost synergies, economies of scale and gain market share.
• A vertical merger is when a company tries to purchase another company along the production chain. The goal of the acquirer is to control the production and distribution process and gain cost synergies via integration, which can be backward (acquirer purchases supplier) or forward (acquirer purchases distributor).
• Conglomerate mergers – are when a company wants to purchase a company completely outside of the scope of its own core operations/competencies. There are multiple reasons for conglomerate purchases, even though at first glance they may seem against the company’s strategic vision.
These different types of M&A transactions can be evaluated by investors to understand management’s vision and potential future objectives. This includes unlocking hidden value, accessing new markets, obtaining new technologies, exploiting market imperfections or overcoming adverse government policies.
Like anything in the world of M&A, deducing these assumptions is art, not science. There are generally additional factors as to why a firm would choose to pay with cash or stock, and why the acquisition is being considered, and often tax can play a huge role.
With that said, the payment method remains a major signal from management. It is a sign of strength when an acquisition is paid for with cash and potentially a weakness if paid for in stock, as it reflects management’s uncertainty regarding potential synergies from a merger. Investors can use these signals to value both the acquirer and the seller.