In this lesson, you will learn how to combine the Income Statements of the buyer and seller in an M&A deal, including how to factor in all the acquisition effects and why and how our figures might disagree with the companies’ own EPS accretion / dilution guidance.
Merger Model: Combining the Income Statements
Welcome to our next lesson in this module on Merger Models and Accretion Dilution. This time as you can see we’re going to be combining the income statements for the buyer and seller, Men’s Wearhouse and Jos A. Bank. In a sense, this is actually one of the easier lessons because conceptually it’s not really that complicated. It’s not as if you have to learn new abstract concepts or anything like that. We’re really going to be putting together the pieces of everything that we’ve done up to this point and also some of the simplified lessons in the beginning where you first learned how accretion dilution and that calculation works.
So remember back the first few lessons in this module, we looked at how you add together the companies pre-tax income and then you adjust for the forerunning interest on cash, interest paid on new debt, issued synergies, the shares issued in the transaction, then you calculate the new combined earnings per share. You compare it to the buyer’s standalone earnings per share and see whether or not the deal is accretive or dilutive.
And so really we’re just going to do a somewhat more complicated version of that where we don’t just start with the pre-tax incomes. We’re actually going to start with revenue and then also combine costs of goods sold and operating expenses and adjust for other things to ultimately get to this combined pre-tax income figure. So really it’s not that complicated. It’s just that we have several more items to factor in like the amortization of intangibles. We have other write-ups that we may have to factor in. We have other fees and the expenses resulting from those.
Now as with the simplified example we also need to include synergies in this exercise but we haven’t calculated them ourselves yet. We’re going to do that actually in the next lesson after this and look at how you might estimate synergies for an M&A deal. So we’ll do that in the next lesson and then come back and slightly revise our income statement here. Let’s get started with the first part of this which is just linking in the revenue and expense figures for the buyer and the seller.
So for the acquirer’s revenue for FY14, the first year in this period, let’s go down and pull in their revenue right from here, and then for the target let’s do the same thing. So we have that. Revenue Synergies we’re going to leave that blank for now because we don’t know what it is.
We’ll have to come back to this later and make an approximation in the next few lessons. Let’s add those up and then let’s copy this across so we have that.
Now for the Cost of Goods Sold, let’s link to the acquirers cost of goods sold over here and then let’s link to the targets cost of goods sold over here. We also have a few items associated with costs of goods sold all related to synergies. When we have revenue synergies we’re going to have to reflect expenses associating with additional sales here but we don’t have that yet.
Then we may just realize some inherent cost savings going along with cost of goods sold. So for example, we saw earlier how Men’s Wearhouse is using their inventory a lot more efficiently than Jos A. Bank because their inventory turnover issue is more like 2.4X versus 1.3 or 1.4X for Jos A. Bank so we may look at items like that to find potential cost savings opportunities here. Who knows? Maybe we can order inventory at a lower price now because of the combined entity and because of economies of scale because they can place bigger orders. So there may be items like that which result in lower inventory costs which of course will result in lower costs of goods sold being reflected and shown on the income statement eventually. For now though let’s just add up our total COGS figure over here and copy this across. For Gross Profit let’s go up and start with our total revenues, subtract our costs of goods sold. We have this.
And just to do a quick check. So far this should be exactly the same as the individual gross profit lined items listed on the company’s statements. So let’s just add this up to check our work along the way. It looks like it matches up so far. So let’s go down. You’ll notice here that I’ve split out Operating Expenses into a couple of different categories essentially SG&A versus Rental Expense. I’ve done that because later on just like we looked at EBITDAR for the underlying companies, we’re going to do the same thing for the combined company. It’s helpful to split up the rental expense for retailers like this that are merging.
So for the acquirers SG&A Expense let’s go over and it’s just the same General and Administrative number in this top row right here. Then for the Target let’s go over to their statements and let’s take these Sales and Marketing number and then the General and Administrative number right there. So we have that.
Then for the Rental expense let’s go to the acquirers income statement, take the rental expense rate from there. And then for the Target let’s take their rental expense from their statement as well. I should probably highlight this in green to make the color coding consistent here. So we have all those, let’s just copy this part across for now. For the Goodwill and Impairment charges the target doesn’t have any of these listed on its income statement so we’re only going to be linking to the acquirers numbers for these. Of course they’re both going to be 0. We really just have this is in the interest of completeness.
