![60
Cisco’s acquisition strategy
Slide
5.10
Vignette – Cisco Systems
Both firms must share similar visions “about where the industry is
going [and] what role each company wants to play in the industry. So you
have to look at the visions of both companies and if they are dramatically
different, you should back away.”
The acquisition must “produce quick wins for [the] shareholders.”
There must be “long-term wins for all four constituencies --
shareholders, employees, customers, and business partners.”
“The chemistry (between the companies) has to be right.” He
thought that this was difficult to define, but involved both parties being
comfortable with their counterparts.
Geographic proximity is important. If the newly acquired firm is
located close to Cisco, then interaction will be easier.
Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004)
By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California](https://image.slidesharecdn.com/ma-12411972307-phpapp01/85/Mergers-amp-Acquisitions-in-High-Tech-Industry-60-320.jpg)
Uploaded byAbhishek Breja
Mergers & Acquisitions in High Tech Industry
The document discusses the different types of mergers and acquisitions (M&A) and the unique challenges that each presents for management. It outlines seven types of M&As - overcapacity M&A, geographic roll-up M&A, product/market extension M&A, M&A as R&D, industry convergence M&A - and notes that distinct activities lead to differing management challenges for each type. Key challenges addressed include rationalizing merged companies, dealing with cultural differences, conducting thorough due diligence, and allowing acquired companies autonomy versus forcing integration. The document is intended to help management tailor their approach to the specific type of M&A.
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- 1. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 2. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study– Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 3. 3M&A and Value Formsof Takeover Slide 1.1 Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition) The Basic Principle of valuation applies: a firms should be acquired if it generates a positive value to the shareholders of the acquiring firm Takeovers Going Private/ LBO Proxy Contest Acquisition Acquisition of Assets Acquisition of Stock Merger or Consolidation
- 4. 4 Takeovers Going Private/ LBO ProxyContest Acquisition Acquisition of Assets Acquisition of Stock Merger or Consolidation M&A and Value Forms of Takeover Slide 1.2 • A merger refers to the absorption of one firm by another. The acquired firm retains its name and it acquires all of the assets and liabilities of the acquired firm. After the merger the acquired firm ceases to exist • A consolidation is same as merger except that an entirely new firm is created Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 5. 5 Takeovers Going Private/ LBO ProxyContest Acquisition Acquisition of Assets Acquisition of Stock Merger or Consolidation M&A and Value Forms of Takeover Slide 1.3 • To purchase the firm’s voting stock in exchange for cash, shares of stock or other securities. Though this may start as private offer from the mgmt. Of one fir to another, the offer may be taken directly to the selling firm’s stock holders – called TENDER OFFER. Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 6. 6 Takeovers Going Private/ LBO ProxyContest Acquisition Acquisition of Assets Acquisition of Stock Merger or Consolidation M&A and Value Forms of Takeover Slide 1.4 • One firm can acquire another firm by buying all of its assets. A formal vote of the shareholders of the selling firm is required. This approach will avoid the potential problem of having minority shareholders which can occur in an acquisition of stock. Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 7. 7M&A and Value Formsof Takeover Slide 1.5 Takeovers Going Private/ LBO Proxy Contest Acquisition Acquisition of Assets Acquisition of Stock Merger or Consolidation • Proxy contest occur when a group of shareholders attempt to gain controlling seats on the board of directors by voting in new directors • Going private refers to what happens when the publicly owned stock in a firm is purchased by a private group, usually composed of existing management. These transactions are frequently leveraged buyouts (LBOs). In a LBO, cash offer price is financed with a large amount of debt. Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 8. 8M&A and Value Thevalue comes from Synergies Slide 1.6 ΔCFt = Δ Revenue t – Δ Cost t – Δ Taxes t – Δ Capital Requirements t r = risk-adjusted discount rate appropriate for the incremental cash flow, at date t, from the merger T Synergy =ΣT =1 ΔCFt (1+r)t Synergy = Vab – (Va + Vb) Va = Value of Firm A Vb = Value of Firm B Vab = Value of the combined Firm Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 9. 9M&A and Value Sourcesof synergy from acquisition Slide 1.7 Sources of Synergy 1 Revenue Enhancement Marketing Gains Strategic Benefits Market or monopoly power 2 Cost Reduction Economies of scale Economies of vertical integration Complementary resources Elimination of inefficient management 3 Tax Gains Net operating losses Unused debt capacity Surplus funds 4 The Cost of Capital Reduced cost of issuing securities Source: Corporate Finance: Ross Westerfield and Jaffe (5th Edition)
