HOLT Market Commentary Worth the Premium? A Systematic Approach for Assessing Acquisition Skill January 2015

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1 Median 12 Month Fwd Excess Returns (%) HOLT Market Commentary Worth the Premium? A Systematic Approach for Assessing Acquisition Skill January 2015 Authors: Tom Hillman, CFA Head HOLT Valuation & Analytics tom.hillman@credit-suisse.com Chris Morck HOLT Model Specialist chris.morck@credit-suisse.com Key Insights: Acquisitions are an important and significant use of capital and acquisitive firms tend to underperform the market three years after a deal is announced. The three-year spread in median excess cumulative total shareholder return between the highest skilled acquirers and the lowest skilled acquires is greater than 40 percent. HOLT s Merger & Acquisition scorecard provides investors an indicator of past acquisition skill and is a valuable reference when a holding makes an acquisition. The scorecard applies a systematic approach to more than 16,000 public and private global transactions since 1992; utilizing HOLT s framework that unwinds the distortions caused by acquisition accounting. Introduction Mergers & Acquisitions (M&A) are the largest means by which managements deploy capital 1. Exhibit 1 presents a global long term view of acquisitive firm shareholder returns surrounding the acquisition. In the three years preceding an acquisition, the median excess return of acquiring firms outperform the market by 4-6% per annum, but after a material transaction, the median firm underperforms over the next three years by 1-3% per annum. Why is there such a noticeable decline in performance? Exhibit 1: Global Excess Shareholder Returns for Acquisitive Firms 6% 4% 2% 0% -2% -4% -3 yr -2 yr -1 yr Deal Announced Source: Credit Suisse HOLT M&A Scorecard. Universe: 9,972 Global Acquisitions from yr +2 yr +3 yr 1 Michael Mauboussin and Dan Callahan, Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance, Credit Suisse, August 5,

2 There are many reasons acquiring firms underperform the market after an acquisition. One important reason is acquisition timing. M&A activity is driven by the market cycle, peaking at market highs. Allocating significant capital and paying a control premium at a market peak can compound the pressure on the stock price as a market cools off. In addition, companies frequently fail to achieve their growth expectations and/or realize their synergies. A decline in CFROI level in the years after a transaction is common. How can investors assess the past acquisition skill of a management team? This report provides a systematic approach for assessing the acquisition skill of frequent acquirers using the HOLT M&A Scorecard. With this information, investors can quickly and effectively assess management s acquisition skill and make hold or sell decisions when a company they own announces a deal. Using Three Dimensions to Assess Acquisition Skill The HOLT framework allows investors to assess acquisition skill across three dimensions: Pricing skill measures management s proficiency at negotiating an attractive purchase price (minimizing the premium paid). Operating skill measures management s ability to assimilate the acquired firm, which is expressed as an improvement in operating returns generated through cost synergies and operating efficiencies. Growth ability measures management s ability to grow the combined firm after an acquisition, either organically or through subsequent acquisitions. Exhibit 2 presents the findings of this study. For each deal year 2, we measure pricing skill (left axis) by classifying acquisitions as either Cheap or Expensive. We then cross-reference the pricing skill against both operating skill and growth ability. We designate operating skill as Declined or Improved based on the change in operating return (measured as the change in CFROI three years after the transaction). Likewise, growth ability classifies firms into two groups designated as Grew Slower or Grew Faster. After we designate each acquisition into one of four quadrants for pricing skill vs. operating skill and for pricing skill vs. growth ability, we show the median threeyear cumulative excess total shareholder return (TSR) following the announcement of the deal. 2 Deal year is defined as a material acquisition year. An acquisition is considered material when the Enterprise Value (EV) of the target is greater than or equal to 5% of the combined acquirer and target EV at the time of announcement. Firms making smaller acquisitions that accumulate to at least 5% EV in a given fiscal year are included as a deal year. This is market commentary and not a research document. 2