So we’re almost done with this section. We don’t have anything to enter for Operating Expense Synergies because that’s something we’re going to look at in the next lesson so that’s blank for now. However, we do have these two new items. The Amortization of New Intangibles and then the Depreciation from the PPE write-up. Now you have to be careful with these because both of these are going to be straight line items for the most part so you’re going to recognize the same amount in every single year.
The problem is that for the intangibles that get created, you have to make sure you’re using the right number. Remember that we had two different types of intangibles, the indefinite lived ones and then the definite lived ones down here. Now the indefinite lived ones are not going to amortize over time. They will be tested annually for possible impairment but the definite lived ones are really the ones that you want to include here. So for this, what we want to do is use a positive sign here because we’re in the expense section. All these expenses are listed with positive signs. So let’s go up and take our Intangible write-up amount and then divide by the period right here. Then for the Depreciation from the PP&E write-up, let’s take our PP&E write- up and then divide it by the period once again. So we have those.
Then let’s sum up… actually I take that back. Let’s take our Gross Profit and then subtract everything in this region to get to our Operating Income.
Just to do a quick check again, this should be just under the actual companies’ combined operating incomes each year. So let’s do a check of that again. So we’ll take the buyer’s number and then the targets number right here. What is the difference in these numbers? It should be equal to the amortization and the depreciation. That should explain the difference with these numbers. Let’s see if that’s actually the case.
So this should be equal to 12.9 or 12.8 close enough, and it looks like that is indeed what is explaining the difference here. So just wanted to do that quick check of the numbers. So we have our combined operating income so far even though a lot of these are blank at the moment. Now the next thing is to go in and fill in the interest and interest expense related line items. So in this section, we have the standard items you’d expect.
The Foregone Interest on Cash, the Interest Paid on New Debt, Amortization of Financing Fees, that’s a new one that we haven’t been over because the financing fees get amortized over time. If the debt lasts for five years the financing fees will be recognized over five years because of the match in principal of accounting. If the debt lasts for ten years these will be amortized over ten years. Here we don’t know exactly what to use. Technically we could go back to the company’s filings and that purchase price allocation document and figure out the proper period to use for both the debt and the financing fees. But I’m not going to bother because they actually don’t give that much information about it so we’re just going to use our own estimates here instead.
But let’s start with thinking about what the net interest income or expense for both the acquirer and target will be before any of these acquisition effects are factored in. We’ll take the acquirers net interest income/expense here. It’s really an expense in this case. So we have this. And then for the target let’s go over and do the same thing. They have net interest income because they have such a huge cash balance.
Now the Foregone Interest on Cash, so here we’re going to use a negative sign because this is going to be an expense. It’s going to reduce the number in this section. So for the Foregone Interest on Cash, let’s go up and we want to take the pre-tax costs of cash here. The cash foregone interest rate and then we want to add the cash used plus the excess cash used right here. We have this and let’s copy this across. We have that.
So then the next thing you have the Interest Paid on New Debt Issued. Let’s once again use a negative sign and go up, and then take our debt issued from the sources and use as a fund schedule right here. That’s the most reliable place to get this number done. We don’t want to take it from the transaction assumptions necessarily because this just gives us a rough idea but we may further adjust these numbers as we did with the cash used depending on the actual funding requirements for the deal, and then let’s multiply it by the pre-tax cost right here.
To make this a little more consistent let’s just change around the formula and the order of the formula and these numbers are going to change. The problem here is that we’re not factoring in the fact that the company is actually going to repay some of this debt over time or at least that it should repay some of this debt over time. If we were just looking at this model over say one year then it really wouldn’t matter. Even if we were looking at it over two years it wouldn’t really matter to factor this in. But since we’re looking at this over a five-year-period, and since these companies have both generated a good amount of free cash flow historically and they will do so going forward, it’s reasonable to assume they’re going to allot some of that cash flow to repaying this much larger debt balance. So we’ll have to factor this in but to do that, we’re going to need to look at a debt paid down schedule that factors in many of these cash flow drivers and these cash flow statement line items.
So for right now just be aware that in year one this interest number might be reasonably close to what they really paid, but then beyond that years two through five, this is going to be significantly more expensive than what it actually will look like in real life because they are repaying a good portion of that debt balance in each subsequent year here.
Another new item here is the Interest Saved on Refinanced Debt. So with this one, remember what’s going on here. In the course of this deal we’re actually refinancing the buyer’s debt of around 97 or 98 million. Now normally in M&A deals you think about whether or not you want to refinance the seller’s debt but this is a bit of an unconventional scenario. However we did want to reflect it because you do see it sometimes in real life as we did with this deal. So what we have to do is think about the interest that we save by refinancing this debt.