- 10. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 11. 11 StrategicObjectivesExample Distinct activities meansdiffering challenges Slide 2.1 Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower The over capacity M&A Geographic Roll-up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A Daimler-Benz acquire Chrysler Banc one buys scores of local banks in the 1980s GE acquires many product companies, Quaker oat bys Snapple Cisco acquires 62 companies Viacom buys Paramount and Blockbuster; AT&T buys NCR,McCaw and TCI Acquiring Company will eliminate capacity, gain market share and create a more efficient operations Company expands geographically; operating unit remains local Acquisition extends a company’s product line or its international coverage Acquisitions are used in lieu of in house R&D to build a market position quickly A company bets that a new industry is emerging and tries to establish a position by culling resources from existing industries whose boundaries are eroding Mgmt. thought leadership
- 12. 12 Rationales for M&Aactivity (1997-1999) Slide 2.2 Data for the chart comprises of all M&A deals over $500 million made between 1997 and 1999. Had we looked at $250mm to $499mm range, we’d have seen a higher % of R&D deals Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 13. 13 Distinct activities meansdiffering challenges Slide 2.3 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A • You can’t run a merged company until you’ve rationalized it, so decide what to eliminate quickly • If it is the merger of equals and process and value differ greatly that except trouble • Also in case of Merger of Equals expect the management groups to fight for control • These tend to be one time event, so they’re especially hard to pull off. Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 14. 14 Distinct activities meansdiffering challenges Slide 2.4 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A • Members of the acquired group may welcome your streamlined processes. If they don’t you can afford to ease them in slowly • If a strong culture is in place, introduce new values with extreme care. Use carrot not sticks • These are win-win scenario and they often go smoothly Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 15. 15 Distinct activities meansdiffering challenges Slide 2.5 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A • Know what you are buying; the farther you get from home the harder it is to be sure • Expect cultural and governmental differences to interfere with integration • The bigger you are relative to your target company, the better your chances for success • The more practice you have the better your chances for success Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 16. 16 Distinct activities meansdiffering challenges Slide 2.6 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A • Build industrial strength evaluation processes so that you buy first class businesses • This category allows no time for slow assimilation so cultural due diligence is a must • Put first rate well connected executives in charge. Make it a high visibility assignments • Hold on the the talent if you can Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 17. 17 Distinct activities meansdiffering challenges Slide 2.7 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A • Give the acquired company a wide berth. Integration should be driven by specific opportunities to create value, not by a perceived need to create a symmetrical organization • As a top manager, be prepared to make the call about what to integrate and what to leave alone; also be ready to change that decision Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 18. 18 Distinct activities meansdiffering challenges Slide 2.8 The over capacity M&A Geographic Roll- up M&A Product or Market extension M&A M&A as R&D Industry Convergence M&A You can’t run a merged company until you’ve rationalized it, so decide what to eliminate quickly If it is the merger of equals and process and value differ greatly that except trouble Also (MOE) expect the management groups to fight for control These tend to be one time event, so they’re especially hard to pull off. Members of the acquired group may welcome your streamlined processes. If they don’t you can afford to ease them in slowly If a strong culture is in place, introduce new values with extreme care. Use carrot not sticks These are win-win scenario and they often go smoothly Know what you are buying; the farther you get from home the harder it is to be sure Expect cultural and governmental differences to interfere with integration The bigger you are relative to your target company, the better your chances for success The more practice you have the better your chances for success Build industrial strength evaluation processes so that you buy first class businesses This category allows no time for slow assimilation so cultural due diligence is a must Put first rate well connected executives in charge. Make it a high visibility assignments Hold on the the talent if you can Give the acquired company a wide berth. Integration should be driven by specific opportunities to create value, not by a perceived need to create a symmetrical organization As a top manager, be prepared to make the call about what to integrate and what to leave alone; also be ready to change that decision Source: Not all M&As are alike and that matters, HBR article Mar 2001 By Joseph L. Bower Mgmt. thought leadership
- 19. 19 Distinct activities meansdiffering challenges Slide 2.9 Areas of Integration The over capacity Geographic Roll-up Product or Market ext. R&D Industry Convergence MOE - MOE - MOE - MOE - MOE - Leadership VH H L VH L L H Facilities, BU’s VH L L L L L L Retaining People L M M H H VH L Business Processes/ IT VH H M VH H VH M Culture VH L L H M H L Values VH H H H M H L VH Very High M Medium MOE Mergers of Equals H High L Low Mgmt. thought leadership
