Kestrel plc: valuing Merlin Ltd and pricing the offer

Earnings basis (P/E)

• EPS = 4.2m/10m = $0.42
• Sector P/E 9 x 0.42 = $3.78; less 20% marketability discount = $3.02 per share = $30.2m

Dividend basis (yield)

• DPS = 1.6m/10m = $0.16
• 0.16/0.05 = $3.20; less 20% = $2.56 per share = $25.6m

Net assets

• 26m/10m = $2.60 per share = $26.0m

Commentary

• The three methods give a range of $25.6m to $30.2m, i.e. $2.56 to $3.02 per share. All three sit below Merlin's stated minimum of $3.40 ($34m), so an offer is only possible if Kestrel shares the synergy.
• The P/E method is the most relevant for a controlling acquisition because Kestrel will control Merlin's earnings, and it is the method the market uses for comparable quoted companies. But the sector P/E of 9 must be checked for Merlin's smaller size, customer concentration and slower growth; a lower multiple would reduce the value further.
• The dividend yield method values a minority income stream and is less useful where control is being acquired; it also falls if Merlin's 38% payout is above the sector norm.
• Net assets is a floor. It says little about earning power, and Merlin's $26m of assets generate a 16% return, so asset value understates the business.

A defensible standalone value is therefore around $30m, or $3.02 per share.

Maximum price The ceiling is the value of Merlin to Kestrel: standalone value plus the synergy Kestrel creates.

• Standalone (P/E basis) = $30.2m
• Synergy PV = $6.0m
• Maximum = $36.2m, or $3.62 per share

Negotiating range

• Merlin's floor: $3.40 per share ($34.0m)
• Kestrel's ceiling: $3.62 per share ($36.2m)
• Range available: about 22 cents per share, or $2.2m of value

Assessment The range exists but it is thin and rests entirely on the $6m synergy estimate. Every $0.10 per share above $3.62 transfers $1m of Kestrel shareholders' wealth to Merlin's owners, and the synergy, once paid away, is never recovered.

The risk is asymmetric. If the synergy is delivered at $6m and the price is $3.50, Kestrel's shareholders gain about $1.2m. If the synergy disappoints by half, at $3.50 Kestrel overpays by roughly $1.8m. The board should also test the standalone value using a sector P/E of 7 or 8 rather than 9: at a P/E of 8 the standalone value is $26.9m and the ceiling becomes $32.9m ($3.29 per share), which is below Merlin's floor and the deal fails.

Recommendation Proceed only with a price at or below $3.50, subject to due diligence confirming the synergy and the quality of Merlin's earnings, and structure part of the consideration as deferred or earn-out so that Merlin's vendors bear some of the synergy risk.

Mechanics of the share offer

• New Kestrel shares = 10m/4 = 2.5m
• Value at Kestrel's market price = 2.5m x $14.40 = $36.0m, i.e. $3.60 per Merlin share
• Merlin's shareholders would own 2.5/27.5 = 9.09% of the combined company

Value test

• Combined value = Kestrel $360m (25m x $14.40) + Merlin standalone $30.2m + synergy $6.0m = $396.2m
• Merlin's 9.09% = $36.0m; Kestrel's shareholders retain $360.2m against $360m before the deal
• So the 1-for-4 offer hands essentially all of the $6m synergy to Merlin's owners. Kestrel's shareholders are no worse off, but no better off either.

Earnings test Combined earnings = 30.0 + 4.2 = $34.2m over 27.5m shares = EPS of $1.2436 against $1.20, apparent growth of 3.6%. This is an accounting illusion: EPS rises because Kestrel's P/E of 12 exceeds the effective multiple paid on Merlin's earnings (36.0/4.2 = 8.6), not because value has been created.

Cash versus shares A $36m cash offer costing, say, 6% pre-tax funded from debt is affordable against a $30m earnings base, but it raises gearing and passes all the synergy and all the risk to Kestrel. Shares spread the risk but dilute control and, at 1-for-4, give away the entire gain.

Recommendation Offer a lower exchange ratio (1-for-5 gives $28.8m, below Merlin's floor) or a mixed cash-and-shares package around $3.45-$3.50, with at least part of the synergy retained by Kestrel.