Now if you wanted to you’d come up with a much more complicated approach here. You could check the portion that’s refinanced and then you could try to reduce the interest expense proportionately.
For example, if they only repaid 50 million of the debt then maybe the interest expense only falls by 50% rather than falling to zero. So you could go in and do that. I’m not going to bother though because it’s usually an all or nothing scenario. For the amount of debt that’s this small they wouldn’t really go in in most cases and say that they’re only going to repay a portion of it.
So instead, I’m just going to go up and do a simple check and say if this is greater than zero, then what we want to do is go over to the acquirers financial statements and then flip the sign of this interest expense because remember, they had estimated an interest payments of 10 million per year over five years they assumed, so we’re just taking this 2 million per year and we’re flipping the sign on it. If they are not refinancing debt then this is going to be zero. Let’s see how this works. Let’s say that we go up and then we decide not to refinance the debt here. So what happens now?
Well now we don’t save any interest on this refinanced debt. If you go to the balance sheet combination, also the existing debt simply stays on the company’s balance sheet and so that’s how it looks slightly different depending on whether or not some existing debt is refinanced here. For now though I’m going to change this back and keep that in.
Then the Amortization of Financing Fees again, the idea here is that you’re going to have to have fees on any debt that is raised in a deal like this because it cost something to hire banks to go out and find investors to fund this type of deal. Or if the banks are providing the financing themselves and listing it on their own balance sheet, they’re actually making the loan directly, it’s also going to cost something to arrange that financing, to go through the credit approval process and all that. So bottom line is that there are going to be financing fees associated with raising debt here. To figure out what those are let’s go up and find our financing fees in the sources and uses schedule, and then we can divide by the period that they’re amortized over which is five years here.
Now we should also change the sign on this and we should anchor both of these and copy this across. Then what we can do now is just add up everything here and get to our net interest income or expense which is the same in each year. Of course this will change later on because our interest paid on new debt issued is going to end up changing in the future.
Now how can we check ourselves here? How can we make sure that we’ve actually done all these calculations correctly? The easiest thing to do in this case is to go up and to take a look at the company’s investor presentation on this deal. They give estimates for the interest from different sources here. So they have a full year pro-form interest expense of 103 million here. Some from the term loans, some from the bonds, some from the fees, and some from the amortization of financing fees. How do our numbers compare to this? So we have our interest paid on new debt of 98 million. We have amortization of financing fees of 11 million. So we get to around a 109 million for our fees versus a hundred and three million that they have.
It’s not clear exactly why this is the case. If you add up just the fees, just the interest paid on debt, they get to around 91 million whereas we have about 98 million. So who knows? It might be because they’re assuming part of the debt is repaid midway through the year or something else like that, however it doesn’t seem like we’re wildly off the mark when it comes to our interest expense estimates. Remember that we got the interest rate themselves directly from this presentation.
Another factor is that we actually have slightly more in debt than they do. We have about 1.8 billion. They have 1.7 billion because they’re not including the asset backed lending facility in this count whereas we are as a simple estimate. So bottom line is that there are a number of ways in which our estimates differ from theirs but it doesn’t seem like it’s so far off the mark as to not be useful here.
So that done, really the last thing to do or approaching the end of this is add up everything, get to the pre-tax income and then we want to use the buyer’s tax rate to calculate net income at the end and also then factor in the additional shares issued to calculate the combined earnings per share.
So let’s go down and actually do this now for the Pre-Tax Income. Let’s take our Operating Income and then add our Net Interest Income/Expense over here. Then for the Income Tax Provision we’re going to tax this at the buyer’s tax rate. We have this. Net Income is just going to be equal to our Pre-Tax Income minus the Income Tax Provision.
Now the Net Income Attributable to Non-Controlling Interest, we didn’t really pay too much attention to this year but what I am going to do is go acquirers income statement and link this in because this is another line item we’d like to factor in. It’s very small but just to be slightly more accurate we’ll keep that factored in. If you have any questions about this take a look back at module three near the end where we covered what non-controlling interest and equity investments are and how you reflect these on the statements.
It’s a very minor item here but we do like to factor it in to be slightly more accurate. Then for Net Income to Common, let’s just add up these two figures, so we have that. Now for the Acquirers Average Diluted Shares and for all these earnings per share calculations, remember here that we’re assuming the acquirer’s average diluted shares actually stay the same. So what we can do is just go over here and take their Weighted Average Diluted Shares from the income statement and then copy this over. We also have to factor in shares issued in the transaction. Now in this case we actually don’t have any shares because we’re not using any stock, but if we did we would definitely have something there. Then to get the total we just add both these up.
