Dilutive Acquisition

What Is a Dilutive Acquisition?

A dilutive acquisition is a takeover transaction that decreases the acquirer's earnings per share (EPS) through lower (or negative) earnings contribution or if additional shares are needed to be issued by the acquiring company to pay for the acquisition.

Understanding Dilutive Acquisitions

An acquisition, or merger, typically involves a combination of two or more companies. Companies make acquisitions for various reasons, including to boost earnings and increase market share. Companies also merge with the goal of reducing costs if there's duplication of processes within the two companies. By eliminating the acquired company's duplicative manufacturing process, for example, the combined entity would realize cost savings — called cost synergies.

EPS is a company's net income — or profit — divided by its number of outstanding common shares of stock. Although the goal of any acquisition is to ultimately boost earnings, the initial result can cause the acquiring company's EPS to decline. In other words, the acquisition has reduced or diluted the earnings of the acquiring company — hence the name dilutive acquisition. Typically, if the standalone earnings capacity of the target firm is not as strong as the acquirer's, the combination will be EPS-dilutive to the acquirer.

A dilutive acquisition often decreases shareholder value, though it is usually temporary. It's important that investors use caution since not all dilutive acquisitions are failed transactions in the long term. However, if the deal has strategic value, a dilutive acquisition can potentially lead to an increase in EPS in later years. In other words, the decline in EPS in the early years following the close of an acquisition could reverse course as revenues and cost synergies take hold. However, the market tends to punish the share price of the acquirer if the benefits are not immediately clear. If the market expects that earnings growth will not be realized or if it's expected to take too long to realize earnings growth, investors may sell the acquirer's stock.

Accretive vs. Dilutive Acquisitions

An accretive acquisition leads to an increase in the earnings per share of the acquiring company. In an accretive acquisition, the price paid by the acquirer is typically lower than any gains realized in EPS as a result of the transaction.

The market tends to respond more favorably to accretive transactions versus dilutive acquisitions since investors can see a profit to be made with accretive deals. However, just as dilutive acquisitions can lead to positive long-term EPS growth, it's possible that an accretive transaction can go bad in the long term, eroding EPS. Whether an acquisition was initially accretive or dilutive, for the EPS growth to be realized, the two companies must integrate effectively.

Dilutive (or Accretive) Acquisitions Modelling

Before a company goes ahead with a takeover bid, it will put together pro forma financial models that combine all the financial statements of the two companies. It is not a simple matter of adding accounts; many adjustments and assumptions must be made to obtain an approximation of combined statements. Much focus is placed on the income statement, where the pro forma EPS will be drawn.

Pro Forma EPS < Acquiring Company's EPS

Dilution to earnings can occur if the profitability of the target firm is lower than the acquirer's profitability. In some cases, the target firm may still be operating in the red. Another way EPS dilution could occur is if a higher share count results due to additional shares being issued for the deal. The model should be multi-year and may or may not show dilution initially. However, dilution should give way to accretion eventually if the deal performs as envisioned by the acquiring firm.

Dilutive Acquisition Example

In 2016, Microsoft announced its acquisition of LinkedIn. Microsoft stated that it expected the deal to have minimal dilution of around 1% to non-GAAP earnings per share for the remainder of fiscal year 2017 post-closing and for fiscal year 2018. However, the company said the acquisition would become accretive in fiscal year 2019. Microsoft paid cash for LinkedIn so no dilution came from additional shares. Microsoft announced over $150 million in synergies annually starting in 2018.

Please note that Microsoft specified a non-GAAP EPS number, which includes stock compensation but excludes purchase accounting adjustments and integration and transaction expenses. It's important that investors differentiate between GAAP and non-GAAP numbers when they evaluate the financial merits of the deal.