Bootstrapping Earnings

Bootstrapping earnings (or bootstrap effect) occurs when a company’s earnings increase because of the merger transaction instead of the resulting economic benefit of the merger.

Example: Bootstrapping Earnings

Axon Ltd. has identified an opportunity to merge with Symbian systems to form A&S systems, and the details of both companies are as follows.

$$\small{\begin{array}{l|c|c|c} {}& \textbf{Axon} & \textbf{Symbian} & \textbf{A&S} \\ \hline\text{Stock price} & \$200 & \$100 & \\ \hline\text{EPS} & \$4 & \$4 & \$ 4.80 \\ \hline\text{P/E} & 50 & 25 & \\ \hline\text{Total shares outstanding} & 200,000 & 100,000 & 250,000 \\ \hline\text{Total earnings} & \$ 800,000 & \$ 400,000 & \$ 1,200,000 \\ \hline\text{Market value of equity} & \$ 40,000,000 & \$ 10,000,000 & {}\\  \end{array}}$$

At a stock price of $200, Axon can issue \(50,000= \bigg(\frac{$10,000,000}{$200}\bigg)\) of its shares and use the proceeds to buy Symbian.

The total shares outstanding for the merged company A&S are \(200,000+50,000=250,000 \text{ shares}\).

The post-merger combined earnings are \(\$800,000+\$400,000=\$1,200,000\).

$$\text{A&S EPS after the merger}=\frac{$1,200,000}{250,000 \text{ shares}}=$4.80/\text{share}$$

The EPS of A&S is $0.80 more than that of the acquirer Axon. If the stock price after the merger remains $200, the P/E ratio would be 20.80. If the acquirer bootstraps earnings to $4.80 per share, the share price will increase to $240 if the investors apply the acquirer’s pre-merger P/E of 50 times earnings \(($4.80×50 = $240)\); however, such share price increases are not expected when there are no expected gains from synergy or other factors.

For bootstrapping to work, the acquirer’s P/E ratio must be higher than the target’s P/E. Although the market recognizes the bootstrapping effect and P/Es adjust accordingly after the merger, sometimes bootstrapping pays off for managers in the short run.

Question

Bolton manufacturing is planning to merge with Ramsey Chemicals, an industrial chemical supplier, to lock in crucial chemical suppliers and lower manufacturing costs. The post-merger company is called Bolts, and the details of the companies are as follows:

$$\small{\begin{array}{l|c|c} {}& \textbf{Bolton} & \textbf{Ramsey} \\ \hline\text{Stock price} & \$150 & \$ 75 \\ \hline\text{EPS} & \$3 & \$ 2 \\ \hline
\text{P/E} & 50 & 37.5 \\ \hline\text{Total shares outstanding} & 200,000 & 150,000 \\ \hline\text{Total earnings} & \$ 600,000 & \$ 300,000 \\ \hline\text{Market value of equity} & \$ 12,000,000 & \$ 4,500,000\\  \end{array}}$$

Bolts’ EPS is closest to:

1. $3.
2. $3.90.
3. $195.

Solution

The correct answer is B.

$$\small{\begin{array}{l|c|c|c} {}& \textbf{Bolton} & \textbf{Ramsey} & \textbf{Bolts} \\ \hline\text{Stock price} & \$150 & \$75 & \\ \hline\text{EPS}^{2} & \$3 & \$2 & \$ 3.90 \\ \hline\text{P/E} & 50 & 37.5 & \\ \hline\text{Total shares outstanding}^{1} & 200,000 & 150,000 & 230,000 \\ \hline\text{Total earnings} & \$600,000 & \$300,000 & \$900,000 \\ \hline\text{The market value of equity} & \$12,000,000 & \$4,500,000 & \\  \end{array}}$$

With a stock price of $150, Bolton can issue 30,000 shares and use the proceeds to buy Ramsey.

$$\text{Number of shares required}=\frac{$4,500,000}{$150}=30,000$$

Total shares outstanding¹ for Bolts = Bolton’s total outstanding shares plus the number of shares needed to buy Ramsey.

$$\text{Total shares outstanding}^{1}\ \text{for bolts}=200,000+30,000=230,000$$

\(\text{EPS}^{2}\) for Bolts = Bolts’ total earnings divided by Bolts total shares outstanding.

$$\text{EPS}^{2}\ \text{for Bolts}=\frac{$900,000}{230,000}=$3.90$$

A is incorrect. This is Bolton’s EPS before the merger.

C is incorrect.  $195 is Bolts’ share price when Bolton bootstrap earnings to $3.90 per share, leading to increased share price \(($3.90×50)\).

Reading 18: Mergers and Acquisitions

LOS 18 (c) Explain bootstrapping of earnings per share (EPS) and calculate a company’s post-merger EPS.