3 Pricing Skill: How much premium was paid? Expensive Expensive Cheap Cheap Exhibit 2: Global M&A Acquisition Skill Matrix Median 3 year Post Acquisition Excess Total Shareholder Return -17% 15% -17% 10% -29% 3% -25% 6% Declined Improved Grew Slower Grew Faster Operating Skill Growth Ability How did CFROI levels change? Did the firm keep growing? Quadrants defined by 50th Percentile of factor on a Sector relative basis. (Table 1) Source: Credit Suisse HOLT. Universe: 9,972 Global Deal Years from The results are quite striking; with significant relative excess TSR between the highest skilled acquirers (upper right quadrants) and lowest skilled acquirers (lower left quadrants) of 44% and 35% respectively for each matrix. Additionally, if a firm pays a large premium (expensive), but recoups this with operating improvements or growth, they outperform, as observed by the lower right quadrants excess TSR of 3% and 6%, respectively. Buying at a low premium (cheap) does not guarantee shareholder performance gains, as subsequent declines in operating performance or slowing growth can erode those gains, as exhibited in the - 17% underperformance in both upper left quadrants. This study was completed leveraging HOLT s framework and the insights derived and the assessment of acquisition skill at the company specific level can be immediately applied through interpretation of a Relative Wealth Chart in HOLT Lens. Exhibit 3 presents the three panels of the Relative Wealth Chart along with annotation of the three dimensions of acquisition skill used in this study. This is market commentary and not a research document. 3

4 Three Dimensions of Acquisition Skill using HOLT s Relative Wealth Chart Exhibit 3: HOLT Relative Wealth Chart for General Dynamics Corp. The top panel illustrates the firm s historical CFROI operating levels (dark blue bars) and Transaction CFROI levels with goodwill included (light blue bars). The forecast includes three data points; FY1 and FY2 forecast CFROI levels (pink bars), HOLT s empirical fade pattern of future CFROI levels (black line), and the market implied CFROI levels (green dot). The market implied CFROI levels are derived by solving for the future forecast CFROI levels needed to justify the current stock price. A target s take out price can be used to solve for synergy expectations. The middle panel presents asset growth of operating assets (dark pink bars). Asset growth including goodwill (light pink bars) indicates significant acquisition years. The third panel presents the firm s TSR relative to its local index. Source: Credit Suisse HOLT Lens, Data Date: November 2014 The three acquisition skill factors listed below are annotated in Exhibit 3 for General Dynamics 2003 acquisitions of General Motors Defense and Veridan Corporation. 1. Pricing Skill: Change in Transaction CFROI 3 level in year acquisition is complete. 2. Operating Skill: Change in operating CFROI 3 years post transaction. 3. Growth Ability: Average real asset growth 3 year pre versus 3 year post acquisition. General Dynamics was very acquisitive from 1995 through 2009 as indicated by the frequency of asset growth with intangibles in the middle panel. The large spread between the operating CFROI and the Transaction CFROI indicatives a significant amount of goodwill on their books, but the change in Transaction CFROI levels in the year of acquisitions are minimal, indicating good pricing skill. Operating CFROI levels 3 Transaction CFROI represents an approximation for the CFROI inclusive of goodwill. It s measured by multiplying the operating CFROI by the ratio of operating assets to operating assets plus goodwill. Large spreads between the CFROI and the Transaction CFROI means significant amounts of goodwill was created from acquisitions. For further understanding see Samuel Eddins, Bartley Madden and Thomas Hillman, Acquisition Goodwill, HOLT Value Associates LP, May 15, This is market commentary and not a research document. 4

