PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 17 doc

561 17 PROFITABLE GROWTH BY ACQUISITION Richard T. Bliss The subject of this chapter is growth by acquisition; few other business transac- tions receive more scrutiny in both the popular and academic presses. There are several reasons for this attention. One is the sweeping nature of the deals, which typically result in major upheaval and job losses up to the highest levels of the organizations. A second is the sheer magnitude of the deals—the recently an- nounced merger between Time-Warner and AOL, worth more than $150 bil- lion, exceeds the annual GDP of 85% of the world’s nations! Thirdly, the products involved are known to billions around the globe. Daimler-Benz, Coca Cola, and Louis Vuitton are just a few of the world-renowned brand names re- cently involved in merger and acquisition (M&A) transactions. Finally, the per- sonalities and plots in M&A deals are worthy of any novelist or Hollywood scriptwriter. The 1988 acquisition of Nabisco Foods by RJR Tobacco—at that time the largest deal ever, at $25 billion—was the subject of a New York Times best-seller and a popular film, both called Barbarians at the Gate. Since then, there have been numerous other best-selling books and movies based on real and fictional M&A deals. In spite of this publicity and the huge amounts of money involved, it is im- portant to remember that M&A transactions are similar to any other corporate investment, that is, they involve uncertainty and the fundamental tradeoff be- tween risk and return. To lose sight of this simple fact or to succumb to the emotion and frenetic pace of M&A deal-making activities is a sure path to an unsuccessful result. Our goal in this chapter is to identify the potential pitfalls you may face and to create a road map for a successful corporate M&A strat egy. 562 Making Key Strategic Decisions We review the historical evidence and discuss some of the characteristics of both unsuccessful and successful deals. The importance of value creation is highlighted, and we present simple analytical tools that can be used to evaluate the potential of any merger or acquisition. Practical aspects of initiating and structuring M&A transactions are presented and the issues critical to the suc- cessful implementation of a new acquisition are briefly described. It is impor- tant to understand that there are many legal and financial intricacies involved in most M&A transactions. Our objective here is not to explain each of these in detail, since there are professional accountants, lawyers, and consultants avail- able for that. Instead, we hope to provide valuable and concise information for busy financial managers so that they can design and implement an effective M&A strategy. DEFINITIONS AND BACKGROUND Before examining the historical evidence on acquisitions, we need to define some terminology. An acquisition is one form of a takeover, which is loosely de- fined as the transfer of control of a firm from one group of shareholders to an- other. In this context, control comes with the ability to elect a majority of the board of directors. The firm seeking control is called the bidder and the one that surrenders control the target. Other forms of takeovers include proxy con- tests and going private, but the focus of this chapter is takeover via acquisition. As we can see, acquisitions may occur in several ways. In a merger, the target is absorbed by the bidder and the target’s original shareholders receive shares of the bidder. In a consolidation, the firms involved become parts of an entirely new firm, with the bidder usually retaining control of the new entity. All original shareholders hold shares in the new firm after the deal. The two transactions have different implications for shareholders, as the following ex- amples make clear. Example 1 There has recently been a wave of takeover activity in the stuffed animal industry. Griffin’s Giraffes Inc. (GGI) has agreed to merge Takeover Acquisition Proxy contest Going private Merger or consolidation Stock acquisition Asset acquisition Profitable Growth by Acquisition 563 with Hay ley’s Hippos Inc. (HHI). GGI offers one of its shares for three shares of HHI. When the transaction is completed, HHI shares will no longer exist. The original HHI stockholders own GGI shares equal in number to one-third of their original HHI holdings. GGI’s original shareholders are unaffected by the transaction, except to have their ownership stake diluted by the newly is- sued shares. Example 2 Kristen’s Kangaroos Inc. (KKI) wishes to take over the operations of Michael’s Manatees Inc. (MMI) and Brandon’s Baboons Inc. (BBI). Rather than giving its shares to the owners of MMI and BBI, KKI decides to establish a new firm, Safari Ventures Inc. (SVI). After this consolidation, shareholders of the three original companies (KKI, MMI, and BBI) will hold shares in the new firm (SVI), with KKI having the controlling interest. The