- 20. 20 Slide 2.10 Source: HBR March2004 The Sin in Synergy by DON MOYER Mgmt. thought leadership
- 21. 21 The Sin inSynergy by DON MOYER Slide 2.11 Source: HBR March 2004 Mgmt. thought leadership
- 22. 22 Alternatives to thebig deal Slide 2.12 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out As Peter Drucker noted, for every mega-merger or large acquisition, there are usually several spin-offs, divestments or asset sales that can give companies – especially smaller ones – lot of growth opportunities BP- Amoco merger in 1998 led to the disposal of 12 oil storage terminal scattered across North America Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 23. 23 Alternatives to thebig deal Slide 2.13 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out It may still make sense to grow regionally rather than globally. Acquire companies – if needed – in a particular region that you understand well. Global merger demands a phenomenal integration which very few companies have Maytag and Lloyd’s Bank Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 24. 24 Alternatives to thebig deal Slide 2.14 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out A big deal takes a lots of time and consumes lots of managerial attantion. If others in you industry are busy with their mega-deals, you can exploit that fact to improve your own competitive position. While Glaxo Wellcome and SmithKline Beecham are busy in their post merger integrations. Merck decided to stay out an improve its position through aggressive marketing and other initiatives Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 25. 25 Alternatives to thebig deal Slide 2.15 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out An alternative to Merger is building scale through alliances and other relationships. Alliances bring about less resistance within companies, from government, and from other interested parties IBM entered into a standing agreement to purchase low prices PCs from Acer to resell under IBM brand Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 26. 26 Alternatives to thebig deal Slide 2.16 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out Even if it make sense for your organization to pursue global consolidation ask yourself if your industry offer significant firms mover advantages (for consolidation). If not it may be smarter for someone else go ahead and clear the path Tricon’s (Pizza Hut, Taco Bells and KFC) international strategy explicitly target markets in which McDonalds’s has already established a significant presence Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 27. 27 In case ofAOL Time Warner acquisition. TW’s shareholders did well in the immediate aftermath of the announcement; many of them rushed to cash out Alternatives to the big deal Slide 2.17 Pick up the Scraps Stay Home Keep your eye on the Ball Make friends Stalk your target Sell out Even in cases where the big deals makes sense, it may be better for your company’s shareholders if you are the seller rather than the buyer Source: The Dubious logic of Global Mega-mergers, HBR article July 2000 By:Pankaj Ghemawat and Fariborx Ghaddar Mgmt. thought leadership
- 28. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 29. 29Some empirical evidences Experience shows that 70% to 80% of acquisitions fail, meaning they create no wealth for the share owners of the acquiring company. Deal volume during the historic M&A wave of 1995 to 2000 totaled more than $12 trillion. By an extremely conservative estimate, these deals annihilated at least $1 trillion of share-owner wealth. For perspective, consider that the whole dot-com bubble probably cost investors $1 trillion at most. Slide 3.1Do acquisitions benefit shareholders? Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin
- 30. 30 The ShortRun Do acquisitions benefit shareholders ? (empirical evidence) Slide 3.2 Abnormal Stock Price change associated with corporate takeover bids Takeover Techniques Target Bidders SuccessfulBids Tender offer 30% 4% Merger 20% 0 Proxy contest 8% n.a. Tender offer -3% -1% UnsuccessfulBids Merger -3% -5% Proxy contest 8% n.a. Source: Modified from Michael C. Jensen and Richard S. Ruback, “ The market for Corporate control: The scientific Evidence, “Journal of Financial Economics 11 (April 1983) Some empirical evidences
- 31. 31 The LongRun Do acquisitions benefit shareholders ? (empirical evidence) Slide 3.3 Abnormal Five Year stock return of Acquiring firms (1970-1989) Acquirers using unfriendly cash tender offers 61.7 % Acquirers who pay cash 18.5 % All acquirers - 6.5 % Acquirers using stock - 24.2% Source: T.Lounghran and A.Vijh, “ do Long term shareholder benefit from corporate acquisitions” Working paper (April 1997) Some empirical evidences
- 32. 32 Slide 3.4 Some empirical evidences Prof.Harbir Singh and Prof. Maurizio Zollo, in the 1998 study, titled ‘Creating value in post acquisition integration process’ studied 228 acquisition in banking industry and tried to analyze the impact of the following on the performance of the acquisitions and also among them selves: Relatedness of resources Quality of the target Replacement of leadership Integration of merged entities Experience of acquisitions by the acquirer Codification of post acquisition experience Harbir Singh Professor of Management, Wharton Maurizio Zollo Asso Professor of Strategy and Management, INSEAD What really adds value and what destroys value Source: Createing value in Post-Acquisition integration process, By Prof Harbir Singh and Prof. Muurizio Zollo
