Article by Robert Currie for Brunswick News

Y
oure sitting at your kitchen tableeating some all-bran cereal on a beautiful fall morning when you open the Globe and Mail on your tablet to catch-up on some investing news before workYou start scrolling through the articles only to find one that jumps out immediately – one of the companies in your portfolio has announced a massive multi-billion-dollar acquisition.



LBI Facebook Link Post 1You jump to the company’corporate website and click on Press Releases to see what the company has to say. There, you find coded language about synergies and strategic fit that sound positive,offering you some relief, maybe even some enthusiasm,over the company’s multi-year integration plan.Later in the day, you check on your portfolio and see the stock down 5% on the newsWhat happened?


It’s not uncommon to see the stock price of a company who’s announced an acquisition fall when the market opens; the market is usually quite apprehensive towards acquisitions. So why do companies do it? Not all acquisitions are created equal and you can usually ascribe defensive or offensive motives to the management team. For example, in April of last year, Transcontinental (TCL.A: TSX) announced the CA$1.7b acquisition of Coveris Americas to accelerate its transformation from a declining cash-rich printing operator to a growing flexible packaging manufacturer – a defensive acquisition. In contrast, in the same month, Metro (MRU: TSX) announced the CA$4.5b acquisition of Jean Coutu, a long-awaited deal between two Quebec titans, bringing scale and vertical integration to their existing pharmacy franchises, as well as the opportunity to leverage a larger store network – an offensive acquisition.  

Regardless of motive, acquisitions must be evaluated to see if the transaction was a wise one or not. When a company decides to invest its money rather than return it to the people who own the business (the shareholders),the expectation is for that investment to earn a rate of return above a stated hurdlerate of return that justifies the expenditure. For example, the Board of a company may set the hurdle rate at 12% Return on Equity (ROE).The more you pay for a business, the lower the return you can expect from that investment.If the return is lower than the hurdle rate, owners of the business would rather take that money and invest it in higher returning investments elsewhere or spend it on consumption.  

Acquisitions are usually financed by diluting current shareholders by issuing shares or levering-up the balance sheet with debt. When a management team makes this decision, they are implying the return on the acquisition is above the hurdle rate. It turns out this is rarely the case. The reason the stock may be falling on the news is because it’s hard to buy a company at a rate of return above the required hurtle rate and investors are smart enough to discount management’s excitement. Either estimates are too aggressive and are never attained, or there are hiccups as you try to put the companies together that cause customers to go elsewhere – see Empire’s (EMP.A: TSX) acquisition of Canada Safeway that went awry in 2016. But not all acquisitions are bad. 

In Part II we’ll look at a few example acquisitions and how you can use them as a framework to think about acquisitions when they’re announced so you can know when to get excited and when to be worried.