Creating Value through Mergers and Acquisitions

1. Chapter 11: Creating Value
through Mergers and
Acquisitions

2. 11.1. Introduction
 What is 'Mergers and Acquisitions - M&A'
 It is a general term that refers to the consolidation of companies or assets through
various types of financial transactions. M&A can include a number of different
transactions, such as mergers, acquisitions, consolidations, tender offers, purchase
of assets and management acquisitions. In all cases, two companies are involved.
 The idea behind Mergers and Acquisitions – to add value to the firm
 Different motives and ways for adding value via M&A:
 Entering a new market
 Synergy effect or
 M&A as a business model/strategy
 Carl Icahn earned a fortunes by acquiring companies, thoroughly improving
their business by improving management and then sold those companies,
thus earning a profit

3. 11.1. Introduction
 Worldwide waves of M&A:
 Late 60’s
 Mid 80’s
 Late 90’s
 Infrastructure backing the M&A activitiies:
 Investment bankers
 Corporate lawyers
 Management consultants, etc.

4. 11.1. Introduction
 Topics addressed in this chapter:
1. Who benefits from M&A?
2. How and when to use M&A as a strategic tool?
3. How to measure value creation using a structured framework?
4. Methods for estimating and capturing synergies
5. The need for emphasizing value creation over accounting treatment
6. Techniques for being a successful acquirer

5. 11.2. Do shareholders benefit from
M&A?
 M&A affects all of the stakeholders, but in different ways
 Positive effects
 value creation
 efficiency improvement,
 higher quality of products/services
 Negative effects
 higher prices,
 redundant job cuts
 Our focus and point of interest is the shareholders of both
parties – acquirer and the seller
 Our interest is to find out how does M&A affects the value of the
shareholder’s return or shares.

6. 11.2. Do Shareholders Benefit From
M&A?
 Empirical studies’ results show:
 That the Target M&A company’s shareholders receive, on average, 30%
premium over the before announcement of the market selling price
 That the Acquirer company’s shareholders suffer losses – value-weighted
average deal lowers the acquirer’s stock price 1-3%
 Both are negative effects of M&A for the acquiring company
 But, the Acquirers do not always lose
 Conducting a M&A is not an easy task, the next section will look at what
makes a successful M&A

7. 11.2. Do Shareholders Benefit From
M&A?
 Academic findings also show us how to conduct a successful M&A:
 The Acquirer is a strong operators – as a company its earned above average
return in the three year period prior to the M&A announcement
 Low transaction premiums paid to the target company are better – higher
transaction premiums earn negative returns on announcement. The market
understands the higher premium as a sign of recklessness of the board or perhaps
inability to arrange better terms for a deal.
 Being a sole bidder helps – returns are negative correlated with the number of
bidders. With more bidders, there is a probability that the Acquirer will have to pay
to pay more.
 These three (3) factors are based on statistical point of view. It is an
important one, but not the only one.
 What is important is also the Acquirer’s ability to translate its superior
performance to the Target company.
 Thus, the focus should be on value creation

8. 11.3. M&A vs Organic Growth As A
Strategy
 When the Acquirer took over the Target company in a M&A, the Acquirer
will gets both tangible and intangible assets of the Target company
 There would be a possibility of an endogenous creation of assets of the
Target Company
 In addtion, there would be a possibility of a positive synergy effect
between the Acquirer and the Target company.

9. 11.3. M&A vs Organic Growth as a
Strategy
$ million, percent Acquired growth
Acquirer
Organic
growth
No
synergies
Increase
profits by
50%
Increase
growth by
50%
Revenues 20,000 1,000 1,000 1,000 1,000
Expected growth 4% 4% 4% 4% 6%
NOPLAT 1,200 60 60 90 60
Invested capital 6,000 300 300 300 300
ROIC 20% 20% 20% 30% 20%
DCF value 16,000 800 800 1,300 1,050
Market value (300) (800) (800) (800)
Premium 30% (240) (240) (240)
Value creation 16,000 500 (240) 260 10
Value creation/acquirer
value
3.1% (1.5%) 1.6% 0.1%
Exhibit 11.3
• Exhibit 11.3 shows
us different
possibilities and
their potential
outcomes
• The idea is to show
the difficulty of
adding value
through M&A

10. 11.4. A Framework For Creating Value
Through M&A
 Value creation – increasing the expected free cash flows of the entities
engaged beyond current expectations
Value
Intrinsic value
of target 900
NPV of
synergies 400
Gross value of
acquired assets
1,30
0
Price
Market value of
target 800
Premium paid 240
Total price paid
1,04
0
Exhibit 11.4.