- 33. 33 Characteristics of the targetfirm What really adds value and what destroys value Slide 3.5 Some empirical evidences Relatedness Quality Acquisition Performance Post Acquisition decisions Replacement Integration Learning Mechanism Codification Experience - + - - + + + + The fit between codification and integration has a very strong positive effect on performance Source: Createing value in Post-Acquisition integration process, By Prof Harbir Singh and Prof. Muurizio Zollo
- 34. 34 Fast and Steadyacquirers have done better Slide 3.6 Source: Your best M&A Strategy, HBR article by Sam Rovit and Catherine Lemire Some empirical evidences
- 35. 35 Fast and Steadyacquirers have done better Slide 3.6 Most important: these frequent buyers excelled at walking away from risky deals. At Cintas and Cisco, every deal gets scrutinized by a dispassionate executives. Source: Your best M&A Strategy, HBR article by Sam Rovit and Catherine Lemire Some empirical evidences
- 36. 36 Mixed ResultsTop-line tribulations 3 6 1 4 12 13 25 36 <3030-50 51-60 61-70 71-80 81-90 91-100 >100 Slide 3.7 Some empirical evidences Capturing Synergies is easy said than done % of companies (n=77) % of anticipated revenue synergies captured after merger 70% of mergers failed to achieve expected revenue synergies One quarter overestimated cost synergies by at least 25% % of companies (n=92) 23 5 13 7 14 8 13 17 0 5 10 15 20 25 <30 30-50 51-60 61-70 71-80 81-90 91-100 >100 % of anticipated cost synergies captured after merger
- 37. 37 What Does themarket Prefer Slide 3.8 Rewards Penalize Expansionists Transformatives Acquisitions Joint venture, Merger or sale Company that is: In a growing industry In a fragmented industry under-performing Company that is: In a stable industry In a consolidated industry Performing well Source: McKinsey quarterly 2001 Number 1. Some empirical evidences
- 38. 38 Revenue growth throughM&A is not easy Slide 3.9 Standard deviation of pre- and post- merger revenue growth from industry mean1 , for mergers in 1995 and 1996 1 Sample of >160 acquisitions by 157 publicly listed companies across 11 industry sectors; revenue growth calculated for combined entity 2–3 years before and after merger in question. Source: McKinsey quarterly 2001 Number 4. Some empirical evidences
- 39. 39 The illusion ofgrowth Slide 3.10 1 Compound annual growth rate. 2 Last full reporting year prior to acquisition; revenues of 5 acquired companies by year include $368 million, 1994; $502 million, 1995; $94 million, 1996; $88 million, 1999; $968 million, 1999. 3 Total revenue growth expected had acquirer and each target continued to grow at average growth rates for industry. Source: McKinsey quarterly 2001 Number 4. Some empirical evidences
- 40. 40 The illusion ofgrowth Slide 3.11 Whatever the merger’s objectives, revenue actually hits the bottom line harder. As shown, fluctuations in revenue can quickly outweigh fluctuations in planned cost savings.Given a 1 percent shortfall in revenue growth, a merger can stay on track to create value only if a company achieves cost savings that are 25 percent higher than those it had anticipated. Beating target revenue growth rates by 2 to 3 percent can offset a 50 percent failure on costs. Source: McKinsey quarterly 2001 Number 4. Some empirical evidences
- 41. 41 The illusion ofgrowth Slide 3.11 Whatever the merger’s objectives, revenue actually hits the bottom line harder. As shown, fluctuations in revenue can quickly outweigh fluctuations in planned cost savings.Given a 1 percent shortfall in revenue growth, a merger can stay on track to create value only if a company achieves cost savings that are 25 percent higher than those it had anticipated. Beating target revenue growth rates by 2 to 3 percent can offset a 50 percent failure on costs. Source: McKinsey quarterly 2001 Number 4. Other reasons that make revenue more important The market penalizes revenue slippage hard: failing to meet an earnings target by only 5 percent can result in a 15 percent decline in share prices Better for motivating talented employees - on either side Some empirical evidences
- 42. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Acquisition strategy framework Conclusion
- 43. 43 • Database • Desktopapplications • Storage • Middleware, application server Semiconductors ($174 billion) • Logic • Micro components • Memory • Analog • Semiconductor equipment • Discrete IT Services ($243 billion) • Professional and Outsourcing services Software ($146 billion) • Enterprise application • Operating systems • Vertical applications • Network/ systems management, security Hardware ($299 billion) • PCs/ notebooks • Servers • Networking • Printers • Storage • Smart handhelds Ripe for restructuring Slide 4.1 Key IT industries and segments, 2002 % of revenues Ripe for restructuring Source: McKinsey quarterly 2004 Number 1. High-tech industry trends
- 44. 44 If throughconsolidation and exits companies can reach the profit and cost structures of the current top three in each industry, total annual operating profits could rise by up to $18 billion$18 billion The Sector would gain $230 billion$230 billion in market value (15 to 20% of total) The scope of sectoral inefficiency Slide 4.2 Source: McKinsey quarterly 2004 Number 1. Potential EBIT improvement (Y), $ billion PCs/ Notebook Networking Storage 2.15 0.65 0.05 Hardware 2.85 Memory Semiconductor equipment Logic 1.30 0.85 0.55 Semiconductor 2.70 Enterprise application Middleware, application server Network/ systems management, security Storage 0.95 0.75 0.55 0.40 Software 2.85 IT Services 0.80 Total 9.00 Assuming that half of this efficiency is achievable High-tech industry trends
