Cross-sector valuation: What financial service companies should consider when acquiring tech targets September 2015 A publication from PwC s Deals practice At a glance As financial service (FS) companies continue transforming themselves through technology-focused acquisitions, unique valuation issues can be an obstacle to deal success. Analyzing the sources of competitive advantage can inform M&A decisions, and help increase shareholder returns. Using the most appropriate valuation method and avoiding common pitfalls and valuation errors can help improve the value gained from acquisitions.
Technology has played an immense role in the evolution of traditional financial service (FS) companies ever since the advent of mainframe computing. But technology has never been as disruptive as it is today. Big Data, cloud computing, mobile applications and payment systems, cryptocurrencies like bitcoin, peer-to-peer lending, and other trends continue to create challenges as well as offer opportunities for FS companies. Today, FS companies are making investments in emerging technologies, as well as acquiring tech companies, to help maintain their relevance and position in the market. A few recent examples The worlds of FS and technology continue to bleed into each other, creating a new landscape for deal makers in the space. A few recent examples: MasterCard s 2014 acquisition of C-SAM (mobile wallet and ondemand software/services) First Data s acquisition of Gyft (mobile wallet/gift cards). Coinbase, the largest Bitcoin exchange in the U.S., recently completed a new round of venture financing that included such players as the NYSE and USAA. The advantages gained and the returns that may materialize from these types of transactions will play out over time, but one challenge remains clear: While earnings are routinely subject to detailed analysis prior to doing a deal, it is not always apparent what drives those earnings in tech companies. When looking at potential targets in the tech sector, valuation can pose unique issues that require specialized analyses. Overlooking blind spots can be dangerous: Without taking precautions, buyers could risk overpaying for their acquisition or perhaps even worse undervaluing the deal and missing entirely a game-changing opportunity. 56% *Source: PwC s 2015 Annual Global CEO Survey. of CEOs think competition will increasingly come from other sectors or sub-sectors. CEOs see technology as the main source of cross-sector competition.* 2 Cross-sector valuation: What financial service companies should consider when acquiring tech targets
What financial service companies should consider when acquiring tech targets Understanding potential value drivers In any acquisition, a significant part of the anticipated value is derived from the expected excess return on invested capital. This excess return is often the result of the target s competitive advantage. Determining the sources and viability of that competitive advantage is particularly important when considering the acquisition of a company with a new or unfamiliar technology. Failure to thoroughly understand the nature and sustainability of a new technology s competitive advantage can lead to critical valuation errors. A competitive advantage analysis of the target can not only help to clarify the strategic rationale of the M&A process, but may also provide a basis for determining a target s value. In the case of early stage technology companies, understanding value might begin with a Buy vs. Build analysis. A competitive advantage that is relatively easy to evaluate may help determine that a target s value is primarily a function of the costs to replicate it from scratch the build scenario. In drilling down into the build scenario, buyers might discover direct and indirect costs that are frequently overlooked. For example, an extended development cycle, or higher risks associated with developing a technology, may mean significant lost profits, compared to a buy scenario. On the buy side, meanwhile, similarly camouflaged costs could be wrapped up in the time, effort, and expense required to integrate acquired technology into the buyer s existing product or services offering. When a competitive advantage is difficult to replicate, value may primarily be a function of future cash flow. Here, if the cost of replicating (instead of acquiring) a technology is not offset by a competitive advantage, it may be appropriate to consider income-based valuation that reveals excess return on capital. In pursuing this approach, the buyer should be aware that the future cash flow of a relatively young technology company, one that lacks a long history of financial performance, often is difficult to determine. This leads to another major challenge in valuing early-stage technology companies: How, indeed, to project cash flow. Analyzing competitive advantage The value analysis of a tech target could benefit from answering the following questions about key drivers of competitive advantage, including: Does the target have a first-mover advantage? Is its technology protected by patents? Is the technology difficult to replicate? Does scale create a barrier to entry? Are customer relationships strong and sticky? If so, why? Is the management team wellregarded and an important factor in the company s performance? It s equally important to examine the sustainability of these competitive advantages. Here, more questions arise: If patents are a factor, how long will they be valid? Can the buyer s capabilities extract maximum value from the target s competitive advantage? Are there industry forces or changing relationships that may disrupt the target s business model? Are competitors likely to respond to the acquisition in a way that will significantly change the competitive landscape? Will an existing competitive advantage lead to other opportunities to extend value creation through the existing customer base? Will the management team be retained? 3
Projecting cash flow In income-based methodologies, value is a function of future cash flow or, to be more precise, a function of expected future cash flow. When assessing value, expected cash flow should not be optimistic or pessimistic, aggressive or conservative, or a best-case scenario versus worst. Rather, expected cash flow should be calculated using a probability-weighted average of a range of possible outcomes based on different scenarios. In the case of early stage technology companies, this range of potential outcomes can be extremely wide. Expected cash flow should reflect measurable company-specific risks. As such, it should be regarded as unconditional, which is to say not contingent on an event that is ignored in the forecasts. This type of approach often benefits from crafting multiple situations, contingencies, and outcomes. It makes for a robust yet perhaps challenging valuation process. When the target is a mature company similar, say, to the company that s doing the acquiring many M&A practitioners understandably may feel it s not necessary to devote extensive time to projecting future cash flow. But when a tech company is the target, one that is characterized as early stage or high growth, doing a cash flow analysis can help clarify the relationship between price and value. Failure here to conduct extensive scenario analyses could lead to significant