three original firms cease to exist. Another method of acquisition involves the direct purchase of shares, either with cash, shares of the acquirer, or some combination of the two. These stock acquisitions may be negotiated with the mangers of the target firm or by appealing directly to its shareholders, often via a newspaper advertisement. The latter transaction is called a tender offer, which typically occur after nego- tiations with the target firm’s management have failed. Finally, an acquisition can be effected by the purchase of the target’s assets. Asset acquisitions are sometimes done to escape the liabilities (real or contingent) of the target firm or to avoid having to negotiate with minority shareholders. The downside is that the legal process of transferring assets may be expensive. Acquisitions can be categorized based on the level of economic activity involved according to the following: • Horizontal: The target and bidder in a horizontal merger are involved in the same type of business activity and industry. These mergers typically result in market consolidation, that is, more market share for the com- bined firm. Because of this, they are subject to extra antitrust scrutiny. The pending acquisition of USAir by United Airlines is an example of a horizontal merger (see p. 564). Because the combined entity would be the world’s largest airline and have a dominant market share in the United States, the Justice Department has demanded that certain assets and routes be divested before approval for the deal will be granted. • Vertical: A vertical merger involves firms that are at different levels of the supply chain in the same industry. For example, stand-alone Internet service provider/portal AOL functions primarily as a distribution chan- nel. Its pending merger with Time Warner will allow AOL to move up the home entertainment industry supply chain and control content in the form of Time Warner’s music and video libraries. • Conglomerate: In a conglomerate merger, the target and bidder firms are not related. These were popular in the 1960s and seventies but are rare 564 Making Key Strategic Decisions today. An auto manufacturer acquiring an ice cream producer would be an example. Armed with a basic understanding of the types of acquisitions and how they occur, we now turn our attention to the track record of M&A transactions. Be forewarned that it is spotty at best and that many practitioners, analysts, and academics believe that the odds are stacked against acquirers. We do not say this to dissuade anyone from pursuing an acquisition strategy, but rather to highlight the fact that without careful planning, there is little chance of success. THE TRACK RECORD OF MERGERS AND ACQUISITIONS There has been tremendous growth in the number and dollar value of M&A transactions over the last two decades (see Exhibit 17.1). In 1998, the total an- nual value of completed transactions exceeded one trillion dollars for the first time in history. The number of deals fell in 1999, but larger deals resulted in a total deal value of almost $1.5 trillion. Exhibit 17.2 lists the largest deal for each of the years between 1990 and 2000. While the data in Exhibits 17.1 and 17.2 focus on large transactions, the growth trend for all M&A deals is similar. And in 1999, for the first time in history, there were more deals done abroad than in the United States. By any SOURCE : The Wall Street Journal, December 20, 2000. Profitable Growth by Acquisition 565 mea sure, the 1990s was an increasingly acquisitive decade around the world. This explosion in deal making might lead one to assume that mergers and ac- quisitions are an easy way for corporate managers to create value for their shareholders. To assess this, we now examine the empirical evidence on merg- ers and acquisitions. Let’s begin with the wealth of academic studies that ana- lyze M&A performance. 1 M&A activity has been the focus of volumes of academic research over the last 40 years. The evidence is mixed, but we can draw several clear con- clusions from the data. We break our discussion into two pieces: short-term EXHIBIT 17.1 M&A activity, 1981–1999. a a Data is for deals valued at at least $5 million and involving one U.S. company. SOURCE : Mergers & Acquisitions, September 2000. 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 Year Number of deals Value (billions) Number of deals (left axis) Total value (right axis) 0 2,000 4,000 6,000 8,000 10,000 12,000 0 200 400 600 800 1,000 1,200 1,400 1,600 EXHIBIT 17.2 A decade of megadeals . Price Year Bidder Target (billions) 1990 Time Inc. Warner Communications $ 12.6 1991 AT&T Corp. NCR Corp. 7.5 1992 BankAmerica Corp. Security Pacific Corp. 4.2 1993 Merck & Co. Medco Containment Services 6.2 1994 AT&T Corp. McCaw Cellular Inc. 18.9 1995 AirTouch Communications US West Inc. 13.5 1996 Walt Disney Co. Capital Cities/ABC Inc. 18.9 1997 Bell Atlantic Corp. NYNEX Corp. 21.3 1998 Travelers Group Inc. Citicorp 72.6 1999 Exxon Corp. Mobil Corp. 78.9 2000 America Online Inc. Time Warner Inc. 156.0 SOURCE : Mergers & Acquisitions, September 2000. 