- 45. 45 Broad strategy Slide 4.3 Source: McKinseyquarterly 2004 Number 1. Type of Company Scale Scope Exit Market Leaders Grow bigger; buy or block challengers Cross sell to boost customer dependence Challengers Merge with peers Buy adjacent businesses Small Companies Carve out sustainable niche Maximum sale value Shape it or leave it High-tech industry trends
- 46. 46 M&A driving forces Slide 4.4 Source:McKinsey quarterly 2004 Number 1. Activity Drivers Examples Scale – Peer consolidation Improved fixed cost structures (SG&A, R&D, Depreciation) Customer preference for bigger suppliers Network platform effects Logic Memory Network/ systems mgmt, security Storage hardware Scope- Strategic cross segment moves Customer preferances for broader-reaching suppliers Channel cross selling synergies Technological synergies (networrking and storage) Value migration from hardware to software, services Maturing core business; capital market pressure Database, middleware, application server Hardware: IT services Networking hardware: storage hardware, software Semiconductor equipment Exit Desire to limit losses, free up capital Refocusing resources on other businesses Logic PCs/ notebooks High-tech industry trends
- 47. 47 In high techwinners take it all Slide 4.5 Source: 2001 McKinsey survey of 485 high-tech companies High-tech industry trends
- 48. 48 The golden rule Slide 4.6 Source:2001 McKinsey survey of 485 high-tech companies High-tech industry trends
- 49. 49 Recipe for success–steadydiet of small deals Slide 4.7 Source: 2001 McKinsey survey of 485 high-tech companies High-tech industry trends
- 50. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 51. Growing with Acquisitions Acase study on how Cisco Systems has mastered the art of acquisitions and integration
- 52. 52 M&A in Cisco’s12 general product categories Slide 5.1 Vignette – Cisco Systems Switching Routing/IP/VPN (8) Network Management/Internet Security Components ATM Token Ring Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California DSL/ISDN (8) Optical Platforms (7*) Next Generation Voice (11) Cable CMTS Wireless Content Delivery Devices * In general, the greater the aggregate deal count and the aggregate deal size, the more valuable the market can be assumed to be. From this perspective, the Optical Platforms category dwarfed the others accounting for 32.2 percent of total acquisition expenditures, and this is despite having made only seven acquisitions. Here, price was a direct function of the telecommunications bubble of the late 1990s.
- 53. 53 Acquisitions breakup by region 32 10 6 4 11 8 0 5 10 15 20 25 30 35 Northern California BostonTexas Israel Other U.S. Non-U.S. Annual number of acquisition 1 5 9 16 21 30 45 7169 0 5 10 15 20 25 30 1993 1994 1995 1996 1997 1998 1999 2000 2001 0 10 20 30 40 50 60 70 80 Acquisition characteristics Slide 5.2 Vignette – Cisco Systems Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California
- 54. 54 Acquisition Success andFailure Slide 5.3 Vignette – Cisco Systems Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California Name Market Capitalization Cisco Systems, Inc. 153674.92 LM Ericsson (ADR) 48591.23 Nortel Networks Corporation 30589.21 Lucent Technologies Inc. 17068.24 Juniper Networks, Inc. 9652.59 CIENA Corporation 2697.7 Extreme Networks, Inc 941.66 General Indicator
- 55. 55 Acquisition Success andFailure Slide 5.4 Vignette – Cisco Systems Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California General Indicator Companies Acquired Closing date Total value $ Closing Total Value $ 2/4/97 % Return (in millions) (in millions) Crescendo Sep-93 95 504 431% Newport Aug-94 93 526 466% Kalpana Dec-94 240 942 293% Lightstream Jan-95 120 120 Cash Deal Combinet Oct-95 132 252 91% Internet Junction Oct-95 6 10 67% Grand Junction Nov-95 400 630 58% Network Translation Inc. Nov-95 33 53 61% TGV Software Mar-96 138 186 35% Stratacom Jul-96 4666 5112 10% Nasboba Aug-96 100 114 14% Granite Sep-96 220 247 12% Telebit Oct-96 200 200 Cash Deal Netsys Nov-96 79 84 6%
- 56. 56 Acquisition Success andFailure Slide 5.5 Vignette – Cisco Systems Market Average: During the late 1990s Silicon Valley, employee turnover averaged 30 percent per annum (O'Reilly 2000: 50) and according to a 2000 Best Practices survey in the first year post-acquisition turnover is approximately 33 percent per annum (Thurm 2000). Cisco’s Performance : On an annualized basis as of 2001, 100 percent of the acquisitions had an overall annual turnover rate under 10 percent (n = 44) and 95 percent had an annual turnover rate among engineers of under 10 percent. Cost per acquired employee increased dramatically from roughly $1.8 million per person prior to 1996 to an average of $5.6 million in 2000. Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California Retention
- 57. 57 Acquisition Success andFailure Slide 5.6 Vignette – Cisco Systems Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California Retention A.Total T/O A. Eng T/O Category Y.Founded Location Compatible Systems 6.71 2.11 R 2000 Boulder, CO Geotel Communications 8.12 2.71 NGV 1999 Lowell, MA Amteva Technologies 7.28 3.15 NGV 1999 Glenn Allen, VA Cocom A/S 5.51 3.8 C 1999 Copenhagen, Denmark Fibex Systems 5.46 4.13 DSL 1999 Petaluma, CA WheelGroup 6.41 6.06 SW 1998 San Antonio, TX Sentient Networks 9.83 6.42 ATM 1999 Milpitas, CA Webline Communications 9.4 7.55 SW 1999 Burlington, MA Precept Software 8 8.7 R 1998 Palo Alto, CA Altiga Networks 8.38 13.33 R 2000 Franklin, MA Netsys Technologies 7.78 13.33 S 1996 Palo Alto, CA (R = Routing, NGV = Next Generation Voice, C = Cable, DSL = DSL, ATM = Asynchronous Transfer Mode, SW = Software, S = Switching).