5 have generally been stable and upward trending over the acquisition period, exhibiting good operating skill. The firm s growth rate has been fairly consistent, exhibiting strong growth ability. General Dynamics is an excellent case study on capital deployment 4. The financially distressed firm was transformed by divesting low return, non-core businesses and focusing on improving operations in the early 90s. Once the financial health of the firm had been restored, the focus turned to growing via acquisitions. This strategy created significant shareholder value as exhibited in the third panel of the Relative Wealth Chart. General Dynamics rank as a highly skilled acquirer in HOLT s M&A scorecard in Exhibit 4. Given past performance investors will likely have confidence in the firm s ability to execute future deals. HOLT M&A Scorecard Using the three dimensions pricing skill, operating skill and growth ability, the M&A Scorecard is constructed by ranking for each deal year the three acquisition skill dimensions on a sector relative basis across the global M&A database. The ranks (100 highest to 0 lowest) for each deal year for a given firm are then deal size Enterprise Value weighted to derive the company specific acquisition score. Exhibit 4 provides the results for the most acquisitive firms with market capitalization over $15B USD. This score provides investors an indicator of past acquisition skill and is a valuable reference when a holding makes an acquisition. Exhibit 4: HOLT s M&A Scorecard Universe: Filter: Filter: Weight: Weight: Weight: Sum: Percentile: Global Firms > $15B >4 > 70% 40% (a) 40% (b) 20% (c) (a)+(b)+(c) Global Relative Name Sector Country Total # of Deals # Material Acquisition Deal Years Sum of Acquired EV (%) In Material Deal Years Operating Skill Score Growth Pricing Skill Ability Score Score Sector Relative Acquisition Skill Score Universe Relative Acquisition Skill Percentile ASSA ABLOY AB Industrials SWE % GENERAL DYNAMICS CORP Industrials USA % CENTRICA PLC Utilities GBR % THERMO FISHER SCIENTIFIC INC Health Care USA % PRECISION CASTPARTS CORP Industrials USA % ABERTIS INFRAESTRUCTURAS Industrials ESP % CRH PLC Materials IRL % CVS CAREMARK CORP Staples USA % BAE SYSTEMS PLC Industrials GBR % CARDINAL HEALTH INC Health Care USA % ROPER INDUSTRIES INC/DE Industrials USA % SYMANTEC CORP IT USA % EATON CORP PLC Industrials USA % NATIONAL OILWELL VARCO INC Energy USA % VALERO ENERGY CORP Energy USA % SCHNEIDER ELECTRIC SA Industrials FRA % PUBLICIS GROUPE SA Discretionary FRA % HUMANA INC Health Care USA % AT&T INC Telecom Services USA % VIVENDI SA Telecom Services FRA % NORTHROP GRUMMAN CORP Industrials USA % DANAHER CORP Industrials USA % TEVA PHARMACEUTICAL Health Care ISR % EXPRESS SCRIPTS HOLDING CO Health Care USA % CONSTELLATION BRANDS Staples USA % CANADIAN NATURAL RESOURCES Energy CAN % DEVON ENERGY CORP Energy USA % RWE AG Utilities DEU % INTUIT INC IT USA % TYCO INTERNATIONAL LTD Industrials USA % BANK OF AMERICA CORP Financials USA % ST JUDE MEDICAL INC Health Care USA % UNITEDHEALTH GROUP INC Health Care USA % BOSTON SCIENTIFIC CORP Health Care USA % Source: HOLT M&A Scorecard; firms with market capitalization > $15B, with > 4 material deal years and total EV acquired >70%. Material deals defined as target at least 5% EV of overall firm. M&A Scorecard methodology: Deal years are EV weighted and sector relative ranked across operating, growth, and pricing skill. Note 4 William N. Thorndike, Jr., The Outsiders: Eight Unconventional CEO s and Their Radically Rational Blueprint for Success, (Boston, MA: Harvard Business Review Press, 2012). This is market commentary and not a research document. 5

6 Median 3yr Post Acquisition TSR With these insights in mind, the remainder of this report provides detail on how the acquisition dimensions are measured and provides sector level observations. Pricing Skill Measuring Pricing Skill What premium did they pay? The price paid to acquire represents the market value of the target, anticipated synergies or new growth, plus the premium needed for the target s shareholders to agree to sell the firm. The acquiring firm s goal is to create additional value above the anticipated synergies and growth. The lower the acquisition price paid, the lower the hurdle to create value from the acquisition. Change in Transaction CFROI is used to measure the pricing skill of acquirers in the study 5. Transaction CFROI is a return on capital measure with goodwill included in the invested capital. Transaction CFROI captures the magnitude of goodwill paid relative to the operating assets and cash flows acquired. Pricing skill is measured as the Transaction CFROI pre-merger compared to Transaction CFROI in the year of the merger. A declining (increasing) Transaction CFROI means the price paid relative to operating cash flow and operating assets acquired was expensive (cheap). Transaction CFROI is also influenced by the quality of the target (high versus low CFROI levels) and the method of payment. This return on capital approach offers an advantage over some traditional metrics, such as earnings, by including monies spent to make acquisitions. To assess pricing skill, acquirers deal years are divided into quartiles on a sector relative basis using the one year change in Transaction CFROI. Within each quartile, the median three year cumulative excess total shareholder return, starting one month prior to the acquisition announcement, is observed. These results are shown in Exhibit 5. Firms in quartile 1 (left) have the most significant decline in Transaction CFROI level and underperformed the market by 17%. As the change in Transaction CFROI becomes less negative (moving right), there is a monotonic improvement in excess TSR, providing evidence the price paid for acquisitions matter. Table 1 provides the sector median change in Transaction CFROI and can be used as a guide for investors when assessing pricing skill for past transactions. Exhibit 5: Pricing Skill - Change in Transaction CFROI, 3 year forward TSR 50% 30% 10% -10% -30% -50% -17.0% Quartile 1 (most negative change) -7.4% -5.6% Source: Credit Suisse HOLT M&A Scorecard. Universe: 9,972 Global Deal Years from % Quartile 2 Quartile 3 Quartile 4 Change in Transaction CFROI 5 In a prior study, pricing skill was measured using HOLT s intrinsic valuation versus market implied CFROI based upon take-out price. Although the results are similar using either method, the previous method was only applicable to public targets. Using Transaction CFROI expands the number of acquisitions studied from approximately 2,500 to over 16,000 by including private targets. See Tom Hillman and Chris Morck, Using HOLT Framework to Assess Acquisition Skill, Credit Suisse HOLT, May This is market commentary and not a research document. 6