Then we can get to our Acquirers Standalone Earnings Per Share by linking in directly from their income statement, and then we can get to our combined earnings per share by just taking the new combined net income and dividing by the total diluted shares.
So it looks actually slightly dilutive in this case. It looks like it starts being accretive or approaching that level by Year 5. I can just tell that by looking at these two numbers and comparing them, but let’s do the calculation ourselves. Let’s take the Combined Earnings Per Share, subtract the standalone number, and copy this across. We can look at this as a percentage as well, so take this number and divide by the Acquirers Standalone Earnings Per Share. We can see it’s around 5 to 10% dilutive. We might say more probably 0 to 10% dilutive over this timeframe over the next five years. Now this is very interesting because if you look at some of the company’s own presentations and press releases, for example if you go back to the investor presentation, if you read through this they’re pretty confident that this deal is going to be accretive.
Part of that, as we’ll see, is because they’re assuming a lot in the way of synergies. Part of it may also be that they exclude some of these items that we factored in like the amortization of intangibles. They don’t have any PP&E write-ups so this is not even an issue for them.
Then they may also be excluding the Amortization of Financing Fees here, so it’s interesting that we come to different initial conclusions. Our numbers are of course going to change because later on we will factor in the debt repayments and how the interest expense decreases. We’ll also be factoring in the synergies just as they do in their presentation as well. So we’re going to come up with different numbers here but the bottom line is that we do get results that are somewhat different from theirs.
Now to deal with this issue of calculating accretion dilution differently and some people not factoring in some items and some people factoring in other items, you often have what are called pro-forma earnings per share numbers.
There is a lot of confusion about this topic which is because companies always calculate this in different ways. So some companies will calculate this and they will just exclude the amortization of financing fees and amortization of intangibles for example and that will be it. That will be their entire calculation. Other people will argue that you should exclude anything non cash on the income statement that happens as a result of the deal. So you might factor in amortization and depreciation, all these being non-cash charges and you might try to remove all these and say that yes, they happen but they don’t actually affect the company’s cash earnings and so you take them out of the picture because of that. Whereas you do leave in synergies, you do leave in the interest paid on debt, the forerun interest on cash and all those because those are actual cash effects. So you see this calculated in a couple of different ways but we think the best way to do it is to be consistent and to remove all the non-cash effects from this number.
So to calculate this, what we can do is take our Pre-Tax Income up here and then we want to adjust for anything non-cash. So the Amortization of Financing Fees, this is a negative so we’ll list it using a negative to make sure it flips into a positive. That’s one component of this. Then moving up, we also want to add back the Depreciation from the PP&E Write-Up and then the Amortization of Intangibles up here. Then what we want to do is tax this number at the buyer’s tax rate, so I’m going to say 1 minus buyer tax rate for this. Then we also want to factor in the Net Income or Loss Attributable to Non-Controlling Interests. Let’s put parenthesis around this whole thing and then divide by the Total Diluted Shares over here so we have this. Let’s copy this across and then let’s take this number and then subtract a Standalone Earnings Per Share. Now we can see a very interesting difference which is that this is actually an accretive deal now if you look at on a pro-forma basis.
So it’s not clear exactly which set of numbers we should be placing our faith in here. However one point to note is that some of this is actually our own creation like the Amortization of New Intangibles, the Depreciation of the PP&E Write-Up, these didn’t actually happen in the real deal. I’m just showing you these for teaching purposes and so you learn how they work. The
Amortization of the Financing Fees, the company even actually includes this in their own numbers right here, or at least something close to what we have. So this one we have a little more faith in, but you could make a very good argument that we should just leave these out because it appears that they do not actually have any definite lived intangibles that were created from this deal in real life.
So you will see references to both of these numbers. This first one will also be called [inaudible 00:22:54] EPS or IFRS EPS, so these more closely follow the accounting standards in conventions.
But this number, the pro-forma one does have its uses as well. You have to be careful because some companies will try to manipulate their numbers by excluding very, very large acquisition related charges. If the company is always acquiring other companies, you can’t really consider those large charges to be one-time non-recurring expenses, you really have to consider them an ongoing part of the company’s operations. So be aware of these concepts but also be aware of the fact that you shouldn’t necessarily place your faith entirely in the pro-forma numbers because they can be manipulated and sometimes they are hiding a lot of what’s going on after a deal like this takes place.
