Merger Rationales and Strategy

1. Merger Rationales and Strategy P.V. Viswanath Class Notes for FIN 648: Mergers and Acquisitions

2. Growth • A reason that is often given for an acquisition is growth. • However, there is no clear evidence that growth through acquisitions is necessarily value-increasing. • In fact, mergers based on the need for growth often end up being undone, later. • The size of the firm that maximizes firm value isn’t necessarily the size that maximizes CEO compensation. • There is some evidence that CEO compensation is increasing in firm size; further CEO compensation is greater for multi-division firms. P.V. Viswanath

3. Why mergers are good for CEOs • If you think of CEOs as having human capital that is tied to the firm that they operate, then • they’d want to reduce the probability of bankruptcy • keeping the firm alive can be often inconsistent with taking risks and maximizing firm value. • Returning money to shareholders can certainly reduce the probability of a manager being able to collect long-term promised payoffs, such as pensions, etc. • A manager with fixed claims on the firm is like a writer of a put; since the value of an option is increasing in volatility, it’s optimal for the manager to try and reduce firm return volatility by keeping firm risk low. P.V. Viswanath

4. More on growth • The market rewards growth. The standard formula for firm value is P = CF1/(r-g). The higher the value of g, the higher is P! • However, this has to be growth in CF, i.e. in cash flows, not in revenues or in assets alone. • Organic growth, that is growth through internal expansion and internal investment can also be mere growth in revenues. • This can happen if the firm objective is to maximize revenues or market share or size instead of profits. • However, this is gradual and there is usual time for the CEO, the board and the shareholders to reconsider. P.V. Viswanath

5. Inorganic Growth • The other kind of growth is inorganic growth – growth through mergers and expansion. • In this case, the firm is buying cashflows in return for compensation. • In any acquisition, there will be growth in assets and growth in revenues, as well as (presumably), growth in cashflows. • The question is – what is the purchase price? If the acquisition is a negative NPV deal, the acquisition is bad. • Sometimes acquisitions can be used to generate growth because the nature of the industry is such that there are no opportunities for organic growth. In such a case, an acquisition can simply be an acknowledgement of the lack of growth. If this is news to the market, the share price will drop. P.V. Viswanath

6. Synergy • Another reason often given for a merger is the exploitation of synergies. • Net Acquisition Value of a merger = VAB – (VA+VB) – (Acquisition Expenses) • If VAB > (VA+VB), there is synergy. • Broadly speaking, there are cost synergies and revenue synergies. • Cost synergies are often referred to as operating synergies. P.V. Viswanath

7. Operating Synergies • Economies of Scale: as output levels rise, per-unit costs decline. This is called spreading overhead. • Gains result from increased specialization of labor and management, as well as the more efficient use of capital equipment, which is not possible at low output levels. • However, after a given point, there are diseconomies of scale – problems of coordinating a larger-scale operation. • Example is the cruise industry -- ability to leverage national television, radio and print advertising campaigns. • In the banking industry, there is evidence that mergers work better when there is a geographical overlap between the areas of operation of the two merging banks. P.V. Viswanath

8. Revenue Enhancing Synergies • Cost cutting is easier than obtaining revenue-enhancing synergies. • Revenue-enhancing synergies work if when two companies merge, A’s products can be sold to B and B’s products to A. • Sears’ acquisition of real estate and brokerage businesses didn’t work very well. Sears thought that its clientele was loyal and would be willing to buy other goods. • The merger of Northrop Grumman and TRW worked. Together, they had the capabilities to bid for some jobs that they would not have been able to bid for separately. • Diverse construction and design capabilities were required. P.V. Viswanath

9. Revenue Synergies • http://www.businessweek.com/magazine/content/04_10/b3873078_mz017.htm • The ink was barely dry on Northrop Grumman Corp.'s (NOC) December, 2002, acquisition of TRW Inc. when the company began marshaling its newly acquired troops for their first big campaign. • The target was an eight-year contract to build the Pentagon's new Kinetic Energy Interceptor, a Star Wars-like antimissile system that aims to destroy enemy rockets shortly after takeoff. • Separately, Northrop and TRW had both passed on the project, thinking they couldn't compete head to head with missile-defense leaders Boeing Co. (BA ) and Lockheed Martin Corp. (LMT). P.V. Viswanath

10. Revenue Synergies • That changed with the merger. Northrop put together a team of people from six of its seven divisions, including specialists in defense electronics, information technology, satellites, and shipbuilding. • A former TRW office in Virginia was put in command of the project, and reinforcements were sent from across the country. • The effort paid off: Northrop scored a surprise victory, winning the $4.5 billion contract last December and vaulting the company past its own sales targets. P.V. Viswanath

11. Access to resources • In some industries, there are huge capital demands, which are difficult to undertake for small firms. The pharmaceutical industry and the water utilities industries are cases in point. • Example: McCaw Cellular and AT&T. • Question: if the projects are worthwhile, why not just go to the capital markets for funds? • Information Asymmetry • Cost of accessing capital markets P.V. Viswanath

12. Access to Resources • In Craig McCaw, AT&T gets one of the leading visionaries of a future teeming with untethered, low-cost communication and service platforms, ranging from pocket phones to personal electronic gadgets. • Combined with Bell Labs (which invented cellular) and AT&T's financial resources (which help neutralize the almost $5 billion of debt McCaw generated to fund its expansion), McCaw may be able to bring his vision to market far sooner than he could have otherwise. • Alone, McCaw faced constant trade-offs: Should he invest in more capacity in metropolitan areas, in broader geographic coverage (including overseas), in new digital technology or in wireless data? Each represents a lucrative market. • Now he can go after them all. • http://www.findarticles.com/p/articles/mi_m0REL/is_n11_v92/ai_13218026 P.V. Viswanath

