A lot of industrial stocks (and elsewhere) tend to have M&A as a big portion of their growth formula. 4% organic with another 2% inorganic growth rate, targeting 250bps margin expansion over next few years, blah blah you get the idea.
The problem is I hate giving credit to companies for things they think they can do. What is your typical approach when it comes to assessing the set ups for these companies? Modeling out the next 2 years feels so awful because you are just assuming that 1-2% comes from acquisitions and hoping for margin expansion from synergies/ mix shift. Boom I assume inorganic growth of 1% - feels just wrong... Do you just add debt on to these companies then - how do you account for cost of acquisitions in the model?
Any other common things to look out for or that you had experience with in these situations that is noteworthy? I haven't found a good pattern recognition model for when is the best time to invest in these kind of setups + how to best model it out without feeling like I am adding zero value.
Have you considered running a regression to estimate average inorganic growth rates by sector and lifecycle stage for each company?
I never once considered doing anything like that - nor would I think that the results help me at all. Talking about modeling here obviously, but also what the common investment set ups can look like for these industries- or is it more you strip away the inorganic part and approach it the same as always.
I guess what I am getting at is how do you spot the inflections in both results and expectations for businesses that rely on inorganic growth as part of the story
with mad leverage bro
For me I don't account for future acquisitions. When I begin valuation I'm looking at that company as it it is right at that point in time. Even if M&A is part of their strategy there are too many variables to consider: purchase price, revenue growth, margin impact etc. It's impossible for me to make an informed decision on any of those.
I generally view M&A with respect to their entire capital allocation strategy. I.e. are they good capital allocators? Has M&A historically been accretive or dilutive? Has it been accretive because the deal was good or because management is good at integrating it into the current business etc.
My comment here would be to open-minded to including acquisitions. Every company has a strategy. Some strategies are risky, some are less risky. In the abstract, growth through M&A is just another strategy, and if you don't like it then price in a higher discount factor.
But if you ignore what (A) the company explicitly states is a part of their growth strategy, and (B) is something demonstrated they can do, then in my mind you're not modelling that company, but something else. It would be like not believing in a restaurant group's growth through now outlets and only being able to believe in growth through increased LFL sales in existing stores.
As for modelling the cash flows, you could model in the cost of M&A through drawdown an acquisition facilities or just general debt issuance to the extent acquisition can't be financed through existing operating cash flows (with appropriate stress-testing).
Got a case study coming up on a name like this - sounds like my 3 year quarterly model should include that M&A financing then. Do you just use a blend of comps / precedents for the cost then (ex: 1.3x sales on average)
Just to clarify that by "cost" you mean the acquisition value? (As opposed to cost of financing, for instance).
If so then yes, I'd keep it simple. For example I'd list out (in an input section in an XLS or as a footnote in a slide) the following:
Ultimately you can make this as complex as you want, but the above should be the basic ingredients to build a bolt-on strategy model, subject to your sector nuances (I cover consumer / Industrials so seldom see anything without EBITDA!)
I prefer to model my companies on a purely organic basis. The implicit assumption when you take this approach is that future M&A will be value-neutral, i.e. they pay fair prices for the assets the buy on an all-in basis (future synergies are appropriately discounted in whatever premium they pay). Empirically, we know that something like 2/3’s of M&A don’t create value, so this is a rather generous assumption TBH.
When I am trying to value an asset I only care about growth that creates value, which can only be the result of buying something for less than it is worth or improving the operations of the target to a point which exceeds the premium paid (synergies in excess of the original expectations originally discounted in the takeout premium).
A simplified mental framework for M&A: If the market rate for pizza is $20, and I buy a pizza for $20, the transaction is value neutral – I bought a pizza for what it is worth. Now I have 1 pizza, if I buy another pizza for $20 my pizza growth rate will be +100%, but did I create pizza or did I just buy more of it at a fair price? Now consider the example again, only this time I negotiate the second pizza down to $15. I immediately sell all my pizza to someone else at the market rate and I net $5. Now through my savvy pizza buying skills, I have created $5 in new value. This might seem like a stupid example, but it is legitimately how I think about M&A and whether or not growth via M&A creates value. Now it isn’t always straight forward like this, perhaps a company buys a competitor in a value-neutral transaction but the elimination of this incremental source of competition allows the company to raise prices in the future and create incremental value that way. In this situation, you would capture that value creation modeling the company organically post-deal IMO.
Some businesses, albeit they are rare, are exceptionally good at creating value from M&A and/or the deal sizes and valuations they execute at are predictably consistent. In these situations, I usually find the market has discounted future M&A and that the organic valuation is quite far off from the all-in valuation. Here the exercise is the same for me, figure out what the business is worth organically, but now we can make some assumptions to figure out what the company has to do on the M&A side for the market price to make sense – essentially reverse engineering the M&A value creation expectations implied by the market. From here we just have to make an over/under type of call on whether or not the M&A premium is reasonable/aggressive/too conservative.