11. 11.4. A Framework For Creating Value
Through M&A
11.4.1 Market Value vs. Intrinsic Value
 Companies do not get undervalued for longer periods of time, but short-
term pockets do exist
 Profiting on short-term pockets is very difficult – the time lag problem
 The problem of overvaluated companies in the bubble periods
 Don’t buy cheap to sell high – instead increase future cash flow

12. 11.4. A Framework For Creating Value
Through M&A
11.4.2 Value Creation Through Synergies
 Fundamentals of value creation:
 Better revenue growth
 Higher margins
 More efficient capital utilization
 A lower cost of capital
 The source of value creation depends on the circumstances, i.e.
Businesses of both the acquirer and the target company

13. 11.4. A Framework For Creating Value
Through M&A
11.4.3 Paying Dearly to Capture Synergies
 The reasons behind:
 Winner’s curse
 The free rider problem
 Hubris
 In general, the acquirer will pay a premium over the price at which the
target company is traded

14. 11.5. Estimating And Capturing
Synergies
 Ideas often collide with day-to-day business
 We will explain the following:
 Process of estimating cost and revenue synergies
 Level of accuracy to expect from synergy estimates
 Cost and timing of implementation
 Top-down approach for checking your synergies
 Alternative deal structures to consider

15. 11.5. Estimating and Capturing
Synergies
11.5.1 Estimating Cost of Synergies
 Calculation of financial performance isn’t always the best way to estimate cost
 Outside – in approach, through publicly shared data and due diligence
 Bottom – up approach with the representatives of both parties
 The analysis should be structured using the following steps:
1. Develop an industry – specific business system
2. Develop a baseline for costs as if the two companies remained independent. Make
sure the baseline costs are consistent with the intrinsic valuations
3. Estimate the synergies for each cost category based on the expertise of experienced
line managers
4. Compare aggregate improvements with margin and capital efficiency benchmarks to
judge whether the estimates are realistic given industry economics

16. 11.5. Estimating and Capturing
Synergies
Example synergies
R&D • Stopping redundant projects
• Eliminating overlap in research personnel
• Developing new products through transferred technology
Procurement • Pooled purchasing (higher volume)
• Standardizing products
Manufacturing • Eliminating overcapacity
• Transferring best operating practices
Sales and
marketing
• Cross – selling of products
• Using common channels
• Transferring of best practices
• Lowering combined marketing budget
Distribution • Consolidating warehouses and truck routes
Administration • Exploiting economies of scale in finance/accounting and other back office
functions
• Consolidating strategy and leadership functions
Exhibit 11.5. – Framework for estimating cost
synergies

17. 11.5. Estimating and capturing synergies
 Three characteristics or aspects of an
insightful business system:
1. 1-1 (one to one) relations between
costs and cost - saving ideas
2. Assigning the savings to segments
3. Detailed design of business
systems

18. 11.5. Estimating and Capturing
Synergies
11.5.2 Estimating Revenue Synergies
 Assuming revenues is tempting, but often not realistic
 Customers may leave (rule of minimum two suppliers)
 Revenue synergies typically include acquiring a new product or a technology
 Cisco as an excellent example
 Four sources of revenue synergies:
1. Improving product’s peak sales level
2. Reaching the increased peak sales level faster
3. Extending each product’s life
4. Adding new products (features) that couldn’t have been developed if the
two companies remained independent

19. 11.5. Estimating and Capturing
Synergies
11.5.3 Evaluating the Quality and Accuracy of
Projected Synergies
 Four sources of synergies:
 Higher margins
 Increased capital efficiency
 Higher growth
 Lower cost of capital
Typically have a rank order of confidence

20. 11.5. Estimating and capturing synergies
 Cost synergies are done with more
success, research shows
 It’s not about buying a high-growing
business, it’s about improving the growth
of both businesses
 Lower cost of capital is often an illusion