13. Value Drivers in Diversification/Focus • Efficiency of Internal Capital Markets • The diversified firm internalizes the capital market by acting as an allocator of resources among businesses in the portfolio. • Pro: Closer proximity to the companies and access to better information about them permits the internal capital market to operate more efficiently than external markets. • Con: Behavioral and Agency considerations intervene to make the internal capital markets less efficient. • People avoid unpleasant decisions about starving or selling unprofitable businesses and therefore tend to subsidize poorly performing units from the resources of high-performing units. P.V. Viswanath

14. Value Drivers in Diversification • Costs of Information and Agency Costs • Multidivisional firms are complicated to understand; investors require more information to value these firms. However, firms usually only provide aggregated information. Opacity creates greater information asymmetry that leads investors to discount the value of these firms. • Opacity also shelters managers of diversified firms from the scrutiny and discipline of capital markets. This leads to greater agency costs and the manager’s expropriation of private benefits. P.V. Viswanath

15. SWOT Analysis • What are the resources of the firm? • How can the firm use these resources to generate capabilities? • Capabilities integrate resources to reach an objective – e.g. to produce custom-designed furniture, a firm must integrate across marketing, design, purchasing, manufacturing, and finance. • Core competencies are strategic capabilities – those skills and activities that translate resources into special advantage for the firm – e.g. Home Depot has a strategic capability in site location and store openings. • Competitive advantage is sustainable, if competitors cannot or will not try to duplicate it. P.V. Viswanath

16. Shapiro’s sources of economic value • Availability of economies of scale in productionInvestments that are structured to exploit economies of scale are more likely to be successful than those that are not. • Possibility of product differentiationInvestments designed to create a position at the high end of anything, including the high end of the low end, differentiated by a quality or service edge, will generally be profitable. P.V. Viswanath

17. Shapiro’s sources of economic value • Cost advantagesInvestments aimed at achieving the lowest delivered cost position in the industry, coupled with a pricing policy to expand market share, are likely to succeed, especially if the cost reductions are proprietary. • Monopolistic access to distribution channelsInvestments devoted to gaining better product distribution often lead to higher profitability. • Protective government regulationInvestments in project protected from competition by government regulation can lead to extraordinary profitability. However, what the government gives, the government can take away! P.V. Viswanath

18. Shapiro Model: Lessons for M&A • Horizontal Mergers can reduce costs through economies of scale • Merging vertically downwards to acquire distribution channels can procure better product distribution • Acquiring firms with R&D capabilities can help generate products with quality edge (Yahoo’s acquisition of Inktomi in 2003 which had a superior crawler) • The flip side is to deny competitors such an ability – cf. Yahoo’s acquisition of Altavista in 2003 to deny MSN access to a ready-made search engine. • Acquiring targets with R&D to reduce production costs; for example, integrated steel producers acquiring minimills. P.V. Viswanath

19. Porter Model: Industry Attractiveness • Barriers to Entry can make it more difficult for new entrants into industry • Regulatory restrictions (e.g. banking license), • brand names (e.g. Xerox, McDonalds – can develop customer loyalty; hard to develop and/or imitate) • patents (illegal to exploit without ownership; e.g. new drugs – cf. also RIM) • and unique know-how (e.g. WalMart’s “hot docking” technique of logistics management) • Accumulated experience (cf. learning curve) P.V. Viswanath

20. Porter Model: Industry Attractiveness • Customer Power (monopsony) • Powerful customers can influence prices and product quality. • Examples are WalMart (consumer goods) and the US government (US defense industry) • If customers are weak, suppliers can keep prices rising, e.g. in filmed entertainment, cigarettes and education. • Supplier Power • Powerful suppliers can extract high prices from firms. • In contrast, in the 1990s, weak suppliers allowed auto manufacturers to extract price concession. • Threat of Substitutes • Substitutes limit the pricing power of competitors in an industry. • The price of coal for electric power generators is influenced by the price of oil and natural gas. P.V. Viswanath

21. Porter Model: Industry Attractiveness • Rivalry Conduct • Balance of competitive advantage can be altered by investments in • new product or new process innovation, • opening new channels of distribution and • entry into new geographic markets • Cartels keep competition low • Predatory pricing can keep profits variable and low. • Rivalry is sharper where • players are similar in size, • the barriers to exit from an industry are high, • fixed costs are high, • growth is slow, and • products/ services are not differentiated. P.V. Viswanath

22. Porter Model: Lessons for M&A • Firms can look for targets to enhance resistance to new entrants – e.g. smaller firms with proprietary intellectual property or R&D capabilities. • Where competitor conduct promotes rivalry, mergers may be undertaken to reduce susceptibility to competition – e.g. • horizontal mergers can increase market share • Targets with new products or new processes • vertically merging downward to obtain new channels of distribution • Merging with targets that permit entry into new geographic markets P.V. Viswanath

23. Porter Model: Lessons for M&A • Where supplier/ consumer power is high, mergers can be used to counter supplier power. • Where supplier/ consumer power is low, horizontal mergers can be used to exploit supplier weakness. • If there are threats from substitutes, firms could • Acquire targets in the “substitutes” industry • Acquire targets with R&D to counter the attractiveness of substitutes • Acquire targets in related industries that are regulated • For example, a coal producer could integrate vertically and acquire an electricity producer. P.V. Viswanath