566 Making Key Strategic Decisions and long-term M&A performance. The short-term is a narrow window, typi- cally three to five days, around the merger announcement. Long-term studies examine postmerger performance two to five years after the transaction is completed. We can offer three unambiguous conclusions about the short-term finan- cial impact of M&A transactions: 1. Shareholders of the target firms do very well, with average premiums be- tween 30% and 40%. 2. Returns to bidders have fallen over time as the market for corporate con- trol becomes more competitive; recent evidence finds bidder returns in- distinguishable from zero or even slightly negative. 3. The combined return of the target and the bidder, that is, the measure of overall value creation, was slightly positive. However, these results are highly variable depending on the specific samples and time periods analyzed. The findings on the long-term performance of mergers and acquisitions are not any more consistent or encouraging. Agrawal et al. report “shareholders of acquiring firms experience a wealth loss of about 10% over the five years following the merger completion.” 2 Other studies’ con- clusions range from underperformance to findings of no abnormal postmerger performance. The strongest conclusions offered by Weston et al. are that, “It is likely, therefore, that value is created by M&As,” and that, “Some mergers perform well, others do not.” 3 So much for the brilliance of the academy! This level of confidence hardly seems to justify the frenetic pace of merger activity chronicled in Exhibits 17.1 and 17.2. If the academic literature seems ambivalent about judging the financial wisdom of M&A decisions, the popular business press shows no such hesitancy. In a 1995 special report, Business Week carefully analyzed 150 recent deals valued at $500 million or more and reported “about half destroyed shareholder wealth” and “another third contributed only marginally to it.” The article’s last paragraph makes it clear that this is not a benign finding and places the blame squarely on corporate CEOs. All this indicates that many large-company CEOs are making multibillion- dollar decisions about the future of their companies, employees, and share- holders in part by the seat of their pants. When things go wrong, as the evidence demonstrates that they often do, these decisions create unnecessary tumult, losses, and heartache. While there clearly is a role for thoughtful and well-conceived mergers in American business, all too many don’t meet that description. Moreover, in merging and acquiring mindlessly and flamboyantly, deal- makers may be eroding the nation’s growth prospects and global competitive- ness. Dollars that are wasted needlessly on mergers that don’t work might better be spent on research and new-product development. And in view of the growing number of corporate divorces, it’s clear that the best strategy for most would-be marriage partners is never to march to the altar at all. 4 Profitable Growth by Acquisition 567 A 1996 survey of 150 companies by the Economist Intelligence Unit in London found that 70% of all acquisitions failed to meet the expectations of the initia- tor. Coopers and Lybrand studied the postmerger performance of 125 com- panies and reported that 66% were financially unsuccessful. We now turn our attention to several specific M&A transactions. While unscientific, this approach is more informative and certainly more interesting than reviewing academic research. We purposely focus on failed deals in an at- tempt to learn where the acquirers went wrong. In the next section, we exam- ine the acquisition strategy and policies of Cisco Systems, the acquirer ranked No. 1 in a recent survey of corporate M&A practices. As you read about these dismal transactions, can you speculate on the rea- sons for failure? On their faces, they seemed like strategically sound transac- tions. While one might question AT&T’s push into personal computers, the other two deals were simple horizontal mergers, that is, an extension of the ex- isting business into new product lines or geographic markets. In hindsight, each deal failed for different reasons, but there are some common issues. The lessons learned are critical for all managers considering growth by acquisition. We now examine these colossal failures in more detail. Analysts believe that the merger between AT&T and NCR failed due to managerial hubris, overpayment, and a poor understanding of NCR’s products and markets. A clash between the two firms’ cultures proved to be the final nail in the coffin. In 1990 AT&T’s research division, Bell Labs, was one of the worlds premier laboratories. With seven Nobel prizes and countless patents to its name, it was where the transistor and the UNIX operating system had been invented. AT&T’s