Merger Rationales and Strategy

1
Merger Rationales and Strategy

• P.V. Viswanath

Class Notes for EDHEC course on Mergers and
Acquisitions
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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
  isnt 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.

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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
• theyd 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, its optimal for the
  manager to try and reduce firm return volatility
  by keeping firm risk low.

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 usually
  time for the CEO, the board and the shareholders
  to reconsider.

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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.

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Synergy

• Another reason often given for a merger is the
  exploitation of synergies.
• Net Acquisition Value of a merger VAB (VAVB)
  (Acquisition Expenses)
• If VAB gt (VAVB), there is synergy.
• Broadly speaking, there are cost synergies and
  revenue synergies.
• Cost synergies are often referred to as operating
  synergies.

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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.

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Revenue Enhancing Synergies

• Cost cutting is easier than obtaining
  revenue-enhancing synergies.
• Revenue-enhancing synergies work if when two
  companies merge, As products can be sold to B
  and Bs products to A.
• Sears acquisition of real estate and brokerage
  businesses didnt 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.

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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).

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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.

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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 ATT.
• Question if the projects are worthwhile, why not
  just go to the capital markets for funds?
• Information Asymmetry
• Cost of accessing capital markets

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Access to Resources

• In Craig McCaw, ATT 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 ATT'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

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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.

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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 managers expropriation of private benefits.

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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.

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Shapiros 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.

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Shapiros 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!

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Shapiro Model Lessons for MA

• Horizontal Mergers can reduce costs through
  economies of scale
• Merging vertically downwards to acquire
  distribution channels can procure better product
  distribution
• Acquiring firms with RD capabilities can help
  generate products with quality edge (Yahoos
  acquisition of Inktomi in 2003 which had a
  superior crawler)
• The flip side is to deny competitors such an
  ability cf. Yahoos acquisition of Altavista in
  2003 to deny MSN access to a ready-made search
  engine.
• Acquiring targets with RD to reduce production
  costs for example, integrated steel producers
  acquiring minimills.

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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. WalMarts hot docking
  technique of logistics management)
• Accumulated experience (cf. learning curve)

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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.

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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.

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Porter Model Lessons for MA

• Firms can look for targets to enhance resistance
  to new entrants e.g. smaller firms with
  proprietary intellectual property or RD
  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

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Porter Model Lessons for MA

• 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 RD 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.