7 Target CFROI Premiums Viewed Through Reverse DCF Analysis An alternative way to analyze premiums paid is using a reverse DCF analysis. The HOLT framework can be used to back out the future CFROI expectations embedded in a target s take-out price. These expectations can be translated into the amount of synergies and/or growth needed to recoup the premium. Precision Castparts December 2003 acquisition of SPS Technologies is used as an example. Precision Castparts is a highly skilled acquirer, receiving particularly high scores in both operating skill and growth ability, but a lower score on pricing skill as measured in the M&A Scorecard. Exhibit 6: SPS Technologies Relative Wealth Chart, Dec 2003 Exhibit 6 provides SPS Technologies market implied CFROI level of 9.8% as of the close (green dot). This market implied level is 100bps higher than the average market implied CFROI levels three months prior to the August 2003 acquisition announcement. Additional synergy cash flow of $19M over the forecast period is needed to recoup the premium, and is well within management s stated ultimate synergy goal of $30-35M 6. Source: HOLT Lens, Data Date: November An aggregate of all the public targets in HOLT s database is presented in Exhibit 7. Historically the median target earns CFROI levels around 7%, but is forecasted to improve CFROI levels to nearly 7.8% (pink bars). Based upon the take-out price, the median market implied CFROI (green dot) is 8.6%, representing a 140bps spread over the last achieved historic CFROI level. This improvement in CFROI is needed to equate to fair value of the target. Exhibit 7: Aggregate Return on Capital and Synergy Expectations for Public Targets yr -2 yr -1 yr Deal Announced Forecast Target CFROI Forecast CFROI Market Implied CFROI (at Deal Close) Source: Credit Suisse HOLT. Universe: 2,439 Global Public Targets ex-financials from Source: HOLT Database. The $19M was solved by comparing the cumulative differences in gross cash flow over the forecast period using the pre-announced market implied CFROI level of 8.8% versus the 9.8% market implied at close. An alternative approach using HOLT s empirical fade level (black line) versus the market implied at close will additionally capture any intrinsic value mis-pricing along with the premium paid. This is market commentary and not a research document. 7

