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By Chris Mayer
January 7, 2011
Dear Penny Sleuther,
There have been a number of acquisitions lately that tell us some important things.
One of them is that corporate insiders are willing to pay a lot to get growth these days. The prices of some of these deals are rich, as I’ll show you.
It also says something important about our present circumstance to reflect a bit on why they are willing to pay these kinds of premiums. And finally, looking at stock market opportunities through the lens of a corporate buyer points to where opportunities are today.
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To begin, let me acquaint you again with the EV-to-EBITDA ratio, which is essential in comparing firms across an industry.
Enterprise value is the market cap of the stock plus debt less cash. It is the value the market imputes on a firm at any point in time. Think of it as the price to buy the whole firm. The EBITDA is the familiar earnings before interest, taxes, depreciation and amortization. It is a broad measure of earnings power.
Therefore, you can think of EV-to-EBITDA as a more comprehensive price-to-earnings ratio. Low numbers imply value. High numbers imply a premium valuation.
So armed, let’s start with PepsiCo’s purchase of Wimm-Bill-Dann Foods, a Russian dairy and juice firm. PepsiCo, as with many large Western companies, is looking for growth. Russia is a high-growth market. Sales forecasts for soft drinks and packaged foods to 2015 show annual growth of 11–12%. This versus the puny growth of only 3% or so in U.S. markets.
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By taking over WBD, PepsiCo becomes the largest food-and-beverage business in Russia. It also gives PepsiCo a doorway into the markets of Central Asia and Eastern Europe.
After this deal, PepsiCo will get close to 70% of its business from emerging markets. This is comparable to Nestlé (67%), Danone (59%) or rival Coca-Cola (55%).
The thing that really grabbed me though was the price paid — 16 times EBITDA. This is a very rich price. These ratios vary greatly by industry, but I’d say a deal done at double digits is rich and PepsiCo pole-vaulted that with ease. But it is in line with other deals done recently…
The PepsiCo deal is not atypical these days. I think the pressure to grow is part of it. But the other pressure this deal reflects is what to do with cash. PepsiCo will use some of its cash hoard to pay for the deal.
When corporate bigwigs gather around the old glossy table in the boardroom, they probably have a hard time finding what they earn on their cash. It is virtually nothing, as you well know. The pressure to spend that cash is immense.
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Another company, ABB, recently made a similar expensive acquisition. I like ABB as a company. I’ve recommended this company in the past to my Capital & Crisis subscribers, and we did well with it. I continue to follow the name, which makes all kinds of gear for the world’s power systems.
But I think the $6 billion in cash at ABB was burning a hole in CEO Joe Hogan’s pocket. Thus did ABB agree to pay $4.2 billion for Baldor Electric. Part of the rationale was that Baldor gives ABB great exposure to North American markets. (It’s a twist on the PepsiCo deal, but in both cases, companies were looking to grow in markets where their presence was light before the deal.)
ABB paid 13 times EBITDA and a whopping 41% premium. These, too, are rich multiples. But ABB will pay cash and it will be immediately accretive earnings — since it wasn’t earning anything on the cash to begin with.
On paper, ABB can defend the premium, but shareholders would probably rather ABB held the cash or gave it back to shareholders. After all, shareholders could have bought the same stock without paying the 41% premium. ABB has a high hurdle there, in my view.
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I think neither of these transactions will prove good returns on investment for either company. The price paid is simply too high.
But there are a few lessons from these typical transactions… Companies with a lot of cash are at risk unless they have strong-willed people at the top that can resist paying these rich prices. On the flip side, it’s a good time to own smaller companies that are possible acquisition candidates because they occupy markets that some big competitor covets. And finally, if you get an offer to sell to an acquirer, you should probably sell, as multiples today are on the high side of the cycle.
Sincerely,
Chris Mayer
How You Can Profit from Company Acquisitions is featured at Penny Sleuth.
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