executives mistakenly believed that this research prowess Disaster Deal No. 1 Between 1985 and 1990, AT&T’s computer operations lost approximately $2 billion. The huge conglomerate seemed unable to compete effectively against the likes of Compaq, Hewlett Packard and Sun Microsystems. They decided to buy rather than build and settled on NCR, a profitable, Ohio-based personal computer (PC) manufacturer with 1990 revenues of $6 billion. NCR did not want to be purchased and this was made clear in a letter from CEO Chuck Exley to AT&T CEO Robert Allen: “We simply will not place in jeopardy the important values we are creating at NCR in order to bail out AT&T’s failed strategy.” OUCH! However, after a bitter takeover fight—and an increase of $1.4 billion in the offer price (raising the premium paid to more than 100%!)—AT&T acquired NCR in September 1991 for $7.5 billion. Aftermath: In 1996, after operating losses exceeding $2 billion and a $2.4 bil- lion write-off, AT&T spun-off NCR in a transaction valued at about $4 billion, approximately half of what it had paid to acquire NCR less than five years before. 568 Making Key Strategic Decisions and $20 billion of annual long-distance telephone revenues, along with the NCR acquisition, would guarantee the company’s success in the PC business. They were confident enough to increase their original offer price by $1.4 bil- lion. The problem was that by this time, PCs had become a commodity and were being assembled at low-cost around the world using off-the-shelf compo- nents. Unlike the microprocessor and software innovations of Intel and Micro- soft, AT&T’s research skills held little profit potential for the PC business. AT&T hoped to use NCR’s global operations to expand their core telecom business. But NCR’s strengths were in developed countries, whereas the fastest-growing markets for communications equipment were in developing third-world regions. And in many companies, the computer and telephone sys- tems were procured and managed separately. Thus, the anticipated synergies never materialized. Finally, the two companies had very different cultures. NCR was tightly controlled from the top while AT&T was less hierarchical and more politically correct. When AT&T executive Jerre Stead took over at NCR in 1993, he billed himself as the “head coach,” passed out T-shirts, and told all of the em- ployees they were “empowered.” This did not go over well in the conservative environment at NCR, and by 1994, only 5 of 33 top NCR managers remained with the company. Disaster Deal No. 2 Throughout 1994, Quaker Oats Co. was rumored to be a takeover target. It was relatively small ($6 billion in revenue) and its diverse product lines could be easily broken up and sold piecemeal. In November, Quaker announced an agreement to buy iced-tea and fruit-drink maker Snapple Beverage Corp. for $1.7 billion, or $14 per share. CEO William Smithburg dismissed the 10% drop in Quaker’s stock price, arguing “We think the healthy, good-for-you beverage categories are going to continue to grow.” The hope was that Quaker could replicate the success of its national-brand exercise drink Gatorade, which held an extraordinary 88% market share. Snapple, which had 27% of the ready-to-drink tea segment was distrib- uted mainly through smaller retail outlets and relied on offbeat advertising and a “natural” image to drive sales. Only about 20% of sales were from super- markets where Quaker’s strength could be used to expand sales of Snapple’s drinks. Aftermath: In April 1997, Quaker announced it would sell Snapple for $300 million to Triarc Cos. Quaker takes a $1.4 billion write-off and the sale price is less than 20% of what Quaker paid for Snapple less than three years earlier. Analysts estimated the company also incurred cash losses of approxi- mately $100 million over the same period. Ending a 30-year career with the company, CEO Smithburg “retires” two weeks later at age 58. Profitable Growth by Acquisition 569 What doomed the Quaker-Snapple deal? One factor was haste. Quaker was so worried about becoming a takeover target in the rapidly consolidating food industry that it ignored evidence of slowing growth and decreasing prof- itability at Snapple. The market’s concern was reflected in Quaker’s stock price drop of 10% on the acquisition announcement. In spite of this, Quaker’s man- agers proceeded, pushing the deal through on the promise that Snapple would be the beverage industry’s next Gatorade. This claim unfortunately ignored the realities on the ground: Snapple had onerous contracts with its bottlers, fading marketing programs, and a distribution system that could not support a national brand. There was also a major difference between Snapple’s quirky, offbeat corporate culture and the more structured environment at Quaker. Most importantly, Quaker failed to account for the possible entrance of Coca Cola and Pepsi into the ready-to-drink tea segment—and there were few barriers to entry—which ultimately increased competition and killed margins. Disaster Deal No. 3 The 1998 $130 billion megamerger between German luxury carmaker Daimler- Benz and the #3 U.S. automobile company, Chrysler Corporation, was univer- sally hailed as a strategic coup for the two firms. An official at a rival firm simply said “This looks like a brilliant move on Mercedes-Benz’s part.”