From an investment discipline perspective, I don’t find the risk-reward very compelling when I am paying for a big chunk of future M&A before it has occurred. I’d rather get that upside for free or at a low probability, or conversely, just not bet at all.
To OP’s original comment, I hate when companies layout their growth algorithm and it includes some target contribution from M&A. I’d prefer my management teams be opportunistic and do deals when valuations are favorable, not do deals to hit some obligatory growth rate that either they have laid out in an investor deck or that is written into their incentive comp plan. If a management team takes this approach, they simply cannot reasonably know what the contribution from future M&A will be in advance.
In my view, poor incentive comp structures are the #1 reason why companies do stupid deals. When comp is tied to growth and unadjusted for M&A, it creates the incentive to just acquire their way to a paycheck without any real consideration on whether the deal creates value, and to be honest, if that was my incentive structure, I’d do the same thing. Moreover, a lot of comp plans are unadjusted for inorganic contribution at the topline, but of course the profitability-based metrics are adjusted for deal transaction costs and amortization. Free growth!
Finally, I’ve read the post and comments. If this is for a case study you probably want try and model M&A and disregard what I have written above as the views espoused are not what I would call consensus views. Most of the time sell side will model future M&A in their growth estimates (which leads to nonsensical models and implicit assumptions, but the sell side going to sell side), so your model could be quite a bit off from consensus numbers if you only model organic and the street is modeling an all-in number. This likely wouldn’t be received favorably in a case study format and the Q&A would likely be more difficult than if you just adopt a more consensus methodology.
Love the thought process here and appreciate the time you took to walk through it all!
So do you agree with above poster on the best way to thoughtfully model out future M&A - would love to get my hand on some good models that do this but it seems scarce ("Sell side is gonna sell side") and I am a bit weary of trusting my own thought process behind the modeling here.
So assume a multiple on acquired EBITDA / sales, model out synergies based on mgmt. targets/past performance (at least gets you to a consensus or baseline point), and then the cost of those acquisitions either feeds into issuing debt / pulling from FCF - any equity financing assumptions or does it get too messy there?
I don't actually have the stock they want for the case study yet (waiting to be assigned) but am working on another name for now that is similar to their universe, and I am struggling a bit to understand the common "set ups" that work well for these kind of stocks - not the DHR TDG compounder narrative, but a more cyclical/macro exposed industrial. I don't like to make the assumption that sales/margin mix will improve because of M&A strategy (to your point, maybe i have to...), but I guess you have to get close to management and the story and maybe you can defend that stance.
I'm more focused on the narrative where I think macro/cyclical pessimism overshadows sentiment, and the true earnings power looking 2 years out is quite strong so valuation is quite attractive / classic margin of safety argument. Then it comes down to timing the inflections and having a view on the true earnings power in 2 years. Well M&A is supposed to be part of that.... so that is why I started the thread.
Ya if you want to capture the changes in debt and equity you'll have to offset those in the cash and goodwill accounts. You could even assume some split between goodwill and intangibles and then route the incremental amortization of intangibles through the P&L if you really wanted to make it look nice. When I have modeled M&A in the past, goodwill is usually the catch all to make everything balance. It all gets really messy fast though IMO, so one way to keep it clean would be to add a separate line for acquired sales and acquired EBITDA. Add a line for cost synergies or whatever vs implicitly integrating it all through the acquirer's P&L. Helps with a third party looking at your model, but also would help with scenario analysis. To your point on cyclicals, you could model out different scenarios such as if the cycle turns but maybe they get more aggressive on M&A in that environment, or conversely, maybe management gets scared and wants to preserve cash (which is what usually happens if the management team aren't the special ones)? Looking at what earnings power looks like in a bunch of different scenarios is generally the best way to get comfortable with these types of stories, and the more you can break out key value drivers (like M&A) and separate them, the more flexible the model will be to playing the 'what if' game
What type of companies/industries/sectors have been able to consistently create value through M&A as you stated above? Is this more about management teams or industry structures?
I think it can be a bit of both. You can have an especially disciplined management team in any sector/industry that just sticks to their knitting and allocates capital opportunistically/intelligently. We can argue about their most recent deals under new mgt, but historically a company like Roper comes to mind. They were never playing for big synergies but rather trying to buy good businesses at attractive prices. Typically niche verticals, none of which have any type of special properties that make them more fertile for M&A IMO.
On the other side, some industries definitely are more conducive to value creation through M&A. Think of the Waste/Trash companies in Industrials. The scaled players all own large networks of difficult to replicate critical infrastructure assets (landfills, transfer stations). A smaller player lacking those assets and that vertical integration often has 30%+ of its cost structure tied to 3P disposal costs. The larger scaled players are able to continuously roll these businesses up and benefit from easy cost synergies as they internalize that cost. Gives them a wide margin of safety on the purchase price of the asset, but most of the assets they are acquiring are also smaller family-owned businesses as well where the multiples tend to be undemanding
DHR, TDG, ROL, ROP just a few big ones
Edit: double post
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