Acquisitions and DisposalsWe penalise companies which make a high number of acquisitions (4 out of the past five years) and where average consideration over the past five years is in the top quintile (in excess of 6.8% of sales). There can be legitimate reasons for companies to make acquisitions and/or disposals. Acquisitions might give access to technology or some other asset which is difficult to attain in house. Acquisitions of competitors can also lead to value-enhancing cost-saving synergies. Meanwhile, it makes sense to dispose of non-core businesses which are outside management’s core competency and a distraction. However, there are also a number of reasons to be concerned:
- Acquisitions for growth: Serial acquirers can boost their reported growth rate far in excess of the real underlying growth rate of their industry. This can lead to an inflated share price (often leading to generous management compensation) and equity valuation. The company can then use its inflated equity to acquire additional assets which are priced at far lower, and more reasonable, valuations. This scheme eventually comes to an end when there are no more assets to acquire. In order to maintain the scheme, the acquirer must find ever-larger assets to buy. At this point, growth disappoints and its share price de-rates. WorldCom’s acquisitive spree in the run up to its eventual collapse in 2002 is a good example of this scheme. We believe the Chinese water sector to be aggressively using acquisition accounting in order to boost growth. In the past, Li & Fung (494 HK) has used acquisitions to inflate profit.
- Acquisition accounting: Acquisition accounting dictates that acquired assets be consolidated at appraised value if it differs from book value. This gives companies the scope to write-down depreciable assets in order to boost profits (through lower depreciation). This write-down is offset by increasing goodwill and, as such, there is no impact on the income statement. Other acquisition accounting gimmicks include revaluing debt liabilities in order to lower interest expenses and making large unspecified provisions which can then be unwound at will. For more reading, please refer to GOODWILL HUNTING: Using acquisition accounting to inflate earnings (1 Nov 2016). In this report, we detail how CKH Holdings (1 HK) has aggressively applied acquisition accounting to boost profits.
- Asset trading: Companies that regularly dispose of assets are often doing so in order to meet earnings expectations and manage their share price. These companies often persuade the analytical community that disposals are part of the recurring business and should be included in commonly followed operating metrics, such as EBITDA.
The primary way to spot companies engaged in acquisition accounting is to highlight those making numerous material acquisitions. In addition, because tangible book value is written down, acquisitions often result in large amounts of goodwill and deferred tax assets.
Of the 16,000 companies in our global sample, 73% made some form of acquisition or disposal in any given year between 2010 and 2015. Around 41% made an acquisition or disposal in four or more of those five years, although the amounts involved were typically very small, with a median average of just 1.2% of sales. Canadian and US companies tend to spend the most on acquisitions, with a median average in excess of 4% of sales, whilst Japanese and Israeli companies spent the least, at below 50bp of sales.
Acquisitions and disposals appear to be more common in technology companies, such as software, communications services and IT services, while least common in old brick and mortar companies such as textile and retail, as shown in Figure 13. Quite a few countries are vying for top position as the most acquisitive companies, including Thailand, Korea and Taiwan; however, India, Pakistan and Russia are the least acquisitive by some distance, as shown in Figure 14.
Our accounting screen is set to trigger a red flag when companies have made acquisitions in four or more of the last five years (anything in excess of the 59th percentile). Another flag is triggered when average acquisition consideration over the past five years is higher than the 80th percentile of global peers, which is in excess of 6.8% of sales.