8 CFROI Separating the Target Aggregate by sector reveals more insights into synergy expectations as presented in Exhibit 8. The All Ex Financials aggregate shown in Exhibit 7 is condensed and presented on the left followed by the sector aggregates, sorted by the spread between the last achieved CFROI and the market implied CFROI. Exhibit 8: Sector Based Aggregate Return on Capital and Synergy Expectations for Public Targets All Ex Financials Telcom Materials Health Financials Care Cons Staples Utilities Info Tech Industrials Cons Disc Energy CFROI CFROI Forecast CFROI Market Implied at Close Source: Credit Suisse HOLT. Universe: 2,439 Global Public Targets from Note Financials are based on CFROE. Financials and Telecom stand out as the sectors with the largest spread, suggesting significant synergies are needed to recoup the parent s shareholders transfer of wealth. For financials, the high synergies expectations are not achieved and post transaction return on equity levels fall 110 bps as presented later in Exhibit 10. Telecom accrues synergies, but only slightly positive improvements. Premiums are nearly always paid for transactions, but how good are managers at recouping them? Focusing on post-transaction achieved operating results provide insights to this question. Operating Skill Characteristics of Acquired Firms What observations can we make about operating performance for acquirers and targets? Exhibit 9 plots the sector median CFROI level of the acquirers and targets the year before an acquisition. Focusing on All firms ex-financials universe (left), the median CFROI of target firms are 270 bps less than the acquirers. One clear observation is that targets generally have lower CFROI levels than their suitors. This can be interpreted as higher quality firms buying lower quality firms. Another explanation is targets tend to be smaller firms, which generally have lower CFROI levels. This is market commentary and not a research document. 8

9 CFROI CFROI Pre-Acquisition Exhibit 9: Sector Based CFROI Levels for Acquirers and Targets All Ex Financials Info Tech Health Care Source: Credit Suisse HOLT. Universe: 2,439 Global Public Targets from Note Financials are based on CFROE. R&D intensive sectors have the largest spread between the acquirer and target CFROI levels; this can be partly explained by the acquisition of low return early lifecycle firms (e.g. internet start-ups and biotech). Consumer Staples and Utility firms show the smallest delta, buying targets that are similar in quality and likely acquiring to benefit from cost cutting or gaining scale. If higher quality firms are buying lower quality firms, what level of integration and synergy are being achieved? Exhibit 10 provides evidence that synergies are not achieved. The three bars plotted for each sector tell the story. First bar represents CFROI level with acquirer and target merged together. Getting to a clean starting point is difficult; given that acquisition accounting riddles the financial statements with distortions. HOLT s CFROI cleans up for these issues to measure clean operating rates of return (see appendix for further details). Shown next are forecast CFROI level driven by consensus IBES earnings. Analysts appear optimistic as the forecast CFROI levels are expected to improve across all the sectors. The third bar is the achieved CFROI results three years post-transaction, showing a decline across nearly all sectors. Exhibit 10: Achieved CFROI Post-Transaction Acquirer CFROI Pre-Acquisition Energy Financials Industrials Materials Cons Disc Telcom Utilities Cons Staples Target CFROI Pre-Acquisition 0 All Ex Financials IT Financials Cons Disc Materials Industrials Health Care Energy Merged CFROI First Forecast CFROI CFROI 3 years post Source: Credit Suisse HOLT. Universe: 9,972 Global Public Targets from Cons Staples Telcom Utilities This is market commentary and not a research document. 9

10 Median 3yr Post Acquisition TSR One of the challenges with analysing M&A is the nature of competitive firm dynamics. Operating performance is impacted by many items, including adoption of new strategies, competition, business cycles, or making additional acquisitions. All of these activities make isolating the change in CFROI that is specific to M&A very challenging. The decline in CFROI across most sectors may be caused by any of these additional factors, but it is clear these acquisitive firms are either not achieving their anticipated synergies and/or not resisting fade in their overall business. In a separate analysis of 900 acquisitive US firms with data available in both HOLT s M&A and governance databases, we observed that only 10% have a history of including acquisition based performance metrics in their executive compensation. Examples of these performance metrics include acquisition of strategic assets, successful acquisitions, successful integration, cost savings, and capture of synergies. Perhaps if more CEO s had post-acquisition integration incentives, the success rates of acquisitions would be higher. The next section will review how important improving post-transaction operations are to creating shareholder value. Measuring Operating Skill How did CFROI levels change? Examining change in CFROI offers insight into which acquisitive firms are best able to resist fade and achieve anticipated synergies. Operating skill seeks to measure management s ability to assimilate the acquired firm and improve operating returns via synergies, operating efficiencies and growth in cash flows. To assess operating skill, the difference between the first merged CFROI and the achieved return three years later is measured and divided into quartiles on a sector relative basis as presented in Exhibit 11. Within each quartile, the median three year cumulative excess total shareholder return starting one month prior to the acquisition announcement is observed. Exhibit 11: Operating Skill - Achieved 3 Year Change in CFROI; 3 Year Post Acquisition TSR 50% 25% 0% 2% 18% -25% -50% -10% -36% Quartile 1 Quartile 2 Quartile 3 Quartile 4 3 Year CFROI Change Source: Credit Suisse HOLT M&A Scorecard. Universe: 9,972 Global Deal Years from Firms in quartile 1 CFROI levels deteriorated the most and the median excess TSR for this group is -36%. As the change in CFROI turns positive, the firms in quartile 4 exhibit positive excess TSR of 18%. While a direct link between the acquisition and the change in CFROI cannot explicitly be made, one of the insights for investors is the importance of owning acquisitive companies who have a track record achieving synergies post transaction. Improving CFROI levels post-transaction is a strong indicator of this. Table 1 provides the median 3 year change in CFROI level. Not only can premiums be recouped through synergies, but growth can also be used to recoup premiums and create new wealth. This is market commentary and not a research document. 10

