Cobalt Analytics: Acquisition Price and Consideration Mix
Cobalt Analytics plc, a software group with 50 million shares trading at £6.00 and a P/E ratio of 18, plans to acquire Delta Insight Ltd. Delta has EBITDA of £12m, depreciation of £3m and net debt of £8m. Its tax rate is 25%. Comparable listed companies trade at a P/E of 14 and an EV/EBITDA of 7.0x. Cobalt expects annual post-tax synergies of £3m, beginning immediately, and will incur £5m of integration costs, to be expensed in year one. Cobalt's WACC is 11%, and it assumes synergies grow at 3% a year in perpetuity. The board is considering paying £110m, either in cash (funded by 5% pre-tax debt) or by issuing new Cobalt shares at £6.00. Cobalt's current earnings are £16.7m. The target's management has indicated that it would accept no less than £100m.
1. Estimate a valuation range for Delta using the comparables and the synergy value. What is the maximum defensible price?
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Comparables
Delta's EBIT = EBITDA £12m − depreciation £3m = £9m. Post-tax earnings = £9m × 75% = £6.75m. P/E method: 14 × £6.75m = £94.5m equity value. EV/EBITDA method: 7.0 × £12m = £84m enterprise value; less net debt £8m = £76m equity value. The range is therefore £76m–£94.5m, with the P/E at the top because it capitalises earnings after depreciation.
Synergy value
Post-tax synergies of £3m growing at 3% in perpetuity, discounted at 11%: £3m/(0.11 − 0.03) = £37.5m. Integration costs of £5m are a one-off cash cost, so deduct £5m.
Maximum price
Maximum defensible price = £94.5m + £37.5m − £5m = £127m. That assumes all synergies accrue to Cobalt and the growth perpetuity is robust. A more prudent maximum is the midpoint of the comparables plus synergies: £85m + £37.5m − £5m = £117.5m. The target's £100m floor is within range. Paying above £127m would transfer all synergy value to Delta's sellers.
2. Calculate the pro forma EPS under cash and share consideration, and comment on which is more attractive.
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Current EPS
£16.7m/50m = 33.4p.
Cash consideration
Debt £110m at 5% = £5.5m interest; after tax = £4.125m. Combined earnings = £16.7m + £6.75m + £3m − £5m − £4.125m = £17.325m. EPS = £17.325m/50m = 34.65p, an increase of 3.7%. Excluding one-off integration costs, EPS = £22.325m/50m = 44.65p, but that flatters year one.
Share consideration
New shares = £110m/£6.00 = 18.33m; total shares = 68.33m. Combined earnings = £16.7m + £6.75m + £3m − £5m = £21.45m. EPS = £21.45m/68.33m = 31.39p, a dilution of 6.0% in year one. In steady state without integration costs: £26.45m/68.33m = 38.7p, which is accretive.
Comment
Cash is more accretive because Delta's earnings yield (1/14 = 7.1%) exceeds the after-tax cost of debt (5% × 75% = 3.75%), while Cobalt's shares are issued at an earnings yield of 1/18 = 5.6%. But cash raises pro forma net debt. If Cobalt's net debt is £20m and EBITDA £28m, pro forma net debt = £130m and EBITDA = £28m + £12m + £3m = £43m, so leverage = 3.0x. That may be acceptable but reduces flexibility.
3. Recommend a price and consideration mix, considering leverage and integration risk.
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Recommendation
Offer £110m, structured as £70m cash and £40m shares. Cash gives Delta's shareholders certainty and captures the low after-tax cost of debt, while shares share the integration risk and preserve some debt capacity. At £110m, Cobalt pays 9.5x Delta's post-tax earnings before synergies and 11.6x including synergies, which is reasonable against the £127m maximum. The £100m floor should be met but not exceeded unless the board is confident in the synergies.
Conditions
Conduct confirmatory due diligence on the £3m synergies, cap integration costs, and set a leverage target below 2.5x within 18 months. If the target insists on £127m all cash, walk away: the premium leaves no margin for error. Consider an earn-out of £100m upfront plus up to £20m if synergies are realised. That bridges the valuation gap and protects Cobalt if the £3m synergy estimate is optimistic.