FIN 562 Discussion comments July 2006

1. FIN 562 Discussion comments July 2006

2. OUTLINE • The diversification discount • Synergies in valuations • Value and use of financial research

3. DIVERSIFICATION DISCOUNT

4. DIVERSIFICATION DISCOUNT Definitional statements: • Diversified firms trade at a discount relative to what they would be worth if they had not, or were not, diversified. • The total value of a diversified firm is les than the sum of its diversified parts. • Diversification results in a discount in value.

5. DIVERSIFICATION DISCOUNT Justification and basis: • Fact based argument: • Empirical evidence exists that demonstrates the discount • Common sense based arguments: • Diversity is difficult to manage • Different businesses require different skill sets • Opinion based arguments: • “Grass is greener on the other side of the fence”

6. DIVERSIFICATION DISCOUNT But there are counter-arguments to support the case that diversification increases value: • Diversified customer bases • Diversified product mixes • Diversified locations • Diversified suppliers • Diversified management skills • Diversified capital sources • Counter-cyclicality

7. DIVERSIFICATION DISCOUNT Then, why does there appear to be a diversification discount? • Arguments on slide 5 are valid • But, perhaps diversification also: • Conjures up bad memories. • Is associated with bad managers. • Has never been effectively tested. • Has never been properly isolated in research.

8. DIVERSIFICATION DISCOUNT Maybe past diversifications conjure up bad memories in those who value companies • The market has a memory • Analysts have memories • “Once burned, twice shy.”

9. DIVERSIFICATION DISCOUNT Maybe diversification is associated with bad managers. • Empire and resume builders • “Deal” addiction people • “Job” creators • Greedy charlatans

10. DIVERSIFICATION DISCOUNT Maybe diversification has never been effectively testedin the market. • Difficult to find good examples. • Perfect business “fits” rarely occur because people and reality get in the way.

11. DIVERSIFICATION DISCOUNT Maybe diversification has never been properly isolated in research. • Myriads of factors influence value • Isolating the impact of diversification is difficult to do

12. DIVERSIFICATION DISCOUNT Valuations are influenced by many factors: • People issues • Quality of management • Quality of governance • Company issues • Degree of diversification • Performance • Synergies • Strategies

13. DIVERSIFICATION DISCOUNT Valuations are influenced by many factors: • Capitalization issues • Degree of over-leverage • Degree of over payment in a deal • Environmental issues • Business cycle • Market perception • Market confusion • Market “greed of the moment”

14. DIVERSIFICATION DISCOUNT Valuations are influenced by many factors: Industry issues • Type of business • Margin structure • Capital intensity • Counter cyclicality or otherwise

15. DIVERSIFICATION DISCOUNT Conclusions and observations: • The diversification discount needs to be kept in context. Understand the concepts, but don’t apply them indiscriminately. • Remember that valuations are not simple. Focused strategies and implementation are required. • People who do deals are self serving. They can argue either side dependent upon which makes them money at the time.

16. SYNERGIES IN M&A

17. SYNERGIES • Definition number 1: Increase in profits through combination of entities. • Eliminate G&A • Absorb then increase middleman’s profit • Definition number 2: Increase in value through strategic fit of two entities based on industry, channel, product or other factors. • Sell more through same sales effort • Product enhancements • Achieve dominant market share

18. SYNERGIES-EXAMPLES • Banking: Elimination of duplicative G&A. • Retail: Increase in sales and margins through elimination of middlemen. • Telecom: Develop dominant market share. • OPEC: Collaboration leading to monopoly. • Internet sales: Increased volume through channel (Amazon). • Distribution: Elimination of duplicative G&A. • Manufacturing: Reduction of capital employed.

19. SYNERGIES-MACADAM CAPITAL • We always normalize income • Eliminate duplication (Sarbanes, audit, executive salaries, etc.) • Reflect operating cost savings • We model enhanced contribution in our sale transactions • Incremental channel gross profits • Elimination of duplicate logistics costs • Elimination of duplicate sales costs • We value market dominance and industry consolidation

20. SYNERGIES-CAUTIONS • Synergies can be real, but are vastly over-rated • Implementation is critical to achieving any synergistic benefits • There must be an acquirer and an acquiree to have much in the way of synergistic savings • Overpaying is too often the norm, and most of the incremental value is lost, despite comments to the contrary

21. VALUE AND USE OF RESEARCH

22. VALUE OF RESEARCH • Scientific methodology rather than opinions and “MSU” approach • Foundation for practical actions • Reduce complexities to manageable issues • Learning and training for future • Proof that BS is not the only answer

23. USE OF RESEARCH • Corporate financial decisions • Investment banking engagements (valuations and execution) • Consulting engagements

24. PRACTICAL VIEW Financial research: • Must be understandable • Must be delivered succinctly • Must make common sense or be thoroughly and completely proven

25. EXAMPLE OF RESEARCH Measuring diversification discount: • Ability to isolate is questionable and measurement is even tougher • But raising, analyzing and debating the subject are invaluable steps • Debunk common sense • Demonstrate lack of simplicity surrounding issues • Provides ammunition for good CFO’s to force companies to think before they act