Mergers and Acquisitions Cox Executive MBA BA 6074, Spring 2008 Jeffrey Allen, Ph.D.

1. Mergers and AcquisitionsCox Executive MBABA 6074, Spring 2008Jeffrey Allen, Ph.D.

2. Why M&A? • Cost reduction - Overcapacity in an industry leads to duplicate assets or functions between firms • Scale…ability to create value through cost efficiencies, leverage fixed costs, or reduce competition to an oligopoly/monopoly • Correction of governance or operational problems • Product or market extension (Q: Does this justify the premium?) • Move acquired products through New distribution channels(same question as above) • R&D – build a market position quickly @ less risk • Industry convergence due to deregulation, technological change, shifts in demographics, competitive pressure, overcapacity, etc.

3. M&A Strategies (cont’d) • Access to Unique resources, technologies or products held by the target • Vertical integration – potential risk reduction and stability in factors of production • Diversification of the corporation’s portfolio • Leverage assets, culture or other expertise of the acquirer • Replace the external capital market that isn’t functioning optimally with an internal capital allocation process • Knowledge transfer across products or industries • Tax motivation, e.g. NOLs

4. Does M&A Create Value? • Target shareholders: YES – premiums of 15% to 40%+ • Acquirer shareholders: Average returns near zero, but with significant variation…. • Combined stock returns (target + buyer): On average, M&A creates significant value

5. The Case Against M&A “The sobering reality is that only about 20% of all mergers really succeed…most mergers typically erode shareholder wealth…the cold, hard reality is that most mergers fail to achieve any real financial returns…” - T. Grubb and R. Lamb, “Capitalize on Merger Chaos” (New York Free Press) • A popular study citing the failure of M&A was titled “Why Most Big Deals Don’t Pay Off” published in Business Week, Oct. 14, 2002. • 302 large mergers between public companies from 1995-2001. The primary metric was the buyer’s share price during the year following the acquisition adjusted for average stock returns in each industry.

6. A Perspective on the Business Week study • A definition of failure using annual stock returns is subject to many other events (noise) during the year. • The time period of the study was a significant outlier in the history of the capital markets • The sample was mostly stock-for-stock deals which have been shown to underperform in several studies (more later) • Nearly all were big deals & between public companies. Smaller private deals tend to fare better than large public deals for acquiring firms.

7. The Effect of Outliers on Averages • In a sample of 12,023 M&A transactions between 1980 and 2001, Moeller, Schlingemann & Stulz (2004) find industry-adjusted losses in dollar value to acquiring firms, but small percentage gains in stock prices (1.1%). In their sample, a significant amount of the lost economic value was concentrated in 87 large deals – mostly during the 1998-2001 period.

8. What is Success in M&A? • Level 1: Did the share price of the buyer rise? Are shareholders better off? • Fails to control for unrelated factors, announcement returns are the best time horizon • Level 2: Did the firm’s returns exceed a benchmark? • Benchmarks are a proxy, but imperfect • Over what time period? How long after the merger is relevant? • Level 3: Are shareholders better off after the deal than they would have been had the deal not occurred? • This is the ideal view, but impossible to measure

9. More Evidence • Announcement returns: In 50 academic studies, 40% report negative announcement returns to buyers while 60% report positive returns. When statistical significance is taken into account, 26% find value is destroyed, 31% show value preservation, and 46% show significant value creation. • Long-term stock performance: In 16 studies of returns to buyers over longer time periods, 11 report negative and significant returns to shareholders of acquiring firms.

10. Examples of Confounding Events • Two Swiss banks, UBS and SBC, merged in June of 1998. The following month, Russia defaulted on its international debt. This, in turn, triggered the collapse of Long-Term Capital Management in which the new Swiss bank, UBS A.G. had a sizeable investment. UBS announced a $900mm write-off and fired its CEO. • AOL acquired Time Warner at the peak of its share price. This was a terrible swap for Time Warner’s shareholders, but great for AOL. The correction in the value of AOL would have been much more significant if not for Time Warner and would have occurred whether the acquisition took place or not.

