How to create value 101
EnhanceValue plc has a market capitalisation of £40m. With 1m outstanding shares, this equates to a share price of £40. The company has annual earnings of £2m, leading to Earnings Per Share (EPS) of £2 (which is earnings of £2m divided by 1m shares) and a (slightly demanding) P/E ratio of 20 (which is the £40 share price divided by EPS of £2).
Target plc has the same earnings and number of shares, but a lower P/E ratio of 12, so it trades at £24 per share (£2 x 12) and therefore has a market cap of only £24m (£24 x 1m shares).
C. Real Acquirer, the CEO of EnhanceValue plc, is planning a value-enhancing takeover of Target plc. The plan is to pay for Target using EnhanceValue's stock, a move widely welcomed by analysts as 'immediately accretive'. In fact, EnhanceValue will need to issue only an additional 600,000 shares (£24m/£40). After the acquisition's completion, the combined entity will have 1.6m shares and earnings of £4m (£2m + £2m), or £2.50 per share. This is a significant improvement of £0.50 per share. The market is expected to value the 'improved' EnhancedValue plc at £50 per share (EPS of £2.50 x P/E ratio of 20), leading to a market cap of £80m (£50 x 1.6m). The total shareholder value created is expected to be £16m (£80m-£40m-£24m), to be added to C. Real Acquirer's already outstanding track record.
However, a group of activist shareholders, led by hedge fund manager E.P.S. Thiruvananthapuram, is opposing this move. He claims the the shareholders of EnhanceValue plc would be much better off with a share buyback programme and that Mr. Acquirer's acquisition frenzy has failed to create any value. "It should be obvious for everybody that while the acquisition of Target plc does increase Earnings Per Share to £2.50, this only happens because Target trades on a lower P/E multiple. It is a mathematical trick. The market will understand that there are no synergies between the two entities and therefore the price of EnhanceValue will be unchanged at £40 and its value will be £64m - possibly less after paying all those fat investment banking fees-, while the implied P/E ratio will now be 16 instead of 20".
Instead, Mr. Thiruvananthapuram thinks that EnhanceValue should undertake an aggressive share buyback programme. He reckons that Mr. Acquirer should return £20m to shareholders, by buying back 500,000 shares (or 50% of all outstanding shares) at £40 per share. To pay for this, EnhanceValue would raise £20m from the debt markets at 5% interest rate. This would lead to an annual after-tax interest cost of £700,000 (assuming a marginal tax rate of 30%). Earnings will therefore be reduced from £2m to £1.3m but now there are only 500,000 shares outstanding, so Earnings Per Share are expected to skyrocket from £2 to £2.60 (which is £1.3m divided by 500,000).
Nothing else has changed in EnhanceValue and the company still has the same growth opportunities, so the same multiple (or P/E ratio) should apply. "This is unlike management's plan where clearly an inferior company is being acquired. Under our plan EnhanceValue is worth 20 times £2.60 per share, or £52, compared to the current price of £40. This is true value creation", concludes Mr. Thiruvananthapuram.
Target plc has the same earnings and number of shares, but a lower P/E ratio of 12, so it trades at £24 per share (£2 x 12) and therefore has a market cap of only £24m (£24 x 1m shares).
C. Real Acquirer, the CEO of EnhanceValue plc, is planning a value-enhancing takeover of Target plc. The plan is to pay for Target using EnhanceValue's stock, a move widely welcomed by analysts as 'immediately accretive'. In fact, EnhanceValue will need to issue only an additional 600,000 shares (£24m/£40). After the acquisition's completion, the combined entity will have 1.6m shares and earnings of £4m (£2m + £2m), or £2.50 per share. This is a significant improvement of £0.50 per share. The market is expected to value the 'improved' EnhancedValue plc at £50 per share (EPS of £2.50 x P/E ratio of 20), leading to a market cap of £80m (£50 x 1.6m). The total shareholder value created is expected to be £16m (£80m-£40m-£24m), to be added to C. Real Acquirer's already outstanding track record.
However, a group of activist shareholders, led by hedge fund manager E.P.S. Thiruvananthapuram, is opposing this move. He claims the the shareholders of EnhanceValue plc would be much better off with a share buyback programme and that Mr. Acquirer's acquisition frenzy has failed to create any value. "It should be obvious for everybody that while the acquisition of Target plc does increase Earnings Per Share to £2.50, this only happens because Target trades on a lower P/E multiple. It is a mathematical trick. The market will understand that there are no synergies between the two entities and therefore the price of EnhanceValue will be unchanged at £40 and its value will be £64m - possibly less after paying all those fat investment banking fees-, while the implied P/E ratio will now be 16 instead of 20".
Instead, Mr. Thiruvananthapuram thinks that EnhanceValue should undertake an aggressive share buyback programme. He reckons that Mr. Acquirer should return £20m to shareholders, by buying back 500,000 shares (or 50% of all outstanding shares) at £40 per share. To pay for this, EnhanceValue would raise £20m from the debt markets at 5% interest rate. This would lead to an annual after-tax interest cost of £700,000 (assuming a marginal tax rate of 30%). Earnings will therefore be reduced from £2m to £1.3m but now there are only 500,000 shares outstanding, so Earnings Per Share are expected to skyrocket from £2 to £2.60 (which is £1.3m divided by 500,000).
Nothing else has changed in EnhanceValue and the company still has the same growth opportunities, so the same multiple (or P/E ratio) should apply. "This is unlike management's plan where clearly an inferior company is being acquired. Under our plan EnhanceValue is worth 20 times £2.60 per share, or £52, compared to the current price of £40. This is true value creation", concludes Mr. Thiruvananthapuram.
posted by DS at 2:01 PM
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