- 58. 58 Acquisition Success andFailure Slide 5.7 Vignette – Cisco Systems Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California Market Share Growth 70% 60% 60% 60% 30%30% 40% 30% 30% 30% 30% 20% 25% 5% 10% 30% 20% 30% 129 3970 6727 5237 11061 1755 98612191279 250 0% 10% 20% 30% 40% 50% 60% 70% 80% Routing/IP/VPN Switching Token Ring Cable CMTS Next Generation Voice ContentDeliveryDevices ATM DSL/ISDN Optical Platforms Wireless 0 2000 4000 6000 8000 10000 12000 Market Share 5 yr. Annualized Growth Dealsize
- 59. 59 Cisco’s acquisition strategy Slide 5.9 Vignette– Cisco Systems In 1997 John Chambers, the Cisco CEO, articulated five guidelines by which to judge the desirability of potential acquisitions (Rifkin 1997) Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California John Chambers President and CEO
- 60. 60 Cisco’s acquisition strategy Slide 5.10 Vignette– Cisco Systems Both firms must share similar visions “about where the industry is going [and] what role each company wants to play in the industry. So you have to look at the visions of both companies and if they are dramatically different, you should back away.” The acquisition must “produce quick wins for [the] shareholders.” There must be “long-term wins for all four constituencies -- shareholders, employees, customers, and business partners.” “The chemistry (between the companies) has to be right.” He thought that this was difficult to define, but involved both parties being comfortable with their counterparts. Geographic proximity is important. If the newly acquired firm is located close to Cisco, then interaction will be easier. Source: Understanding Cisco’s Acquisition and Development Strategy (Working paper , 2004) By: Prof. Martin F. Kenney, Department of Human and Community Development, Univ. of California
- 61. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 62. 62 Seven steps backto sanity Slide 6.1 Common biases in valuation The cost of equity used for an investment should reflect the risk of the investment and not the risk characteristics of the investor who raised the funds. Risky businesses cannot become safe just because the buyer of these businesses is in a safe business. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern Step 7: Don’t transfer your risk characteristics to the target firm If you fail on this principle, safe companies will end up overvaluing and overpaying for risky companies (as many did in the late 1990s)
- 63. 63 Seven steps backto sanity Slide 6.2 Common biases in valuation As an acquiring firm, it is entirely possible that you can borrow much more than the target firm can on its own and at a much lower rate. If you build these characteristics into the valuation of the target firm, you are essentially transferring wealth from your firm’s stockholder to the target firm’s stockholders. When valuing a target firm, use a cost of capital that reflect’s the debt capacity and the cost of debt that would apply to the firm. Step 6: Render unto the target firm that which is the target firm’s but not a penny more..Don’t transfer your risk characteristics to the target firm The minute you start building into the valuation strengths that flow from you (as the acquiring firm), you start giving target firm stockholders premiums that they do not deserve. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 64. 64 Seven steps backto sanity Slide 6.7 Common biases in valuation Valuation is cluttered with rules of thumb. After painstakingly valuing a target firm, using your best estimates, you will be often be told that It is common practice to add arbitrary premiums for brand name, quality of management, control etc… The target company is cheap if it trades at below some arbitrary value – 8 times EBITDA, 15 times earnings, PE less than the growth rate, below book value… Step 5: Beware of rules of thumb Rules of thumb in billion dollar valuations are signs of laziness and indicate an unwillingness to actually estimate the value of control or what a reasonable value to EBITDA multiple is for a firm. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 65. 65 Seven steps backto sanity Slide 6.8 Common biases in valuation Through time, acquirers have always found ways of justifying paying for premiums over estimated value by using buzz words - synergy in the 1980s, strategic considerations in the 1990s and real options in this decade. While all of these can have value, the onus should be on those pushing for the acquisitions to show that they do and not on those pushing against them to show that they do not. Step 4: Don’t pay for buzz words Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 66. 66 Seven steps backto sanity Slide 6.8 Common biases in valuation All too often acquisitions are justified by using one of the following two arguments: • Every one else in your sector is doing acquisitions. You have to do the same to survive. • The value of a target firm is based upon what others have paid on acquisitions, which may be much higher than what your estimate of value for the firm is. With the right set of comparable firms (selected to back up your story), you can justify almost any price. Step 3: Don’t be a lemming The fact that everyone else in the sector is doing bad acquisitions and over paying for them is not a good reason to join the group. It is entirely possible that you are operating in a value destroying sector and it may be time for you to consider shrinking. