Analyzing an Acquisition Announcement

When one company acquires another, there is a possibility that the deal will be a tremendous success, or a catastrophic failure. The key for investors is to be able to decipher the news reports and then to determine whether the deal warrants the investment in, or the immediate sale of, the purchasing company. Read on for some suggestions for analyzing acquisition deals.

Some companies are well capitalized. They have all the money they need for the foreseeable future to grow their businesses and remain competitive. However, many companies are not so lucky. They routinely have to tap the equity or debt markets or seek bank loans in order to obtain funds.

For this reason, investors should read what management is saying about the company it is about to acquire, or has recently acquired. Is cash needed to fund future growth, add employees or to build additional office space? If the company being acquired is a public company, review its most recent 10-Q or 10-K.

Check the cash position. If the company is losing money, try to determine its burn rate. This will enable you to gauge if and when the company will need additional funds.

If you think the company will need a cash infusion, try to determine how it will be supplied. Does the acquiring company have ample cash to fund the acquired company's growth with no problem, or will a potentially dilutive stock offering have to be completed in order to secure funds? These are all questions that should be answered in order to determine the deal's impact on the acquiring company's financials.

You should also remember that unless a company receives an offer it simply can't refuse, companies that are on solid financial footing typically don't sell at all.

One of the worst things that a company can do is to acquire an enterprise that has a huge volume of debt that's scheduled to come due at some later date. After all, increased debt loads can be a tremendous distraction to the acquiring company, particularly in the troughs of a business cycle.

That said, in some instances, large volumes of debt can provide a significant opportunity for the suitor. How? Through refinancing. In fact, during the late 1990s and early 2000s, a number of high-profile casinos scooped up smaller players, and saved a ton of money for their shareholders by refinancing debt that had originally been issued at high coupon rates.

In short, lofty debt loads should send up a red flag. That is, unless the suitor has deep pockets or collateral and a reputation as a low credit risk so as to refinance the obligations at a materially lower rate.

When a deal is announced, or even suspected, and both the buyer and the seller are known, investors should immediately go to the seller's proxy statement and 10-K to review Management's Discussion & Analysis, as well as any content about risks or disclosures. The idea is to try to determine whether the suitor will be acquiring a huge potential liability. Look for lawsuit details, or guarantees the company has offered to secure the debt of third parties. Read the fine print. You'll be happy you did.

Almost every public company at one point or another will be sued. For the most part, a large number of the suits will be settled without anyone declaring bankruptcy. However, if a number of suits are pending, and management's description of the situation is ominous, consider steering clear of the situation.

Obviously, when the acquisition is consummated, there is no need for two chief executives or two chief financial officers. In addition, there may be no need for some facilities because of these redundancies. As such, investors need to determine how long a successful integration will take and at what cost.

There will be some costs associated with the combination of two companies, particularly if two sales forces are merging. However, if the costs seem excessive, or if management is suggesting that the deal won't add to earnings for a year or more, consider bailing. Remember, there are plenty of things that can go wrong in a year's time. Ideally, you want to be on the lookout for acquisitions that are immediately accretive to earnings or that can be soon after the deal is inked.

In conjunction with the elimination of redundancies, layoffs are likely to occur. Many former employees may be entitled to pension benefits and a host of other costly payroll items. This is just one (of the many) reasons why consolidation in unionized industries isn't more popular—the cost of paying benefits to thousands of laid-off union members would be prohibitively expensive.

If a company that you're interested in announces an acquisition, be on the lookout for how much severance costs will amount to, and whether they can be booked in a short period of time. If it appears that these costs may go on for a number of years or consume a significant percentage of earnings, consider heading for the exits.

Acquisitions can present tremendous opportunities or major disasters for investors. It is up to the investor to determine how a stock will be affected and, if necessary, get out before it's too late.