Part 2 – Lesson 14
In Part 2, Lesson 13, we discussed the role of IRR in helping management teams to prioritize between various uses of capital including internal (organic) growth, acquisitions (inorganic) growth, and return of capital (dividends and stock buybacks). Evaluating IRR relative to the company’s discount rate is an excellent tool, which management teams use in deciding how to deploy company capital. But as a public company, both the management team and the investors ultimately care about one thing: the stock price.
While IRR is great for evaluating returns on specific projects and acquisitions, how do we ultimately measure the impact of large corporate actions such as acquisitions and buybacks to the stock price of the overall company? Investors will evaluate the accretion or dilution of a specific action to the existing level of cash flow or earnings, which will give us insight into the potential impact to the stock price.
FCF Accretion (or Dilution) – FCF accretion/dilution is expressed as a percentage change of the “pro forma” (incorporating the impact of the acquisition or buyback) FCF/share relative to the current FCF/share.
For example, let’s assume that Company A has FCF/share of $2.00 currently. Following its acquisition of Company B, the pro forma FCF/share is estimated to be $2.50. Therefore, the FCF accretion is 25%.
EPS Accretion (or Dilution) – EPS accretion/dilution is also expressed as a percentage change of the “pro forma” EPS relative to the current EPS level.
For example, let’s assume that Company A has EPS of $1.00. Let’s assume that Company A institutes a large share buyback that ultimately has the effect of increasing its EPS to $1.15. The EPS accretion from this stock buyback is 15%.
Let’s now evaluate accretion/dilution for an acquisition and a buyback.
Calculating Accretion/Dilution – T-Mobile Acquisition of Sprint
The below “mini-merger” Excel model can be found in the Part 2 download (Part 2 Excel Download). In May 2018, T-Mobile announced a long-awaited merger with Sprint. T-Mobile offered to acquire Sprint in an all-stock transaction offering 0.10256 shares of T-Mobile per Sprint share.
T-Mobile and Sprint are pursuing a merger as there are significant cost savings in a combination of the two companies. In an acquisition (or merger), these cost savings are referred to as “synergies.” Together, T-Mobile and Sprint can lower their network costs, IT costs, billing costs, tower lease costs, and administrative costs. Much of these savings will come from combining their wireless networks, back-end systems, and store locations. In fact, T-Mobile and Sprint have estimated that they will achieve $6Bn in run-rate synergies by 2022, which will be split 93% in opex savings and 7% in capex savings.
For T-Mobile to pursue this transaction, management must believe that the transaction will be “accretive” to the free cash flow and earnings of the business. Below, we have evaluated the FCF/share accretion to T-Mobile following its proposed acquisition of Sprint.
Let’s review the steps in building this accretion/dilution model and the takeaways from this analysis:
We have not built a full-blown merger model that consolidates every line item of Sprint and T-Mobile. We have found that simplicity is king with financial modeling, so we have built a simple one-page model that will help us solve how much accretion or dilution there is in this deal.
The first step in building out a simple merger model is to clearly lay out the standalone financials of each company. At the top of the model, you will see that we have laid out the T-Mobile standalone financials and the Sprint standalone financials. We have pulled 2019-2023 forecasts from sell-side research. In the standalone financials section, we look to calculate the current FCF/share estimates for each company. This will provide the baseline FCF/share that we will use in comparing to the pro forma FCF/share.
After laying out the financials, we calculate the total number of shares that T-Mobile needs to issue to Sprint to complete the transaction. T-Mobile is offering 0.10256 T-Mobile shares for every Sprint share outstanding. Since there are currently 4,090mm Sprint shares outstanding, T-Mobile will have to issue 419mm T-Mobile shares to all the Sprint shareholders. Essentially, the 4,090mm Sprint shares will convert to 419mm T-Mobile shares at the completion of the transaction. This will result in the combined company having a pro forma share count of 1,279mm shares.
