Indigestion from Acquisition

18 Mar 2011 Biting off more than one can chew? By MICHELLE TAN WITH the quarterly batch of company results due soon, the impact of various acquisition 'strategies' carried out by companies recently might come to light. Taking a walk back in time, one can probably envision the potential scenarios that could play out after companies make sizeable investments to pay for acquisitions. Some have spent funds buying out competitors or similar businesses and moved on to grow their earnings base successfully. On the other side of the coin, things can go awry when companies bite off more than they can chew by spending more than they can reasonably afford on acquisitions. Abterra Ltd could turn out to be a case in point. Just a couple of days ago, Abterra announced that its subsidiary has entered into a conditional sale-and-purchase (S&P) agreement to acquire an additional 55.22 per cent equity interest in a Chinese mining company for a ticket price of 883.52 million yuan (S$171.7 million) - more than 50 per cent of Abterra's total market capitalisation. The company said the acquisition would be funded by 'internal resources'. This might perhaps raise some sceptics' eyebrows as they ponder just where these 'internal' funds would come from, considering that the company was loss-making just last year, registering a net loss attributable to equity-holders of $8.9 million (before accounting for the proposed acquisition) and remains relatively strapped with debt. In addition, Abterra faced difficulties obtaining credit facilities from banks in the latter part of 2010, which hurt the group's earnings for the last financial year. Then there is the valuation of the asset in question. The Chinese mining company's (the acquiree's) preliminary value stands at 1.6 billion yuan, which is in line with the purchase consideration of 883.52 million yuan for a 55.22 per cent cut of the pie. However, valuing a mining company or any company at all is not an exact science. Also, the valuation was derived via the discounted cash flow method - one that could be significantly swayed by minor changes in assumptions. So in light of the abovementioned, is Abterra spending too much on its proposed acquisition? More importantly, how can investors determine whether proposed acquisitions are beneficial or potentially detrimental to the company? On paper, a company like Abterra may look like a good bet as it deals with the trading of hard commodities, such as iron ore and minerals internationally. The layman investor who hears from the grapevine that commodities are in vogue may think a quick buck could be made buying Abterra shares. The problem is that things aren't as simple as that. There is no shortage of quick avenues for businesses to grow a business. Buy out your competitors or similar businesses and integrate them. With that and a little hocus-pocus, the company now has a much bigger earnings base in quick time. But the fact is that there are potential pitfalls when a company tries to grow via acquisitions. For one, an acquisition target is unlikely to sell its business for absolute book value, unless it is loss making or straddled with debt and basically needs a quick exit strategy. To illustrate, if an acquisition target has $10 million in assets, the acquirer may be asked to pay $20 million due to the former's good reputation and strong management. The excess of $10 million paid by the acquirer will then be booked into the balance sheet as 'goodwill' - an intangible item. As the name suggests, intangible items cannot be physically valued; in other words, there are no assets to back up the extra $10 million paid. So there will be nothing to sell or use as collateral should the company run into cash flow problems. So do not be lulled into thinking that a company is safe when its balance sheet reflects enough assets to balance its debt after making hefty acquisitions. Goodwill is not a normal asset and can be written down overnight if trouble starts brewing in the business. That said, it is a general rule of thumb that companies should build market share in recessionary periods to hopefully leave the weak weaker and make the strong stronger. In contrast, companies that overspend on acquisitions in better times will almost invariably face trying times when turmoil strikes. What investors should do is to hold their horses and spend the time to do some homework before betting on a company that is making a hefty acquisition. After all, a larger earnings base derived from acquisitions might not be as beneficial in terms of shareholder value as advertised by the company itself.