Yesterday we promised to take a look at the Warrnambool Cheese and Butter Factory (WCB) takeover. It's one of Australia's largest listed dairy companies and it's the subject of a bidding war between Canadian, New Zealand and Australian dairy interests. (Nick Hubble's Money for Life Letter did quite nicely out of a pre-bidding war WCB tip.)

Let's have a look at the numbers and see who is getting the best deal from all this...

In 2013, WCB made a net profit of just $7.5 million dollars. According to forecasts, it should make a profit of around $14.5 million this year (2014). That's a big improvement, but considering the stock now has a market capitalisation of around $510 million, it puts it on a price-to-earnings multiple of 35 times.

Looked at another way, WCB should generate a return on equity of 9% in 2014. As a business investor (which is what the acquiring companies are) you wouldn't want to pay more than the company's equity value to achieve that 9% return.

But the current equity per share is $2.93. The current share price is $9.25. That means the potential acquirer of WCB is paying 3.16 times the equity value. It also means the acquirer is guaranteeing themselves a return of just 2.84% on the deal, given the forecast earnings.

You can get this number by dividing the forecast earnings ($14.5 million) by the market value ($510 million) or you can divide the forecast return on equity (9%) by the market value of the company's equity (3.16).

Clearly, this is a lousy business return, and therefore those bidding for WCB obviously must see strong growth for the company. But how strong does the growth have to be ensure an adequate return?

Well, we consider a 12% return on shareholders' equity to be a minimum requirement for a sound investment and account for the risk of investing in a volatile industry like dairy farming and production. To achieve such a return, WCB would have to increase profits to around $40 million to justify the current market price. That's around a 180% increase on current forecasts, which isn't going to happen in a hurry.

On these numbers, it seems to us that any buyer will have a lot of hard work to do to make the WCB acquisition pay off. More realistically, the buyer will guarantee themselves years of low returns, and will eventually write off some of the $350 million plus in goodwill it will pay to get control.

The lesson here is that competitive takeovers/auctions are nearly always good for the sellers and bad for the buyers. The buyers simply pay too high a price, which locks them into low long term business returns. We can see why the farmer owners of Warrnambool are of two minds...they're both sellers and buyers.

The only competitive auctions that don't seem to guarantee a low future return to buyers are residential propertyauctions. More on that tomorrow....

Regards,

Greg Canavan+
for The Daily Reckoning Australia