Since this is an all-stock transaction, there is no new debt that T-Mobile is issuing. In transactions where a component of the offer price is paid in cash, the acquiring company will take on new debt to pay for this cash portion. In the merger model, we would have to account for the new interest expense that comes from the new acquisition debt. However, in this transaction, there is no new debt to account for.
Next, we lay out the trajectory of synergies for the transaction. T-Mobile and Sprint management have communicated that they expect to reach $6Bn in run-rate (annualized) synergies by 2022. In the financial model, we have made a simplifying assumption that the company will achieve 25% of this total amount each year starting 2019. To find information on the merger, we have used the T-Mobile investor relations website. The investor relations website of public companies is a tremendous resource for information.
After forecasting the synergies, we will sum together each individual line item to calculate the combined company cash flow. We will add T-Mobile EBITDA, Sprint EBITDA, and the expected cost savings. If there was new debt issued, we would have added the new acquisition debt interest expense along with the Sprint and T-Mobile interest expense. While summing up the tax expense of each company, we should adjust the taxes for the incremental taxes that will be owed due to higher income from the cost savings. Lastly, we will sum up the individual capex line items while accounting for expected capex savings.
The pro forma FCF divided by the pro forma shares outstanding will yield our pro forma FCF / share for the combined company. We can see from these results that the transaction appears to be dilutive to FCF/share in 2019 and 2020 but becomes significantly accretive to FCF/share in 2021 and beyond.
T-Mobile trades at 13.5x FCF multiple on 2019 standalone FCF. If we were to project a price target for T-Mobile, many investors would use the current multiple applied to the pro forma cash flow per share in determining a price target. By applying a 13.5x FCF multiple, we can see how the future T-Mobile could trade in the $80-100 range after a few years.
Where could we be wrong in this analysis? First, all projections (even from sell-side analysts) are inherently uncertain, particularly the further in the future we get. To the extent Sprint cash flows are incorrect, the actual T-Mobile accretion achieved could be substantially different in the future. Additionally, the timing of the ramp-up of synergies is based on our projection. This timing could change based on guidance from the company management team.
T-Mobile and Sprint have guided to $10-11Bn of free cash flow in 3-4 years (per their merger presentation), which compares to our forecasts of $9.8-10.2Bn in 2022-23. Our projections appear to be slightly below management guidance.
The easiest way to learn how to calculate accretion / dilution is to try building a financial model yourself. Download the Part 2 file (Part 2 Excel Download) and go through the model cell by cell. After this, try your handing at changing the numbers and then building a hypothetical merger model between two companies.
Calculating Accretion/Dilution – T-Mobile Share Buyback Analysis
The calculation of FCF/share accretion or dilution is a similar process as building a mini merger model. However, we only need to look at one set of financials, and we only need to forecast a few items: 1) the buyback amount, 2) the shares repurchased and resulting share count, 3) any new interest expense from raising debt to repurchase shares, and 4) the resulting FCF/share.
Below is a forecast of FCF/share if T-Mobile were to hypothetically deploy 90% of its FCF towards share repurchases. Prior to the acquisition of Sprint, many investors believed that T-Mobile could start a significant share buyback program as the free cash flow of the company ramps higher. Since buybacks were an available option to T-Mobile, it is helpful to compare what T-Mobile FCF could have looked like under a buyback scenario vs. a Sprint acquisition scenario.
Let’s review the steps in building this accretion/dilution model and the takeaways from this analysis:
After forecasting the FCF of T-Mobile (which we have pulled from sell-side research), we assumed that T-Mobile would use 90% of its yearly FCF towards buying back its own stock. This results in a yearly buyback of $3.5-4.5Bn. When analyzing a share buyback, it is always important to compare the total size of the buyback to the market cap of the company. This buyback level implies that T-Mobile will be buying back 6-7% of their market cap each year. Based on our experience, this is a doable level. Once buybacks become a larger percentage of the market cap, companies face several issues including not having enough trading volume to execute the share buyback without unduly influencing the stock price. Our experience suggests that buybacks north of 10% of market cap can run into execution difficulties.
