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Eleven Financial Clues in Acquisition Targets

Evaluating potential acquisition targets involves a combination of qualitative and quantitative factors, including fundamental market analysis and company-specific execution history.  This post focuses strictly on eleven financial clues in acquisition targets that either a strategic or financial acquirer will look for. 

  1. Does the company have a track record of over-promising and under-delivering on quarterly results? The more inconsistent a company is quarter-after-quarter, the more interest it may attract from an activist holder, a strategic buyer or a financial buyer.  Underneath, this track record may suggest a management not in touch with the realities of its end markets or simply poor execution from the top and out in the field.  Cynics may suggest a management that is strongest in hype than anything else.
  2. What has the company's revenue performance been relative to peers?  A lagging growth rate could be a sign of market share loss, weak sales execution or a failure to expand distribution channels.  A rising dependence on service revenue rather than product revenue could also signal these factors as well as a tired product cycle in need of refreshing.  Another clue is sales compensation: are salespeople being paid to harvest existing accounts or is compensation weighted toward hunting for and gathering new accounts?
  3. Does the potential target have a division or business unit that has under-performed?  Companies tend to milk their cash cows, invest in growth segments, and starve their dogs.  Assessing the marketplace the segment is in, and a few questions about capital spending allocation may reveal a dog.  Clues might also be found in the segment data of public companies filing documents.  This could open the door to possible divestiture or spin-off.  Alternatively, the division or business unit may be a growth segment in build-out mode that has not yet bloomed into its full product cycle, completed its go-to-market strategy or maximized its market penetration.
  4. How do the company’s margins compare to peers?  Weaker gross margin may suggest inefficient materials sourcing or manufacturing processes, or a revenue mix skewed toward lower-margin products or services.  Underperforming operating margins could be an extension of gross margin issues.  More often, flagging operating margin may be caused by high operating expense ratios due to headcount additions that have not yielded productivity benefits, higher R&D spending for future products or rising compliance, legal and accounting costs.  Lastly, operating expenses may be bloated by inefficient management or from the aftereffects of a prior acquisition that has not been digested.  Underperforming margins may create cost savings opportunities through rationalization or integration.
  5. Does the company generate positive cash flow from operations (CFFO) and free cash flow (FCF)?  Opportunities exist in working capital accounts, such as improving cash collections, production efficiency, inventory turns, benefits allocations and payment terms, among others.  FCF can also benefit from more efficient capital investments or reductions, as needed.
  6. Does the target company have a large cash hoard?  While this may reflect the CFO’s concerns about a slowing or maturing market, it may also indicate inefficient cash management.  Regardless, a large cash balance provides flexibility in how to finance the acquisition.  It also helps reduce the cost of acquisition.
  7. Does the company have a large deferred revenue balance?  This is important, because it means the company has a recurring stream of future revenues that a buyer can harvest.  However, depending on the acquirer, this deferred revenue may not be recognizable under GAAP accounting rules.  For a strategic buyer, this is of less consequence in the short term, as the rationale for acquisition is to generate incremental growth and market share over time.
  8. Does the potential target have a sizable net operating loss (NOL)?  If so, this can favorably impact tax status and reduce acquisition cost for the acquirer.  NOL can be beneficial to either a strategic or financial acquirer.
  9. If the potential target has debt, do the terms allow for re-financing to reduce interest payments?  Lower interest payments provide the double benefits of preserving cash outlays and boosting pretax income.  Conversely, for a strategic buyer, especially one that has no outstanding debt, adding some leverage to the balance sheet may be efficient and beneficial.  Terms will be the determining factor.
  10. If the target company is public, float, ownership concentration and shareholder composition are relevant factors.  The float (publicly traded shares and market value) reveals how any shares are held in the public domain.  This is noteworthy in panning to accumulate shares, particularly for a financial buyer.  If there is concentration of ownership – either by insiders or a few large institutional holders – the potential acquirer will know which owners will have to be persuaded about the merits of the deal.  It also reveals which will be instrumental in negotiations. Related to the previous point, it can be helpful to know who the largest outside shareholders are, and how much they own.
  11. How is the company being valued?  In the public market, comparisons to peer group on various valuation metrics can quickly provide clues.  For example, a deeply discounted valuation relative to peers on several key metrics may simply suggest operating underperformance due to weak management.  However, it may also be an indicator of something more endemic fundamentally.  For a private company, how the owners value the business provides clues into what the true prospects might be.  Just as with beauty, valuation is in the eye of the beholder.  It is therefore the most subjective of financial criteria.  Sound qualitative due diligence in conjunction with financial analysis should help buyers determine what a company’s fair value is to them.  

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Tags: &, Acquisitions, Finance, M&A, Mergers, Strategy

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