Dilutive Acquisition

A dilutive acquisition is a takeover transaction that decreases the acquirer's earnings per share (EPS) through lower (or negative) earnings contribution or if additional shares are issued to pay for the acquisition. A dilutive acquisition can decrease shareholder value temporarily, but if the deal has strategic value, it can potentially lead to a sufficient increase in EPS in later years.

In general, if the standalone earnings capacity of the target firm is not as strong as the acquirer's, the combination will be EPS-dilutive to the acquirer. This may be true in the first one or two years post-transaction closing, but as revenues and cost synergies take hold through scale economies, the acquisition should become accretive to earnings. The market tends to punish the share price of the acquirer if the benefits are not immediately clear. A lower EPS, after all, at the same trading multiple will reduce the stock price. (Conversely, an announcement of an EPS-accretive deal in Year 1 will quickly reward shareholders with a higher stock price.)

Before a company goes ahead with a takeover bid, it will put together pro-forma financial models that combine all the financial statements of the two companies. It is not a simple matter of adding accounts; many adjustments and assumptions must be made to many items to obtain an approximation of combined statements. The focus will be on the income statement, where the pro-forma EPS will be drawn. Dilution to earnings can occur if the profitability of the target firm is lower than the acquirer's profitability. In some cases, the target firm may still be operating in the red. Another way EPS dilution could occur is if a higher share count results due to additional shares being issued for the deal. The model should be multi-year and may or may not show dilution initially; however, eventually dilution will give way to accretion if the deal performs as envisioned by the acquiring firm.

In mid-2016 Microsoft announced its acquisition of LinkedIn. Microsoft stated that it expected the deal to have minimal dilution of around 1% to non-GAAP earnings per share for the remainder of fiscal year 2017 post-closing and for fiscal year 2018, but then it would become accretive in fiscal year 2019. $150 million in synergies annually by 2018 was forecasted at the time of the deal announcement. Microsoft paid for LinkedIn all in cash; therefore, no dilution came from additional shares. Note that Microsoft specified a non-GAAP EPS number, which includes stock compensation but excludes purchase accounting adjustments and integration and transaction expenses. Informed investors are able to differentiate between GAAP and non-GAAP numbers when they evaluate the financial merits of the deal.