21. 11.5. Estimating and Capturing
Synergies
11.5.4 Implementation Costs, Requirements and Timing
 Implementation costs are unavoidable
 Expectations regarding the time needed for capturing synergies are often overly
optimistic
 Synergies may not be captured at all, if the timing isn’t respected

22. 11.5. Estimating and Capturing
Synergies
11.5.5 Checking Your Estimates With A Simple Top – Down
Approach
Exhibit 11.5.5. Checking your estimates with a simple top – down approach

23. 11.5. Estimating and Capturing
Synergies
11.5.6 Alternatives to Acquisition
Joint ventures:
Takeover premium usually not required
Ability to focus on individual parts of the business
system
Lower risks, lower profits
Legal arrangements for alliances and joint
ventures more complicated

24. 11.6. How to pay: Cash vs stock
 The question: Should the
rewards and the risk of the
acquisition be shared with the
target’s shareholders? Downside scenario
Synergies = 100
Fair market value before the deal
Acquirer 1,000
Target 500
Price paid 650
(30%
premium)
Upside scenario
Synergies = 200
Consideration in
cash
Acquirer shareholders 950 1,050
Target shareholders 650 650
Acquirer value creation (destruction) (50) 50
Consideration in
stock
Acquirer shareholders 970 1,030
Target shareholders 630 670
Acquirer value creation (destruction) (30) 30

25. 11.6. How to pay: Cash vs stock
Two questions to be addressed when making a
decision:
1. Is your and/or target company undervalued or
overvalued?
2. How confident are you about the value creation in the
deal?

26. 11.7. Focus On Value Creation, Not
Accounting
Focusing solely on accounting usually leads
to bad deals with no value created
In 2005, IFRS and U.S. GAAP eliminated
Goodwill amortization, making cash – paid
acquisitions more accretive, but also more
value destroying

27. 11.7. Focus On Value Creation, Not
Accounting Impact on EPS Cash deal Stock deal
Net income from
acquirer ($ million)
80.0 80.0
Net income from target
($ million)
30.0 30.0
Additional interest ($
million)
(19.5) 0.0
Net income after
acquisition ($ million)
90.5 11.0
Original shares
(million)
40.0 40.0
New shares (million) 0.0 12.5
Number of shares
(million)
40.0 52.5
EPS before acquisition
($)
2.0 2.0
EPS accretion ($) 0.3 0.1
EPS after acquisition
($)
2.3 2.1
Assumptions Acquirer Target
Net income ($ million) 80.0 30.0
Shares outstanding
(million)
40.0 10.0
EPS ($) 2.0 3.0
Preannouncement share
price ($)
40.0 40.0
P/E ($ per share) 20.0 13.3
Market value ($ million) 1,600.0 400.0
Price paid ($ million) 500.0
Exhibit 11.7. – EPS Accretion with value
destruction

28. 11.7. Focus On Value Creation, Not
Accounting

29. 11.8. How To Be A Successful Acquirer
Earn the right to acquire by having a strong core
business
Consider only targets for which you can improve
future free cash flow
Excel in estimating overall value creation
Maintain discipline during negotiation
Rigorously plan and execute an integration

30. 11.8. How To Be A Successful Acquirer
11.8.1. Earn the Right and Focus On Where You Can Have An
Impact
“Two dogs don’t make a lion”
Be an active, not a passive acquirer
Create and update a strategic database of potential
targets
Properly estimate synergies
General Electric: ROIC rose from 20 to 50% in two
decades of intensive growth through M&A

31. 11.8. How To Be A Successful Acquirer
Properly estimate synergies
 Apply previously outlined guidelines
 Do not neglect implementation costs and timing issues
Be a disciplined negotiator
 Make sure to understand why your company is still in the race in case of a
bidding war
 Quantify all terms of the deal that have any influence on potential value creation
 On-the-fly deals can significantly affect value creation for shareholders
 Negotiation team and financial team should act as one
Plan and control the integration
 Start early
 Put a team in place
 Use both financial and non-financial benchmarks

32. 11.8. How to be a successful acquirer
Start the integration process early – before the announcement
 Starting implementation planning in parallel with the valuation and
negotiation is recommended, based on previous experiences
 At the announcement moment, integration team, new organizational
structure and key positions should be known
Put a strong team in charge
 The manager of the process should be a strong performer
Use nonfinancial benchmarks in tracking implementation

33. Questions?
33