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 67. 67 Seven steps backto sanity Slide 6.9 Common biases in valuation If you define your objective in a bidding war as winning the auction, you will win. But beware the winner’s curse. The premiums paid on acquisitions often have nothing to do with synergy, control or strategic considerations (though they may be provided as the reasons). They may just reflect the biases of the CEOs of the acquiring firms and I-Banker’s valuation. The opinions of investment banks on the value of the deal itself are worth nothing (though they will charge you a substantial fee for offering them). Investment bankers make their money on the size of the deal and not on it’s quality. Step 2: Don’t let egos or investment bankers get the better of common sense… Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 68. 68 Seven steps backto sanity Slide 6.10 Common biases in valuation Firms that do acquisitions often do so because they want to grow fast and at low cost. It is true that mature companies can buy growth companies and thus push up earnings growth, but at what price? If you pay too much for growth, your stockholders will be worse off… On average, the stock prices of acquiring firms falls on the date of the acquisition announcement by 3-4%. Step 1: With acquisitions, recognize that the odds are against you… Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 69. 69 Synergy: Oft promised,seldom delivered… Slide 6.11 Common biases in valuation • McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for evidence on two questions – - Did the return on the amount invested in the acquisitions exceed the cost of capital? - Did the acquisitions help the parent companies outperform the competition? • They concluded that 28 of the 58 programs failed both tests, and 6 failed at least one test. • KPMG in a more recent study of global acquisitions concludes that most mergers (>80%) fail - the merged companies do worse than their peer group. • Large number of acquisitions that are reversed within fairly short time periods. In studies that have tracked acquisitions for longer time periods (ten years or more) the divestiture rate of acquisitions rises to almost 50%. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 70. 70 Seven steps backto sanity Slide 6.12 Common biases in valuation As a firm becomes badly run, the status quo value can very quickly deviate from the optimal value. In practice, getting an optimal value will require assumptions about: Investment policy: What types of margins and returns on capital a well run firm will have in this business? (You can compare your firm to the industry averages, for instance) Capital structure: Is your firm under levered? Dividend and Reinvestment policy: Is the firm reinvesting too little (if the ROC is way above the cost of capital) or too much (if it is earning well below the cost of capital) Once you value control, you have to figure out how much of the control you are willing to concede to target firm stockholders and how much you will claim for yourself. As a general rule, you should try to lay claim to any part of control that you feel would be impossible to claim without your intervention. How much Mgmt. Control worth? Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 71. 71 When do Synergieswork better Slide 6.13 Common biases in valuation In general, Mergers of equals are less likely to work than mergers of unequals - the political and cultural clashes are much more difficult to resolve. Cost saving mergers seem to have better odds of success than growth synergy mergers. (Perhaps cost savings are more tangible and easier to deliver) Some of the most successful acquisition strategies have been directed towards acquiring private firms where you do not have premium on the market price. Mergers are more likely to work when firms plan for synergy before the merger rather than just hope that synergy shows up. Source: Aswath Damodaran, Prof. Of Finance, NYU Stern
- 72. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
- 73. 73 M&A Identification Framework Evaluation methodology Individual investment lifecycle Slide 7.1 AcquisitionStrategy Framework Acquire funds to invest Identify investment needs Investigate available products Effect transaction Integrate Manage & make profits Sell Reinvent
- 74. 74 Identification framework (iF) Slide 7.2 AcquisitionStrategy Framework ALLIANCE / ACQUISITION IMPERATIVE
- 75. 75 Identification framework Slide 7.3 Acquisition StrategyFramework Source: Booz-Allen & Hamilton Over capacity Geographic Roll-up Mkt. Extension R&D Ind. Convergence iF
- 76. 76 0 2 4 6 8 10 Distribution skills Netw orkcoverage Cash Market share Company Credibility Public Acceptability R&D Sales and Marketing Customer Service Market Know how Technical Skills Opeartion Skills Capabilities and position asset analysis Slide 7.4 Acquisition Strategy Framework Source: Booz-Allen & Hamilton CAPABILITIES POSITIONAL ASSETS Know-How • Technology • Application experience • Customer knowledge Mkt. Presence • Market chare • Product portfolio • Franchise Processes • Technology • Delivery • Management/ Control Infrastructure • Facilities • Distribution chains • Supply chains • Systems iF