11. Examples (cont’d) • Advanced Micro Devices acquired NextGen, Inc. in 1995 and then underperformed its peer group of semiconductor manufacturers in the following year. The acquisition, however, led to the introduction of the Athlon processor which propelled AMD to become a viable competitor to Intel. Some observers have stated that they believe AMD would not be alive today without the NextGen acquisition.

12. Economic Value of M&A • In 24 studies of combined returns on a weighted average portfolio of buyer and target firms, 23 report positive combined returns, with 14 of the 24 being significantly positive.

13. A Formula for Successful Acquisitions • Key 1:Solid Rationale based on Gains in Economic Value • See slide #2 & 3 “THE RULE” The present value of the economic benefits related to the acquisition must exceed the premium paid for the target.

14. Successful Acquisitions (cont’d) • Key 2: Opportunistic Investment • Targets that are underperforming & would benefit from restructuring operations or replacing management. Beware, however, of how the corporation will fare by adding “fixer-uppers” to the portfolio. • Privately owned firms – studies have found an average discount of more than 20 percent in the prices paid for private firms relative to their publicly-traded counterparts. • Hot and cold markets – buying with overvalued stock may offer a chance to obtain a target at a price that would not be justified in a cash deal. • Never stop shopping – acquisitive companies are always looking for opportunities rather than waiting for banks to bring them deals. • Motivated seller– ability to acquire the right assets at an attractive valuation

15. Successful Acquisitions (cont’d) • Key 3: Currency • Several studies have documented that the form of payment has a significant impact on the profitability of the deal for the buyer • Cash: Lower premiums to the target and significantly higher returns to the buyer (zero to positive in several studies) • Stock: Higher premiums to the target and significantly lower returns to the buyer (negative in studies)

16. Successful Acquisitions (cont’d) • Key 4: Financial Discipline • If the CFO doesn’t know the walk-away price and enforce the limits, it’s likely no one will. • The required return in a deal must be established through board approval. • Bring realism to your expectations and cash flow projections. All key assumptions must be realistic and defendable. • Be explicit on how synergies will be achieved within the target company. • Raising external capital for a deal often provides a rational view on the merits of a transaction

17. Successful Acquisitions (cont’d) • Key 5: Thorough Due Diligence • This step requires objective investigation – understanding what you’re really buying is very important. • What is the value of the human capital in the target? Will it walk out the door? • Don’t rely on projections supplied by the sellers…analyze the company and industry and make your own judgments • Do you know the market, industry, products, competitors, and customers well? Where are the opportunities and pitfalls? • What potential problems or contingencies exist? • Know when to investigate further or walk away (HBR article). • Accounting, operations, legal, environmental, etc. are key areas.

18. Successful Acquisitions (cont’d) • Key 6: Integrate Well • Establish an experienced integration team well before the deal closes • Understand your assets – both human and physical • 100-day plan for leadership transition • Integrate teams • Understand and communicate performance metrics • Gain consensus on changes to be made • Select the appropriate time frame for full integration • Less than 1 year for smaller roll-up type of acquisitions • No more than three years in any deal

19. Other Keys • 1) Buyer’s experience in M&A, 2) ability to screen deals, 3) availability of capital at appropriate cost, and 4) assimilate assets and make changes quickly. • Beware of deals involving surplus internal cash – cash provided by external sources is accompanied by more discipline • Ensure the surviving company is not burdened with significant interests costs that exceed availability of cash flow and capital requirements • Hot vs. cold M&A markets – the latter equates to better valuations and less competition for deals

20. Corporate Structure: Diversification vs. Focus? • Should firms diversify through acquisitions or focus on key competencies? The evidence suggests the following: • Restructurings that increase focus create significant value • Diversified public firms trade at a discount to focused firms (avg. 15 percent) • Examples of successful diversified organizations (e.g. GE) are rare, but often include a corporate culture focused based on creating competitive advantage through 1) innovation, 2) market leadership, 3) acquisition strategies and 4) divisional autonomy.

