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Making Money On M&A – The Deferred Revenue Factor

Making Money On M&A – The Deferred Revenue Factor

In M&A transactions, the accounting treatment of deferred revenue can have a significant impact on how the acquirer’s stock trades in the year following the initial M&A announcement.

In most cases where the acquiree’s deferred revenue is derived from recurring sources (i.e. maintenance or subscription fees), accounting standards dictate that a substantial portion of the acquiree’s deferred revenue must be written off. In doing so, the acquiree’s reported-revenue contribution will be negatively impacted for a few quarters. At the same time, its expense structure will remain a full-force drag on the acquirer’s results (excluding any synergistic efficiencies that the acquirer wrings from the deal).

As a result, many of these deals prove dilutive in the initial 1-2 quarters, before becoming accretive. Once accretive, the return of deferred revenue to the balance sheet (via contract renewals) generates a tailwind (bullish) for the acquirer’s reported revenue growth. However, after the anniversary of the deal, the tailwind abates (and with it, the perception of accelerated growth).

From 2003 until the anniversary of its Sun acquisition, Oracle (ORCL) did a masterful job of timing acquisitions to optimize the impact of this dynamic. This is exemplified by the fact that ORCL’s shares provided approximately zero return to shareholders in the two years following the anniversary of its Sun acquisition (the last “large” acquisition that undertaken by ORCL).

This knowledge enabled Pipeline Data to make market-beating calls during the 2007-2009 bear market. This was done by identifying 1) attractive acquisition targets with high deferred revenue balances and 2) entry and exit points in the acquirers’ stock. The performance on both counts is documented via our proprietary tracking sheet (click hyperlink to download spreadsheet).

The best acquisition targets were those who had a high deferred revenue balance relative to their enterprise value, especially those who also had operating structures that were most conducive to an accretion M&A transaction. With regard to acquirers, Pipeline Data tracked M&A transactions where the acquisition price represented a notable percentage of the acquirer’s market cap & where the acquiree held a relative large deferred revenue balance.

Acquisitions of this sort don’t happen often, but when they do, they offer numerous low-risk / high-reward trading opportunities. They are most prevalent during market declines. Witness that only 7 occurred in then 2.5 years ending 6/30/07 (2 in 2005, 4 in 2006, and just 1 in the first-half of 2007). In the 2-years that followed (July 2007 through the market trough in 2009), that activity spiked to 13 deals. In the 27-months after that, only 4 took place.

Among acquirers, the initial market reaction to 56% of these deals was negative, producing a -4% return on average (regardless of initial reaction). However, investors quickly came around, bidding up 75% of the issues. The average issue outperformed the market by an annualized 40% from the initial reaction through completion of the acquisition.

Upon completion of the transactions, investors came to realize that deferred revenue would be written off, negatively impacting near-term results. Accordingly, 63% of the issues underperformed the market driving the entire group to underperform the market by an annualized 30% in the months following deal-completion.

After 1-2 quarters, when the negative impact began to reverse, 63% of the issues outperformed the market in the ~8 months that followed by an aggregate annualized average of 15%. Upon the anniversary of the completion of the transaction, our coverage ceased.

If the markets begin to decline again, we expect that this sort of M&A will reaccelerate. In the meantime, we still find the occasional deal that fits the bill. Most recently, we took note of Datawatch’s (DWCH) acquisition of Panopticon. Already, we have seen our thesis play out, with DWCH’s shares skyrocketing in the days following the announcement. Accordingly we expect a pullback to occur once investors and analysts come to realize the negative near-term impact this deal is likely to have on DWCH’s financials.

By: Mark Gomes, CEO




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