11 Real Asset Growth (%) Growth Ability Aggregate Growth Growth ability relates to management s ability to grow the combined firm after making an acquisition. Exhibit 12 provides the median real asset growth rate in the three years pre-acquisition, the year of consolidation, and the year three years post-acquisition. Preceding the acquisition, growth was 8-10% and accelerating. After the acquisition, two observations can be made; the level of growth is lower and decelerating, which is not surprising given a focus on integration. Exhibit 12: Aggregate Real Asset Growth Before and After Acquisitions yr -2 yr -1 yr Merged +1 yr +2 yr +3 yr Source: Credit Suisse HOLT. Universe: 9,972 Global Deal Years from Maksimovic, Phillips and Prabhala find a large amount of restructuring is done after acquisitions and examined plant-level data for manufacturing firms. They found that 27% of plants acquired are sold and another 19% are closed within three years of the acquisition 7. While this study was limited to manufacturing firms, the restructuring most likely occurs in other industry groups. Acquisitions of whole entities means management teams are deploying capital into assets that may not be core or that are duplicative in nature and may eventual sell off or shutting down these assets. Measuring Growth Ability Did the firm keep growing? One of the most interesting observations is that firms that continue to grow after an acquisition tend to outperform. Growth Ability was measured as the difference between the three year average real asset growth before and after a material deal year. A positive spread indicating the firm is growing at a faster pace than before an acquisition. The results of the growth ability study are presented in Exhibit 13. Growth Ability is divided into quartiles on a sector relative basis and then the median cumulative excess three year relative total shareholder return observed. Firms in the first quartile that grew slower underperformed by -32%. A strong monotonic relationship exists as firms who grew faster exhibit higher excess return, with a return of 16%. Table 1 provides the sector change in three year average real asset growth rate. 7 Vojislav Maksimovic, Gordon Phillips and N.R. Prabhala, Post Merger Restructuring and the Boundaries of the Firm SSRN Working Paper, August 1, This is market commentary and not a research document. 11

12 Median 3 Year Post Acquisition TSR Exhibit 13: Growth Ability - Achieved Change in Asset Growth, 3 Year Forward TSR 50% 25% 0% 0% 16% -25% -50% -32% -11% Quintile 1 Quintile 2 Quintile 3 Quintile 4 Source: Credit Suisse HOLT M&A Scorecard. Universe: 9,972 Global Deal Years from In addition to divestment of non-core or duplicative assets, another explanation for slowing growth rates may be due to a firm s position in the corporate life cycle. Maturing firms starved for growth may make large transactions that take time to digest and are primarily meant to scale production and lower costs. While firms in their growth phase may acquire to complete product offerings, grow into new areas or are serial acquires. Despite the challenges of maintaining growth, firms showing the ability to continue growing are more likely to outperform the market. Conclusion Capital allocation is one of the most important responsibilities of firm management and M&A is the area where the largest amount of capital is deployed. Management s goal in acquiring is to create additional shareholder value, but acquisitive firms tend to underperform the market for three years after deal announcements. HOLT has developed a systematic approach to critique management s acquisition skill along three dimensions; pricing skill, operating skill and growth ability. Insights from the HOLT framework can be used by investors to help them decided when to hold or sell a firm after an acquisition announcement. Use HOLT Lens to assess acquisition skill: 3 Year Average Growth Rate Pre - Post Merger Review HOLT s Relative Wealth Chart: 1. Is the firm a frequent acquirer? Asset growth with intangibles provides evidence of frequency and magnitude of transactions. 2. Pricing Skill: How much premium was paid? Firms with small decline or small increase in Transaction CFROI levels indicate good pricing skill. 3. Operating Skill: How did CFROI levels change? Stable or increasing CFROI levels posttransaction indicate execution on synergies or new profitable growth opportunities are being found, indicating good operating skill. 4. Growth Ability: Did the firm keep growing? Continual reinvestment as evidenced in real asset growth rates indicates good growth ability. More advanced assessments can be achieved by: A systematic review of companies using HOLT s M&A Scorecard (available upon request). Access HOLT s M&A database in Lens to view public targets relative wealth chart at take-out-price and to quantify market implied expectations. View pro-forma firms for major announced transactions to see the dilutive impact of a target and combined market expectations. Screen in Lens on 3 and 5 year average organic growth rates. This is market commentary and not a research document. 12