21. Form of Payment • Cash transactions: All risk is assumed by the acquiring shareholders – target shareholders are bought out in full. • Stock transactions: Risk is jointly shared with target shareholders (in proportion to the combined company they will own). Stock tends to be used more when 1) a deal is friendly, 2) the buyer’s stock price is relatively high, 3) management ownership in the buyer is less, 4) deals are larger in size, and 5) the buyer has less cash

22. Stock Deals - Terminology • Exchange Ratio – the number of shares the target shareholders receive from the acquiring firm in exchange for their current shares. Example: SDC is buying GLM in a stock transaction with an exchange ratio is 0.665. SDC has 115.5 mm shares outstanding and GLM has 176.6 mm shares. Ownership following the acquisition will be:

23. Terminology (cont’d) • Acquisition Premium – the percentage premium paid to target shareholders above the pre-announcement closing price. The formula is: SACQ x Exch. Ratio – STGT STGT Example (cont’d): If the stock price of SDC is $25.30 and the stock price of GLM is $14.40, the acquisition premium would be: (25.30 x 0.665 – 14.40) / 14.40 = 16.84%

24. Terminology (cont’d) • Minimum Required Economic Gains – Total value of premium paid to target shareholders. From the prior example: ($25.30 x 0.665 - $14.40) x 176.6 mm sh. = $428.2 mm • This is the minimum value that must be created in the deal to make the acquirer’s shareholders as well off as they were before the deal.

25. Fixed Shares vs. Fixed Value • Fixed shares – shareholders in the target are vulnerable to a fall in the acquiring firm’s stock (e.g. Enron & Dynegy) • Fixed value – the number of shares issued to target shareholders is not fixed until closing. No price risk until close.

26. Deal Structure • Earnouts – two studies report that the returns to buyers are higher when the payment is structured to be contingent on meeting future performance benchmarks • Collars – A collar is used in a stock-for-stock transaction to hedge uncertainty about the value of the buyer. It changes the payment if the buyer’s price falls beyond pre-determined levels. Gives an ability to renegotiate or cancel the merger • Increases probability of closing the deal. Slightly lower returns to buyers and slightly higher returns to sellers.

27. Deal Structure (cont’d) • Control issues – Evidence suggests that managerial control issues such as selection of the CEO, board, senior managers, headquarters location, and compensation can have a huge influence on deal pricing • In mergers of equals, premiums are typically much smaller than in cases where control is lost (e.g. JP Morgan Chase / Banc One had only a 14% premium while BofA / Fleet was 40%) • CEOs trade power for purchase premiums

28. Management Compensation in M&A • In a 2004 study, J. Harford of the University of Washington examines CEO compensation in the year following acquisitions (not including M&A bonuses): • CEO’s in “successful” M&A buyers (defined by author as positive adjusted stock returns in the year following completion) total wealth increases by 110 percent. • CEO’s in median performing acquirers total wealth increases by39 percent. • CEO’s in underperforming acquirers total wealth increases by 36 percent.

29. In Summary, Watch Out for… • Lack of solid rationale and economic gains • Competitive bid situations (higher premiums) • Unrelated diversifying acquisitions • Stock deals • Hot M&A markets • Excessive leverage relative to stability of cash flows • Acquiring managers with a minimal ownership stake • Buyer has significant excess cash or weak management team • Lengthy integration periods • Loss of key talent

30. How to Evaluate a Deal? (slide from PE firm) • People • Relevant experience • Values • Industry Structure / Competitive Dynamics • Customer proposition / Unit Economics • Return on Invested Capital (ROIC) • Price • Leverage and Structure • Multivariate equation with colinearity • Risk/Reward

31. Valuing an M&A Target • Comparisons to other transactions • Public market multiples • Discounted cash flow • Not a science – imprecision is part of the game • Sensitive to certain assumptions

32. Comparable Transactions • Multiples of: • Earnings • Cash • Revenues • Assets • The last two should be avoided if at all possible. • Revenue often has no relation to cash flow • Book value of assets is a weak basis, at best, of market value