We’re not going to say too much else about this for now because later on we’re going to expand on this over the next few lessons and draw some additional conclusions about this. We’ll also draw some conclusions about what this deal looks like in the sensitivity tables and the case study discussion at the end. Now this exercise may have seemed pretty simple to you so you might have a question which is what makes this hard.
The answer would be that it depends on how detail oriented you want to be. You can always make things more difficult and more complicated. For example, the synergies, which we haven’t looked at yet, but as you can imagine these can be very complicated to estimate yourself. Even if you’re using company provided numbers these can be tricky to integrate properly. We’ll look at that coming up soon. The DNA formulas, so the depreciation and amortization on the financing fees and the write-ups, if you think about it these formulas are not very flexible right now. The reason being that we’re assuming that these are amortized; they’re depreciated over a period of at least five years or more. But if we change this period, and let’s say we made one of these, let’s say we made the amortization period three years instead, well now we’d run into a problem because we have this three year number going all the way across for five years.
So we could go in and make that formula a little more flexible and make sure that that scenario doesn’t happen. We’re not going to worry about it too much here because it doesn’t matter for this model and amortization of intangibles almost always takes place over at least five years anyway. Another problem is that with the foregone interest on cash and the interest paid on debt, these are going to change over time because the debt is going to be repaid and we will look at that actually in one of the upcoming lessons. Then even with the cash, the issue here is that as they lose more and more cash over time as a result of the interest that they’re giving up on that cash, they also have a lower cash balance in the future meaning that over time their foregone interest on cash will keep growing because they lose this 1.1 million. Now that means that they have 1.1 million less of cash earned interest on in the future. Then they lose another 1.1 million in the next year and then another in the year after that so there is accumulative effect to this. It’s very small here because interest rates are so low but it is worth noting that that’s another effect.
The share count could also change if the acquires actually repurchasing or issuing shares in the deal or afterward or something like that. We ignored it here and kept it the same for simplicity. Then we could also have other acquisition effects. For example, sometimes deferred revenue is written down depending on the company and the industry. We ignored it here in the interest of simplicity and also because the companies don’t really have any deferred revenue but those are some other things you could see. Now as the final check, another thing that you could do is just go in and change around the acquisition consideration slightly. What we could say is something like let’s make it 10% cash, and then 50% stock, 40% debt, and let’s see if everything here now works correctly.
Now since we are now using a lot more stock we’d expect this to be more dilutive overall. So looks like our interest numbers have updated properly. It looks like we now have shares issued.
Sure enough on both the pro-forma EPS and [inaudible 00:27:06] EPS basis it is now significantly more dilutive. So just something interesting you could do to check your work a little bit at the end. In general with models like this it is always best to check yourself by actually including
numbers for all these types of acquisition effects and different financing methods. Even if in real life this is not really what happened or doesn’t match the deal just to check your model itself, it’s good to do something like the exercise that we just went through here.
So let’s do a recap and summary as always. The basic idea here is really not that complicated. You add together the individual items on the income statement down to pre-tax income, then you adjust for the main acquisition effects, foregone interest on cash, interest paid on debt, and additional shares issued. You also have amortization and depreciation from write-ups and fees, and then you tax everything at the buyer’s tax rate at the end.
You take that combine that income number, you divide by the total shares that’s standing to get the new EPS figure so you have to factor in the additional shares issued there as well. And then you compare this to the buyer’s standalone figures to determine accretion dilution and you can also variations like the pro-forma EPS that we went through here.
So that’s it for this lesson. Coming up next we’re going to jump into the estimates for synergies and you’ll see how you can use some of the companies you own provided numbers to come up with these. You’ll see how you can look at other sources like equity research to come up with these as well. In general you’ll see the impact of these synergies on a merger model and how it might make an M&A deal more viable or less viable when you factored these in.
Table of Contents:
- 1:53: Revenue and COGS
- 4:21: Operating Expenses
- 7:44: Net Interest Income / (Expense)
- 15:57: Net Income and EPS Accretion / (Dilution)
- 19:49: Pro-Forma EPS Accretion / (Dilution)
- 23:57: More Advanced Nuances
- 27:34: Recap and Summary
Files & Resources
How to Download These Files:
In Firefox, Chrome, and Internet Explorer:
Right click the link and click Save Link As...
Right click the link and click Download Linked File As...