13 Table 1: Sector Median Acquisition Skill Factors Pricing Skill Operating Skill Growth Ability One Year Change in Transaction CFROI Change in CFROI 3 Years Post Acquisition Change in 3 Yr. Average Real Asset Growth Pre and Post Acquisition Consum er Disc Consum er Staples Energy Financials Health Care Industrials Inform ation Technology Materials Telecom m unication Services Utilities Source: Credit Suisse HOLT M&A Scorecard. Universe: 9,126 Global Deal Years from Sorted: alphabetical. This table provides the 50 th percentile (median) level of each acquisition skill factor presented in Exhibits 5, 11 and 13. For example, in Consumer Discretionary the median change in Transaction CFROI is negative 50 bps, meaning acquirers with drops in Transaction CFROI greater than negative 50 bps exhibit poor pricing skill. For operating skill the median three year change in CFROI level is negative 60 bps and for growth ability the median change in average real asset growth rates is negative 60 bps post acquisition. These data points are a useful reference for investors analyzing acquisitions in HOLT Lens. This is market commentary and not a research document. 13

14 Appendix Measuring Clean Operating Economic Rates of Return Acquisition accounting riddles the financial statements with distortions that take years to unwind, making track records less reliable. For firms that continually acquire the problem is compounding and unending. It was sorry day in 2001 when the US accounting boards adopted the distortion causing purchase accounting rules. For example, assume two firms that have similar track records of earning steady 20% CFROI levels merge in an all-stock transaction. Merged Operating CFROI levels will be around 20%, but only if adjusted to remove acquisition distortions. As an example, Inbev acquired Anheuser-Busch in November of With the late year acquisition, 10 months of income are missing from Inbev s 2008 income statement, making traditional metrics hard to use. As seen in Exhibit 14, RONA declines from 17% to 5%, while the cleaned-up CFROI metric remains relatively stable, reflecting the dilution of Anheuser-Busch lower CFROI level of 11%. Exhibit 14: Inbev Acquisition of Anheuser-Busch Source: Credit Suisse HOLT The HOLT framework unwinds the distortions caused by acquisition accounting to get back to pooling accounting and has made over 40,000 adjustments 8. The major adjustments include. Gross Plant Recaptured restated the plant account back to historic cost. Missing Cash Flow capture missing cash flows prior to the acquisition close date. Purchase accounting only requires recording the income statement effect from the acquisition date forward. For late year closes, this can be a significant adjustment. Missing Rent Expense captures full year of rental expense to capitalize all off-balance sheet leases. Missing Sales captures sales prior to acquisition date to measure organic growth rates. Acquired R&D captures the historic R&D expenditures of the acquired firm. 8 Tom Hillman, Chris Morck, and Dave Larson, Removing Acquisition Distortions and Measuring Organic Sales Growth, Credit Suisse, February This is market commentary and not a research document. 14

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HOLT Disclaimer The HOLT methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any of which could occur. The warranted price is an algorithmic output applied systematically across all companies based on historical levels and volatility of returns. Additional information about the HOLT methodology is available on request CFROI, CFROE, HOLT, HOLT Lens, HOLTfolio, HOLTSelect, HS60, ValueSearch, Signal Flag, Forecaster, and Powered by HOLT are trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries. HOLT is a corporate performance and valuation advisory service of Credit Suisse Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved. 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