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Merger Rationales and Strategy

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Title: Merger Rationales and Strategy


1
Merger Rationales and Strategy
  • P.V. Viswanath

Class Notes for EDHEC course on 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
    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.

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
  • 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.

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.

6
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.

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.

8
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.

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).

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.

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

12
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

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.

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 managers expropriation of private benefits.

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.

16
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.

17
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!

18
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.

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

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.

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.

22
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

23
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.
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