valuation errors. The infusion of dynamic assumptions into the valuation model is at the core of cash-flow forecasting. Commercial due diligence, focusing on the source and sustainability of competitive advantages, can help identify key variables. The illusion of market multiples as an escape hatch Given the complexities of earlystage cash flow forecasting, a market-based evaluation of value, which is expressed as multiples of revenue or other operating metrics such as EBITDA, is sometimes used as an alternative to income based valuations. But that approach doesn t eliminate the need to analyze core value drivers. Market multiples are outputs, not inputs; they simply Is there such a thing as intrinsic value? In the end, the intrinsic value of any acquisition may be an elusive concept. Instead, the true, ultimate value of the company targeted for acquisition may depend on its suitor. Different suitors are likely to attach different values to the same target, depending on how it fits the acquirer s strategy and capabilities. And here, FS companies face another challenge: In pursuing technology companies, they may often find themselves competing in the deal with other tech companies, whose capabilities much better align with those of the target. These buyers may be better positioned to realize value from emerge from observed market values, driven by the same core drivers of value. Put another way, a market multiple is a compacted representation of these value drivers. To accurately evaluate the market multiple(s) applicable to a particular target, it s critical to understand the core value drivers of similar companies, and how they compare with those of the target company. Here, buyers should be careful about taking equivalence for granted. Market multiples may be adequate in valuing public companies that are deeper into their operating life cycle and past their peak growth opportunities. But taking such an approach with early-stage tech companies may understate their value without also analyzing key value drivers. the transaction through various synergies, and thus be willing and able to pay more. Therefore, as part of a disciplined M&A process, FS buyers may benefit from understanding the value of an identified target not just from their own and the seller s perspective, but also from the point of view of other likely buyers. Crafting a view of the value perspectives of multiple buyers can help inform deal strategy, the negotiation process, and, ultimately, decisions about if or when to withdraw from deal talks when prices exceed value-creation opportunities. 4 Cross-sector valuation: What financial service companies should consider when acquiring tech targets
Key variables impacting cash flow forecasting In forecasting the cash flow of a technology company, several key factors should be considered: Strength of underlying technology and patents. In cash-flow modeling, a competitive advantage can translate into excess returns on capital. Perhaps the most powerful competitive advantage is having a technology that is difficult to replicate. In calculating future cash flow, consider giving particular attention to the strength of the target's technology compared with competing technologies, and the extent to which it's protected. The answers may impact not only projected revenue and gross profit, but could also influence assumptions about expected research and development costs. Variability in projected cash flow. Technology companies may be particularly exposed to cash-flow variability. "Framing exercises" for developing technologies ranging from considering the upside where the technology succeeds and generates positive cash flow, to then examining the downside where it fails and generates negative cash flow can help identify realistic valuation scenarios. life cycles may produce fluctuations in projected cash flows. Focus on the residual calculation. In many valuations of earlystage technology companies, the value of cash flow at the end of a particular forecast period could range from 50% to 100% or more of the total business value at acquisition. The buyer should look closely at the assumptions underlying such long-term calculations of this magnitude. Too often, a consistent annual excess return on capital is presumed to exist well into the future, but without first establishing the long-term viability of the competitive advantage that produced those returns in the first place. With more mature industries it may be reasonable to assume a continuing competitive advantage, but the unpredictability of the tech world makes this assumption much less certain. FS buyers can gain insight here by separately considering assumptions about returns on capital and growth, as well as the investments required to generate both. Technology life cycles. A fundamental question may be whether next-generation technology will provide the same competitive advantage as the target company's existing technology and its normal life cycle. Given the risks associated with creating nextgeneration platforms, technology 51
www.pwc.com/us/deals Conclusion We expect FS companies to continue seeking M&A opportunities as industry trends foster heightened competition among legacy and emerging players. Technology targets may be particularly sought after as sources of innovation and growth. But FS companies can expect to face challenges in accurately valuing those technology targets. These challenges may arise in no small part because early-stage, high growth tech entities typically operate so differently from the FS sector s traditional acquisitions. M&A activity can represent tremendous potential for growth and transformation. Given its challenges though, buyers are well advised to invest sufficient time and effort in valuation on the front end of transactions to help avoid unwelcome surprises on the back end. Robust valuation diligence that focuses on the source and sustainability of value creation, and effectively considers the relationship between price and the value perspectives of different buyers, may help improve the odds of success when FS companies make technology-driven acquisitions. To have a deeper conversation about how this subject may affect your business, please contact one of our Deals specialists: James Marshall Principal, Valuation Services j.marshall@us.pwc.com 646 471 4256 Renton Squires Principal, Valuation Services renton.c.squires@us.pwc.com 415 498 5625 Dennis Trunfio Partner, Banking & Capital Markets Leader dennis.trunfio@us.pwc.com 646 471 7360 For a deeper discussion on deal considerations, please contact one of our practice leaders or your local Deals partner: Martyn Curragh Principal, US Leader martyn.curragh@us.pwc.com 646 471 2622 Bob Saada Partner, New York Metro Leader bob.d.saada@us.pwc.com 646 471 4000 Scott Snyder Partner, East Region Leader scott.snyder@us.pwc.com 267 330 2250 Mel Niemeyer Partner, Central Region Leader mel.niemeyer@us.pwc.com 312 298 4500 Jeff Kotowitz Partner, West Region Leader jeff.kotowtiz@us.pwc.com 415 498 7305 About our deals publications: PwC provides tactical and strategic thinking on a wide range of issues that affect the deal community. Visit us at www.pwc.com/us/deals to download our most current publications. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. 2015 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.