* The stock market agreed as the two companies’ shares rose by a combined $8.6 bil- lion at the announcement. A 6.4% increase in Daimler-Benz’s share price ac- counted for $3.7 billion of this total. The source of this value creation was simple: There was very little overlap in the two companies’ product lines or ge- ographic strengths. “The issue that excites the market is the global reach,” said Stephen Reitman, European auto analyst for Merrill Lynch in London.* Daim- ler had less than 1% market share in the U.S., and Chrysler’s market share in Europe was equally miniscule. There would also be numerous cost-saving op- portunities in design, procurement, and manufacturing. The deal was billed as a true partnership, and the new firm would keep operational headquarters in both Stuttgart and Detroit and have “co-CEOs” for three years after the merger. In addition, each firm would elect half of the directors. Aftermath: By the end of 2000, the new DaimlerChrysler’s share price had fallen more than 60% from its post merger high. Its market capitalization of $39 billion was 20% less than Daimler-Benz’s alone before the merger! All of Chrysler’s top U.S. executives had quit or been fired, and the company’s third-quarter loss was an astounding $512 million. As if all of this weren’t bad enough, DaimlerChrysler’s third-largest shareholder, Kirk Kekorian, was suing the company for $9 billion, alleging fraud when they announced the 1998 deal as a “merger of equals.” * “Auto Bond: Chrysler Approves Deal With Daimler-Benz,” The Wall Street Journal, May 7, 1998. 570 Making Key Strategic Decisions In this case, Quaker’s management was guilty of two mistakes: failure to ana- lyze Snapple’s products, markets, and competition correctly and overconfi- dence in their ability to deal with the problems. Either way, their lapses cost Quaker ’s shareholders billions. Although the jury is still out on the Daimler-Chrysler merger, analysts al- ready have assigned at least some of the blame. There were culture issues from the start, and it quickly became apparent that co-CEOs were not the way to manage a $130 billion global giant. Chrysler CEO Robert Eaton left quietly at the beginning of 2000 and there were other departures of high-level American executives. Morale suffered as employees in the U.S. realized that the “merger of equals” was taking on a distinctive German flavor and in November 2000, the last remaining Chrysler executive, U.S. president James Holden, was fired. Rather than deal with these issues head-on, Daimler CEO Jergen Schremp took a hands-off approach as Chrysler’s operations slowly spiraled downward. The company lost several top designers, delaying new product in- troductions and leaving Chrysler with an aging line of cars at a time when its competitors were firing on all cylinders. The delay in merging operations meant cost savings were smaller than anticipated as were the benefits from sharing technology. Finally, analysts suggested that Daimler paid top dollar for Chrysler at a time when the automobile industry in the U.S. was riding a wave of unprecedented economic prosperity. As car sales began to sag at the end of 2000, all three U.S. manufacturers were facing excess capacity and offering huge incentives to move vehicles. This was not the ideal environment for quickly restructuring Chrysler’s troubled operations and Daimler was facing a 35% drop in projected operating profit between 1998 and 2001. Conclusions: These three case studies highlight some of the difficulties firms face in achieving profitable growth through acquisitions. Managerial hubris and a competitive market make it easy to overestimate the merger’s benefits and therefore overpay. A deal that makes sense strategically can still be a financial failure if the price paid for the target is too high. This is espe- cially a problem when economic conditions are good and high stock prices make it easy to justify almost any valuation if the bidder’s managers and direc- tors really want to do a deal. Shrewd managers can sell deals that make little strategic sense to unsuspecting shareholders and then ignore signals from the market that the deal is not a good one. The previous examples make it clear that it is easy to overstate the bene- fits that will come after the transaction is completed. Whatever their source, these benefits are elusive, expensive to find and implement, and subject to at- tack by competitors and economic conditions. Managers considering an acquisi- tion should be conservative in their estimates of benefits and generous in the amount of time budgeted to achieve these benefits. The best way to accurately estimate the benefits of the merger is to have a thorough understanding of the target’s products, markets, and competition. This takes time and can only come from careful due diligence, which must be conducted using a disciplined [...]