Wear a “black hat” when assessing a bargain

Whether driven by the recent economic impact of COVID-19, or resulting from the ordinary course of business, the release of profit warnings, missed earnings guidance or the release of results significantly below consensus expectations, may result in favourable acquisition opportunities. Providing bidders approach these opportunities with their “eyes open” to potential transaction risks, we see significant upside may be realised when transacting in choppy markets where businesses face headwinds.

However, the lure of a potential bargain should not divert an acquirer’s attention from the following key checkpoints we consider essential when assessing an acquisition in the current market:

Red flags in financial information which indicate potential future problems

Profit downgrades may indicate fundamental issues within the business and buyers should seek a thorough understanding of the business’ underlying performance including any normalisation adjustments proposed by management.

Retain healthy professional scepticism

Don’t be afraid to challenge opinions and simply accept financial information passing audit. Ask yourself does the information meet your due diligence requirements and is it free from risk?

Maintain a sharp cash flow focus

This can uncover issues “buried” in a balance sheet or P&L via understanding what drives earnings to cash flow conversion.

The above factors were all present in the aborted merger of McMillanShakespeare Limited (MMS) and Eclipx Group Limited (ECX), which was launched following an ECX earnings downgrade and subsequent share price erosion. Whilst ECX’s share price, along with the potential benefit of industry consolidation, presented an attractive merger opportunity, the merger did not proceed following ECX flagging an additional material downgrade to earnings and withdrawing earnings guidance.

ECX partly attributed its earnings downgrade to issues flagged during due diligence, including a reassessment of recovery rates on some debtor groups resulting in the need for a higher level of provisioning. These issues were identified through a cash flow focused due diligence process, whereby assessing the earnings to cash conversion highlighted collectability concerns in specific debtor group balances.

Given recent market conditions, we expect the following months will present many acquisition opportunities and recommend bidders wear a “black hat” when assessing opportunities which appear to be a bargain.


Christopher Davey

Christopher Davey
Partner, Melbourne
T: +61 3 9038 3137
E: cdavey