33. Multiples • Why use transaction multiples? • Based on (hopefully) similar and recent transactions • Easy • Commonly reported – but the value generated from more sophisticated analyses can ultimately be expressed as a multiple of current year cash flow

34. Multiples (cont’d) • Drawbacks of transaction multiples • Basis is a single period in time – ignores growth and longevity of cash • Direct comparisons are difficult due to differing situations, motivations for sale, asset composition, etc. • Subject to manipulation and large swings in value • Subjectivity of multiple selection – no theory • Did buyers in prior deals over or underpay? • Should be used as a reference point only, not as the sole basis for determining value

35. Public Market Comparables • Issues: • Differences between public and private firms • Control • Illiquidity • Governance • Size • Subject to market sentiment – are public market prices efficient? Do you want to pay what Nortel paid? • Multiples are used much more by M&A advisors and those with a minimal understanding of valuation relative to sophisticated investors (e.g. PE firms)

36. Discounted Cash Flow “The value of any financial asset is the present value of its future cash flows” • e.g. Treasury or corporate bonds – priced to the penny • Since the measure is future cash flow extending over several periods, assumptions must be made to arrive at the proper valuation • One cannot predict the future with certainty; forecasting, however, is a crucial exercise in business. • Variance is smaller in industries where cash flow is highly predictable or there is a long history to serve as a basis • Sensitivity analysis must be used to increase confidence in key assumptions

37. Key Inputs • Basis of DCF is therefore the cash flow estimatesin future periods and the discount rate • Cash flow estimates should be: • Reasonably conservative • Based on the underlying fundamentals of the business and industry • Forecasted in detail over a short horizon with future cash flows estimated using a conservative terminal value calculation • Remember that the length of a forecast must not affect the valuation!

38. Free Cash from Operations • Total after-tax operating cash flow generated by the company that is available to both shareholders and creditors • Before financing and therefore unaffected by capital structure • Does not include non-operating cash flows! Non-operating cash flow, however, should be reflected in the overall value of a company

39. Net Income to FCFFO Start with Net Income: add: increase in deferred taxes (equals “adjusted” or cash taxes) add: amortization or impairment expense (no tax adjustment) = Adjusted Net Income add: net interest expense after taxes (multiply by 1 – tax rate) add: rent/lease expense after taxes if included in WACC (x by 1 – t) less: non-operating income after taxes (x by 1 – t) = Net Operating Profit less adjusted taxes (NOPLAT) add: depreciation expense less: increase (+ decrease) in non-interest bearing working capital less: capital expenditures and investment in goodwill (*note variations) less: increase (+ decrease) in other assets, net of other liabilities plus: foreign currency translation gains (- losses) = Free Cash Flow from Operations

40. Enterprise Value Enterprise value: Present value of a company’s FCFFO + Present value of after-tax non-operating cash flows (e.g. interest income) + Cash & marketable securities

41. Estimating Terminal Value • Much of the value of many acquisitions is tied up in the “terminal” or “residual” value • Growth assumption is key • Appeal to conservative estimate • Effect is reduced because cash flows in the future are discounted at an increasing rate

42. Adjustments • Control premium relative to minority ownership • Depends on extent of power held by those in control • Up to 25-40 percent in studies of public companies • What is economic justification? Overpayment? • Illiquidity discount relative to public securities

43. Adjustments (cont’d) • Subtractions or adjustments should be made for the following: • Off-balance sheet liabilities (e.g. guaranteed debt in unconsolidated subsidiaries) • Underfunded pension liabilities • Unusual capital or refurbishment costs not in forecast • Pending liabilities – e.g. legal actions or other potential liabilities

44. Minimizing Subjectivity • Sensitivity analysis – what happens to the value if key assumptions change? • Discount rate • Growth rates • Capital requirements • Economic assumptions • Use post audits to boost accountability and learn from past mistakes

45. Practice… • Calaveras exercise • Compute the free cash flows for Calaveras Vineyards using the handout distributed in class

46. Mergers and AcquisitionsCox Executive MBABA 6074, Spring 2008Jeffrey Allen, Ph.D.