There are a variety of factors – both quantitative and qualitative – that a strategic or financial buyer will look at in evaluating a potential acquisition target. Here are 13 clues that might make you a target.
- Does the company have a track record of over-promising and under-delivering on quarterly results? The more inconsistent a company is quarter-after-quarter, the more interest it may attract from an activist investor, a strategic buyer or a financial buyer. This track record may suggest execution issues related to personnel, processes, product portfolio or systems or it may signal that management lacks a fundamental understanding of its end market trends and customers.
- How has the company performed relative to peers? A flagging growth rate could be a signal of market share loss, failure to innovate, insufficient distribution channels or market maturity. Another cause might be whether salespeople are being compensated to harvest existing accounts or to sign more new logos. On the other hand, a slowdown in a software company might be masking a shift to a subscription-based ratable revenue stream from a perpetual license model.
- Does the company have a division or business unit that has under-performed? Companies tend to milk their cash cows, invest in growth segments, and starve their dogs. Assessing the market this segment is in, and a few questions about capital spending allocation may reveal a dog. This could open the door to possible divestiture or spin-off. Alternatively, the division or business unit may be a growth segment in build-out mode that has not yet blossomed.
- How do margins look? Weaker gross margin may suggest intense pricing pressure, inefficient materials sourcing or manufacturing processes, or a revenue mix skewed toward lower-margin products or services. Underperforming operating margins could be an extension of gross margin issues. More often, the cause is high operating expense ratios due to unproductive headcount, aggressive new hiring to support a land grab, higher R&D spending for future products or rising compliance, legal and accounting costs. Operating expenses may also be bloated from a prior acquisition that has not been digested or rationalized.
- Does the company generate positive cash flow from operations (CFFO) and free cash flow (FCF)? Opportunities exist in working capital accounts, such as improving cash collections, production efficiency, inventory turns, benefits allocations and payment terms, among others. Take not of how much stock-based compensation is contributing to cash flow. FCF can be harvested to quickly increase shareholder value.
- Is the company sitting on a large cash hoard? While this may reflect the CFO’s concerns about a slowing or maturing market, it may also indicate inefficient cash management or an absence of expansion ideas. Regardless, a large cash balance provides flexibility in financing a takeover.
- Does the company have a large deferred revenue balance? This is important, because it means the company has a recurring stream of future revenues that a buyer can harvest. However, depending on the acquirer, this deferred revenue may not be recognizable under GAAP accounting rules. For a strategic buyer, this is of less consequence in the short term, as the rationale for acquisition is to generate incremental growth and market share. A financial buyer taking the company private may not be concerned either.
- Does the potential target have a sizable net operating loss (NOL)? If so, this can favorably impact tax status and reduce acquisition cost for the acquirer. NOLs can be beneficial to either a strategic or financial acquirer.
- Is there no succession plan? In a relatively young company, this does not set off alarms. But in a large, mature company, it could be a sign of an autocratic or narcissistic CEO who is unwilling to cede control.
- If the company has debt, do the terms allow for re-financing to reduce interest payments? Lower interest payments provide the double benefits of preserving cash outlays and boosting pretax income. Conversely, adding some leverage to the balance sheet may be efficient and beneficial.
- Public, float, ownership concentration and shareholder composition are relevant factors. The float represents how much of the total outstanding shares are held in the public domain. If there is concentration of ownership – either by insiders or a few large institutional holders – the potential acquirer will know which owners will have to be persuaded about the merits of the deal. It also reveals which will be instrumental in negotiations.
- How is the company being valued? In the public market, comparisons to peer group on various valuation metrics can quickly provide clues. For example, a discounted valuation relative to peers may reflect operating underperformance or inconsistency. But it might also signify something more fundamental – and longer term. It could also reflect analyst and investor skepticism about the company ability to execute. As with beauty, valuation is in the eye of the beholder.
- Is the company’s messaging ineffective? Stocks trade on perception, which is often a function of fundamentals and messaging. If a company cannot effectively communicate its value proposition to analysts and investors it also cannot effectively manage Wall Street expectations. Clear, concise, credible, consistent and compelling messaging helps avoid disappointments and volatility, while narrowing the gap between perception and reality in the marketplace.
What other clues do you think make for a potential acquisition target?