... − Incremental Taxes − Incremental Investment in New Working Capital − Incremental Investment in Fixed Assets = Incremental Cash Flow With this in mind, we can look more closely at potential sources of incremental cash f lows and therefore, value in acquisitions We focus on the following three areas: 1 Incremental revenue 2 Cost reductions 3 Tax savings Incremental Revenue More revenue for the combined... changes The U.S oil industry in the late 1970s provides an excellent example of this Excess production, structural changes in the industry, and macroeconomic factors resulted in declining oil prices and high interest rates Exploration and development costs were higher than selling prices and companies were losing money on each barrel of oil they discovered, extracted, and refined The industry needed to... from U.S standards While there is a move to standardized financial reporting via generally accepted accounting principles (GAAP) or international accounting standards (IAS), there is still great variability in the frequency and reliability of accounting data around the world The problem is that developing nations, which offer some of the best acquisition opportunities, have the most problems Doing M&A... dynamic issue In fact, as this chapter is being written, accounting- rule makers in the United States were proposing to eliminate the pooling of interests method of accounting for acquisitions Because of this, it is important to get timely, expert advice on these issues from competent professionals Tax Issues Taxes were discussed brief ly in the paragraph comparing cash and stock deals In a tax-free... emotionally attached to a deal In spite of the time pressures inherent in any merger transaction, this is truly a situation where “haste makes waste.” A common factor in each of these transactions and one often overlooked by managers and researchers in finance and accounting is culture Two types of culture can come into play in an acquisition One is corporate or industry culture and the second is national... present some of the key issues managers should consider when initiating and structuring acquisitions SOME PRACTICAL CONSIDERATIONS In this section, we brief ly discuss the following issues you may encounter in developing and executing a successful M&A strategy: • • • • • • Identifying candidates Cash versus stock deals Pooling versus purchase accounting Tax considerations Antitrust concerns Cross-border... both their potential as stand-alone companies and the synergies that would result from a combination Cash versus Stock Deals The choice of using cash or shares of stock to finance an acquisition is an important one In making it, the following factors should be considered: 1 Risk-sharing: In a cash deal, the target firm shareholders take the money and have no continued interest in the firm If the acquirer... and the elimination of inefficient management Economies of scale result when a certain percentage increase in output results in a smaller increase in total costs, resulting in reduced average cost It Profitable Growth by Acquisition 577 doesn’t matter whether this increased output is generated internally or acquired externally When the firm grows to its “optimal” size, average costs are minimized and. .. from marketing gains, strategic benefits, or market power Increased revenue through marketing gains result from improvements in advertising, distribution or product offerings For example, when Citicorp and Travelers Inc announced their merger in 1998, incremental revenue was a key factor: 576 Making Key Strategic Decisions “Finally, there is the central justification of the deal: cross-selling each other... up an incredible 55% to $18.9 billion, while net income grew to $3.9 billion, resulting in a healthy 21% net profit margin Even more impressive was its 10th consecutive quarter of accelerating sales growth, culminating in a 61% sales increase for the last quarter At $356 billion, Cisco’s market capitalization trailed only General Electric Company What is behind such phenomenal results? Beginning in 1993, . overlooked by managers and researchers in finance and accounting is culture. Two types of culture can come into play in an acquisition. One is corporate or industry culture and the second is national. Citicorp and Travelers Inc. announced their merger in 1998, incremental revenue was a key factor: Incremental Revenues − Incremental Costs − Incremental Taxes − Incremental Investment in New Working. of economic activity involved according to the following: • Horizontal: The target and bidder in a horizontal merger are involved in the same type of business activity and industry. These mergers