FOOL'S DEN
Intro to “Accretive to Earnings”

Merger announcements often boast that a deal is “accretive” to earnings. What exactly does that mean? Rick Munarriz walks through the process and hopes that the assessment is “accretive” to your market knowledge.

By Rick Aristotle Munarriz (TMF Edible)
October 10, 2000

Another day, another merger, another fancy piece of financial jargon.

Yesterday, e-commerce processor Concord EFS (Nasdaq: CEFT) announced that it would buy privately held Star Systems in a deal that would be "accretive" to future earnings.

Accretive? It's a word you are seeing more and more in acquisition-related news stories. Based on the fact that the term is being touted in press releases one might assume that it is a positive thing, or at least a gauge being spun favorably. But what exactly does that word mean?

By definition, accretive is "the process of growth or enlargement by a gradual buildup." Yes, it plays like the sheet music to the mega-merger symphony, but there's more to it than that. Just because a company scoops up another profitable concern does NOT make the deal accretive.

Well, it will make it accretive to earnings, but when companies say "accretive to earnings" they actually mean accretive to earnings per share. For a deal to be, as they say, accretive, the acquiring company will have to report higher earnings per share after all the costs of the transaction are figured in.

Confused? Let's get fictional. Let's say Choco Chocolates (Ticker: ZITS) agrees to buy out Nutty Peanut Butter (Ticker: NUTZ). Yes, history shows that chocolate and peanut butter marry well together, but, remember, we got fictional. Choco had earnings of $50 million this year -- or $2.00 for each of the 25 million shares outstanding. With Choco's stock at $40 a share, that translates into a trailing P/E ratio of 20.

Nutty on the other hand produced bottom line profits of $20 million. Whether the deal is accretive immediately or not is simply a matter of the buyout price. If Choco's deal values Nutty at less than 20 times earnings (or $400 million), it's accretive. If Choco pays more than that, the lingo flipside brands the deal dilutive.

But, of course, nothing is that easy. The above example works well in an all-stock transaction. If it's a cash purchase the rules need to be tweaked. Profits from the company set to be acquired must offset any lost interest income that would have materialized had the company let the cash sit in the bank (after taxes). If the buyer has to finance the purchase, then the challenge is for profits to clear the higher hurdle of interest expense payments.

In cases where the terms of compensation involve both stock and cash, the sums are adjusted and added accordingly.

There's more. We've only brought "accretive" to a mall portrait studio and taken a snapshot. Companies buy other companies for the potential of future income statements, not those filed in the past.

Let's get back to the sweetness of Choco-Nutty. Let's say Choco's earnings are projected to climb by 10% to $55 million next year. However, Nutty is on a tear. Its profits are expected to double to $40 million in the coming year. At what point is the deal accretive?

Well, let's say Choco's stock is still trading at $40. The $55 million in fiscal 2001 profits translates into earnings per share of $2.20 on the 25 million shares. The P/E is now down to 18. At what price point will buying Nutty become accretive? Multiply 18 by $40 million and the bar is now set at $720 million.

So if Choco winds up offering 15 million new shares for Nutty -- or stock valued at $600 million with the stock at $40 -- the deal may be dilutive in the near term (above $400 million) but accretive next year (below $720 million).

That is a similar situation to yesterday's Concord deal, which the company anticipates will be "non-dilutive in the first year and accretive in future years".

But, sorry, we're still not done. Few mergers occur where the companies continue to operate autonomously. Separate beds after marriage is the stuff of I Love Lucy and The Flintstones reruns. Reality finds that merged companies often try to incorporate strengths, weed out weaknesses and rid themselves of overlap.

With vision, even the buyout of a deficit-ridden entity can be dubbed accretive -- eventually.

Last month, when WorldCom (Nasdaq: WCOM) announced its intent to acquire a majority stake in Web-hosting specialist Digex (Nasdaq: DIGX), it predicted that the deal would be "accretive" to earnings two years from now.

Breaking down the numbers might lead some to believe that the claim was simply wishful thinking on the part of the telco giant. While Digex is an explosive company with a prized client list and booming revenue growth the same can't be said for the bottom line. Estimates are calling for a $2.27 a share deficit this year and for the losses to widen to $2.53 next year.

But WorldCom is looking beyond the projections. WorldCom is looking into the synergy. By offering Digex' services to its huge customer base -- and influencing operations through its 94% voting control -- WorldCom hopes to provide the catalyst for Digex to turn the corner towards profitability.

That's accretive, in a nutshell. Some companies relish the art of growing the bottom line by paying bottom dollar for quality additions. Motley Fool Research standout Cisco (Nasdaq: CSCO) -- trading at just over 70 times this year's estimates -- will find that most of its profitable buyout candidates are accretive to earnings.

But companies with low P/E ratios can get in on the fun, too. Stock buybacks can be accretive to earnings. Sure. Having fewer shares outstanding will help grow earnings per share using the same principles of a cash buyout. If the cost of the capital (the interest income forgone or the interest expense incurred) is lower than the benefits (the smaller numbers of shares to divide net profits into) then the transaction is accretive. It all depends on how cheap the company can buy back the shares on an earnings basis.

So, that's it. Accretive is now accretive to your lexicon. Which brings up another question:

What's a lexicon?