IHS (IHS) and Markit (MRKT) announced a so-called merger-of-equals in which IHS will be the surviving partner. The deal will create a huge player in terms of business information, analytics and related solutions.
While both firms have good experiences with dealmaking, and this deal makes sense from a strategic point of view, I see little appeal for shareholders. Even as synergies and share buybacks can lift earnings per share in the years ahead, shares trade at high multiples based on GAAP accounting. The focus on non-GAAP earnings and EBITDA metrics provide too much of a distraction in my eyes, as the discrepancy with GAAP earnings is too large and very consistent.
While the deal is presented to the investment community as a strategic tie-up in order to create a larger and more diverse player, the reality is that other motives might be at work as well. The combination will be headquartered in London. This results in significant tax synergies which are key to drive the value being created in this deal.
US-based IHS and UK-based Markit are set to create a global giant for information and business intelligence. Investors in Markit will receive 3.5566 shares in IHS for each share which they own in Markit. Combined, the current shareholders in Markit will own a 43% stake in the newly formed combination.
The $13 billion deal (in terms of equity valuation), does not include any cash component. This makes that the leverage position of the combination will be similar to the combined leverage ratio of both companies at this moment in time. The deal will therefore not put additional leverage pressure on the balance sheet, as IHS has recently announced two smaller deals as well.
Given that IHS's shares closed at $110.71 per share on Friday, investors in Markit will receive a $31.12 stake in IHS for each Markit share. This represents a modest 5.5% premium for their shares.
Markit's Contribution To IHS
Markit has only been founded in 2003, but it has gown quickly as a provider of financial information offering information, processing and solution services. The main focus of Markit has been the wider financial industry.
The company grew its revenues by 4.5% to $1.11 billion in 2015. Providing information to financial services companies has been very lucrative as Market reported non-GAAP adjusted EBITDA of $488.2 million and actual operating earnings of $243.4 million.
The 190 million outstanding shares value equity in Markit at $5.9 billion based on the deal price of $31 per share. It should be said that the company has $700 million in net debt as well, for an enterprise valuation of $6.6 billion. This is equivalent to 5 times sales and 13-14 times adjusted EBITDA.
IHS itself if much bigger, as it reported sales from existing operations of $2.18 billion for the year 2015. Adjusted EBITDA amounted to $696 million last year. This translates into margins of 32% of sales, and wile this is still very impressive, they trail the 44% margin being reported by Markit.
Unlike Markit, IHS has no real presence in the financial industry, as it mostly focuses on information and market research services for energy, industrial and technological industry cohorts. It should be said that IHS has been very active in terms of M&A. It announced the $460 million purchase of CarProof and the $650 million acquisition of OPIS in recent months.
Ahead of the IHS merger, and before taking into account the closure of the purchase of CarProof and OPIS, IHS reported a net debt load of $1.8 billion. This number will increase to $2.9 billion if I take into account these two purchases.
The 69 million outstanding shares were valued at $7.6 billion based on the closing price of $110 per share on the day before the deal has been announced. Based on the "old" net debt load of $1.8 billion, IHS was valued at $9.4 billion which amounts to 4.3 times sales and 13-14 times EBITDA. These multiples are fairly similar compared to the value at which Markit is being valued in the latest deal.
The Pro-Forma Business
The combination of IHS and Markit will post sales of $3.3 billion, not taking into account the recent acquisitions being made by IHS. The combined EBITDA amounts to $1.18 billion, which translates into a 2.1 times leverage ratio given the combined debt load of $2.5 billion. Again, this leverage position does not take into account the combined $1.1 billion purchase of CarProof and OPIS, both being announced in recent months. After accounting for these two deals, the leverage ratio will come in close to 3 times.
The new giant, which is valued at $16 billion, will reinforce its position versus the likes of other (business) information providers. The $16 billion valuation amounts to roughly 13.5 times adjusted EBITDA, but this analysis is severely flawed. IHS only reported GAAP earnings of $240 million on the back of $696 million in adjusted EBITDA in 2015. Similarly, Markit reported a GAAP profit of $152 million on the back of $497 million in adjusted EBITDA. If I simply add up the GAAP profits of both firms, they do not even amount to $400 million per year. With a $13 billion valuation for the equity of the new combination, the new company trades at 33-34 times GAAP earnings.
This is a fairly expensive multiple in my eyes as both companies have quite a large integration task ahead. The pro-forma leverage ratio is fairly high as well at roughly 3 times EBITDA as organic growth rates are not that great, in order to justify a +30 times earnings multiple.
The good news is that the tie-up should reduce annual costs by at least $125 million per year by 2019. It should be stressed that an important part of this is driven by a lower effective tax rate, as the company will move towards the UK. Management furthermore believes that cross-selling opportunities could increase revenues by +$100 million per year. Combined, cost and revenue synergies should be able to improve the bottom line by roughly $150 million by 2019. In that case the GAAP earnings could improve towards $550 million.
IHS furthermore comforted investors by announcing a $1 billion share buyback program for both 2017 and 2018. At a current price of $122 per share, after taking into account the 10% jump in the share price of IHS, these buybacks could reduce the float from 117 million shares towards 101 million shares by 2019. That suggests that after taking into account synergies and cost savings, IHS now trades at roughly 22 times the GAAP earnings which are projected for the year of 2019, still three years ahead in time.
Information providers have traditionally traded at rich multiples. While I understand that the EBITDA multiples for the new combination can somehow be justified, I would like to point towards the huge discrepancy between this kind of earnings and the GAAP results. That being said, both IHS and Markit have seen a strong operational performance over the past decade, in part because of continued bolt-on acquisitions.
The latest deal is sizable and improves the diversification of the combination as the potential for synergies and cost savings will be a net positive given the fact that this is an all-stock deal. The absence of cash financing makes that the synergies should be accretive and the market seems to agree. Shares of IHS jumped 10% in response to the news. Including the to be issued shares for Markit, this represents a $1.4 billion increase in value in response to the anticipated synergies resulting from the deal. This suggests that the market is fairly aggressive with regards to pricing in the benefits of the deal.
While the long-term track record and fundamentals of both businesses appear fine, I am put off by the GAAP valuations. Given the fact that leverage levels are already somewhat elevated, and organic growth rates are not that impressive, I fail to see the real margin of safety at current prices.
While information providers generally deliver on very consistent cash flows, which makes them desirable for investors, I can only be induced to buy these kind of businesses at market-equivalent valuation multiples. An 18x valuation multiple, which is more or less in line with the rest of the market, still amounts to a $100 entry target based on 2019 earnings projections.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.