Next, we need to forecast the stock price at which T-Mobile will be able to repurchase stock. We have assumed that the stock price will increase 15% per year. We will use the yearly buyback amount divided by the annual buyback price to calculate the number of shares repurchased each year. In 2019, this results in 58mm shares being repurchased, which will reduce the year-end share count to 802mm shares. However, when calculating the 2019 FCF/share, we should use the average share count for the year rather than the share count at year-end.
Based on these buyback levels, we calculate FCF accretion levels reaching well into the double digits. Similar to the Sprint acquisition analysis, we will choose our T-Mobile price target by applying today’s 13.5x FCF multiple to the pro forma FCF/share.
Interestingly, when we compare the implied target price for T-Mobile because of the share buyback, we get a target price that is fairly similar to what seems to be achievable through an acquisition of Sprint. However, buying back stock is a much safer strategy than buying Sprint, so why would T-Mobile choose to take on so much extra risk to essentially end up in the same spot as a buyback?Our assumptions for the Sprint acquisition could be conservative. Management has guided to $10-11Bn of FCF, which was higher than our forecasts, and typically, management teams like to guide conservatively so that they can beat expectations in the future. If T-Mobile can achieve revenue synergies or achieve higher than expected cost synergies, then, the actual FCF generation could be materially higher. Additionally, the Sprint acquisition could be seen as taking risk out of the equation for T-Mobile by eliminating a weaker competitor (one less price discounter in the market) and becoming a stronger competitor to AT&T and Verizon. By being a stronger competitor, T-Mobile may believe that they can gain market share at a faster clip than T-Mobile operating as a standalone company.Lastly, long-term growth is never achieved through buybacks. While buybacks may increase FCF/share, it does it through reducing the share count as opposed to growing revenue. To grow the business for the very long-term, a company cannot rely on buybacks for growth.
Can a stock buyback destroy value?
Yes. The reason why stock buybacks create value is because a company is buying back its stock at an FCF yield that is higher than the cost of capital it uses to fund the buyback. In the T-Mobile example, T-Mobile is using cash (which earns nothing or close to northing) to repurchase T-Mobile stock, which earns a 7-8% FCF yield. This arbitrage is what creates value.
However, if T-Mobile was raising debt to repurchase stock, then, we’d need to compare the after-tax cost of debt to the FCF yield to judge if it creates value. If the after-tax cost of debt is less than the FCF yield, then, we know that buying back stock will be accretive. However, if the after-tax cost of debt is more than 7-8%, it will be dilutive to repurchase stock. It all comes down to the cost of the capital that will be replacing the equity. Let’s look at an example:
Let’s review the takeaways from this analysis:
In the first section, we have laid out a scenario where Company A is repurchasing shares at a 10% FCF yield. The company is funding these purchases by raising new debt at a 4% after-tax Since the 4% cost of debt is less than the FCF Yield, then, we can have confidence the buyback will be accretive to FCF/share. Company A is replacing the higher cost equity capital with lower cost debt capital.
In the second section, we have laid out a scenario where Company A is repurchasing shares at a 2% FCF yield while using a 4% after-tax cost of debt. This is clearly a dilutive scenario since Company A is replacing low cost equity capital (2% yield) with higher cost debt capital (4% interest rate).
The major takeaway is that the stock price at which a company repurchases stock and the cost of the capital employed in repurchasing that stock are important factors in determining accretion/dilution. Companies that trade at very high valuation multiples generally have less opportunity to repurchase shares in an accretive manner vs. companies that trade at low valuation multiples.
Additionally, companies that can use cash on the balance sheet (or cash generated by the business) to repurchase shares can generally do so in a more accretive manner vs. raising debt to repurchase shares.