Gartner (IT) announced a rather sizable deal with the purchase of CEB (CEB). The deal looks reasonable based on relative multiples, as Gartner is paying similar sales multiples compared to the value at which it is trading itself. Cheap financing options, an unleveraged balance sheet and synergies allow for earnings accretion, yet investors are not too pleased.
Gartner's shares fell by more than the premium being offered for CEB, despite the promise of cost synergies, which theoretically should justify the premium. I have to agree with the market as the current sales trends of CEB and margin profile is not that encouraging, although Gartner believes it can "export" operational excellence to CEB, like it has done with previous (smaller) acquisitions.
Given the leverage incurred there is not hope for (special) dividends as Gartner´s balance sheet flexibility will be limited going forward. This observation and the sky-high earnings multiples, even if we generously use non-GAAP metrics, make it easy to avoid the shares.
Gartner has agreed to buy CEB in a $3.3 billion deal if net debt of $700 million is taken into account. The $2.6 billion equity component consists out of a 70% cash and 30% stock component. Investors in CEB will receive $77.25 for their shares, comprised out of a $54 cash component and 0.2284 shares of Gartner. All in all, CEB investors will hold a combined 9% equity stake in Gartner following the deal.
The deal terms look very reasonable as investors receive a 25% premium compared to the unaffected share price, as the premium is a bit higher if longer time periods are being considered.
Gartner rationalizes the deal by pointing towards an expansion of services into HR, sales, finance and legal functions, areas best covered by CEB. Gartner hopes to "export" its best practices and give CEB global coverage, as both items are expected to yield better revenues and earnings at CEB. These drivers alone should make the deal accretive to earnings, as costs savings of $25-$50 million per annum from 2018 onwards should act as icing on the cake.
What Is Gartner Buying?
CEB has been doing a good job expanding its business over the past decade, having essentially doubled sales between 2006 and 2016, with sales hitting $950 million this year. The issue if you like is that scale has not brought better margins. GAAP operating margins ranged at 15-20% in the period 2006-2011, and in some years even surpassed the higher end of the range. Margins have fallen towards 10-15% in recent years, and even come in below the 10% mark in recent times on the back of deal-related charges.
The $3.3 billion deal valuation appraises CEB at 3.5 times sales. Adjusted EBITDA is seen at 25.5% of sales this year, valuing the business at 14 times EBITDA. This is a full multiple given that sales are flattish at best at the moment, and the EBITDA number is highly "adjusted." If the $232 million EBITDA number could benefit from $50 million in annual cost savings, the effective multiple could fall to a little below 12 times by 2018/2019.
The $77.25 price seems reasonable given that CEB anticipates adjusted earnings per share of $3.75 per share or more this year. As referred to before, non-GAAP earnings exclude real costs such as amortization charges, deal-related costs and stock based compensation charges. These costs are projected to be very high in 2016. Even in more normalized recent years, GAAP earnings have come in a fifth below the non-GAAP earnings on average.
In November of last year, Gartner released its third quarter results which revealed a clean balance sheet. The company held $465 million in cash and operated with just $745 million in debt for a modest net debt load of $280 million.
The 84 million shares are valued at roughly $8.5 billion at $101 per share, levels at which Gartner traded ahead of the deal announcement. This valued the overall business at $8.8 billion, equivalent to 3.6 times the revenue forecast of $2.45 billion. Coincidentally, Gartner is paying a similar multiple to get its hands on CEB.
Adjusted EBITDA is seen at 19% of sales this year, seen around $465 million. This reveals that Gartner trades at a staggering 19 times adjusted EBITDA multiple. GAAP earnings are seen at $200 million, with adjusted earnings seen around $250 million. Depending on your accounting preference, this results in very steep valuation multiples with equity trading at 34-42 times earnings.
The Market Does Not Like The Deal, Avoid Following Years Of Multiple Inflation
The $15 premium offered for CEB, given that it has 32 million shares outstanding, implies that Gartner is paying a roughly $480 million premium to buy the company. Yet the market is reacting negatively to the deal.
Including the shares to be issued to investors in CEB, Gartner will have roughly 90 million shares outstanding. As shares are down nearly 9% to levels around $93 per share, the valuation of Gartner has come down by $800 million, much more than the premium paid for CEB.
If $25-$50 million in pre-tax costs synergies are capitalized at a 20 times multiple, after applying a 30% tax rate, the value of the synergies could be roughly $350-$700 million. As such the market is clearly taking the deal as a negative, perhaps on the back of the incurred leverage and fact that the company moves away from its research focus towards HR.
While I think this could be an overreaction, I did not like Gartner as a stand-alone opportunity, as the sell-off has not meaningfully changed this stance. Non-GAAP earnings power for Gartner runs at around $3 per share. The claim that 2018 non-GAAP earnings will increase by double digits might support earnings of $3.30-$3.50 per share that year. That still results in an elevated 28 times non-GAAP earnings multiple a year ahead in time at this point in time. For simplicity, let's forget that the balance sheet is highly leveraged and GAAP earnings are meaningfully (roughly 20%) lower.
Adding the $232 million adjusted EBITDA contribution of CEB, and the $465 million number from Gartner, pro-forma EBITDA comes in at $700 million, or $750 million including synergies. The net debt position of CEB and existing debt load of Gartner combined comes in at close to a billion. The cash component of the deal represents another $1.7 billion, for a net debt load of $2.7 billion. That yields a leverage ratio of 3.8 times ex-synergies, or 3.6 times if those are taken into account.
I simply want to avoid Gartner at this point. At best, using a non-GAAP multiple, the earnings yield is just 3.5%, while the realistic GAAP yield is just 2.5%-3%, amidst a leveraged balance sheet and lack of dividends. While the company is a decent grower, the deal will probably work out fine, and the long term outlook is solid, the valuation is simply too rich for me. This follows a multi-year momentum run in which share gains have far outpaced the revenue and earnings advancements.
This is a dangerous cocktail for investors amidst a balance sheet which in the short to medium term leaves little flexibility.
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.