- 77. 77 Identification framework Slide 7.5 Acquisition StrategyFramework Over capacity Geographic Roll-up Mkt. Extension R&D Ind. Convergence OPPORTUNITY SIZE iF
- 78. 78 Looking at acquisitionthrough a balance sheet Slide 7.6 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Before Acquisition After Acquisition Revenue 1,000$ 1,000$ Cost 900$ 900$ Net operating profit after tax 100$ 100$ Invested capital 500$ 3,000$ Return on invested capital 20.00% 3.33% Cost of capital 10% 10% Economic profit 50$ (200)$ Market value/ intrinsic value 2,000$ 2,000$ Share owner value creation 1,500$ (1,000)$ Acquisition Strategy Framework eF
- 79. 79 Looking at acquisitionthrough a balance sheet Slide 7.7 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Before Acquisition After Acquisition Revenue 1,000$ 1,000$ Cost 900$ 700$ Net operating profit after tax 100$ 300$ Invested capital 500$ 3,000$ Return on invested capital 20.00% 10.00% Cost of capital 10% 10% Economic profit 50$ -$ Market value/ intrinsic value 2,000$ 2,000$ Share owner value creation 1,500$ (1,000)$ Even $ 200 MM in cost cutting (though quite unlikely) Leads to Acquisition Strategy Framework eF
- 80. 80 Wall Streetanalysts have shown that the deal will not dilute earnings. (Preoccupation with the Income St.) Wall St. Analyst What happens in (unperfected) real world Slide 7.8 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin CFO is waving around discounted cash flow analyses (heavily loaded on the back end, with the payoff coming five to ten years out) Mr. CFO Acquisition Strategy Framework eF
- 81. 81 Wall Streetanalysts have shown that the deal will not dilute earnings. (Preoccupation with the Income St.) Wall St. Analyst What should happens in a perfect world Slide 7.9 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin CFO is waving around discounted cash flow analyses (heavily loaded on the back end, with the payoff coming five to ten years out) Mr. CFO What investors should really worry about is not earnings dilution but rather dilution of ROIC and economic profit. The acquisition in our example is hugely dilutive to economic profit, which declines from $50 million to negative $200 million. Acquisition Strategy Framework eF
- 82. 82 Buying apples ina grocery store Slide 7.10 Apples 1 Pound $ 0.89 $ 1.29 / pound V/S Acquisition Strategy Framework eF
- 83. 83 What’s the commontheme? Slide 7.11 Ten largest M&A deals AOL and Time Warner Pfizer and Warner-Lambert Exxon and Mobil Comcast and AT&T Broadband Verizon and GTE Travelers and Citicorp SBC and Ameritech Pfizer and Pharmacia NationsBank and Bank of America Vodafone and AirTouch CUSTOMERS Its all about cross selling Of course, there are other reasons to buy a company: to get real estate / other facilities, brands, trademarks, patents, technology, or employees. But ultimately, it’s still about the customers. The acquirer buys those capabilities to help it serve existing customers better or to help it acquire new ones. Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Acquisition Strategy Framework eF
- 84. 84 New customer portfolioapproach to M&A Slide 7.12 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin For two years Larry and Geoffrey analyzed companies – not in the traditional way, as a portfolio of products, services, territories, or functions, but rather as a portfolio of customers. One implication of this research is that managers who want to increase the value of their company must understand the true economic profitability of customers. They must also understand that their company’s value is actually the aggregated value of their customers. Larry Selden Professor of finance and economics at Columbia University’s Graduate School of Business Geoffrey Colvin senior editor-at-large at Fortune magazine and co-anchor of Wall Street Week with Fortune on PBS. They are also the authors of Angel Customers & Demon Customers Acquisition Strategy Framework eF
- 85. 85 Segmenting the customerportfolio Slide 7.13 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Recall the deal we imagined earlier, this time supposing that the target company’s customers are classified into four profitability quartiles. From most profitable quartile to least, we’ll call them the Darlings, the Dependables, the Duds, and the Disasters. For simplicity, the company’s capital is divided equally among the four quartiles. Each customer quartile is assigned an after-tax operating profit; Acquisition Strategy Framework eF
- 86. 86 Slide 7.14 Source: M&A needn’tbe a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Segmenting the customer portfolio Acquisition Strategy Framework eF
- 87. 87 Rationalizing M&A usingcustomer profitability Slide 7.15 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Acquisition Strategy Framework eF
- 88. 88 Steps to ‘customerportfolio‘ acquisition Slide 7.16 Source: M&A needn’t be a loser’s game, HBR article June 2003 By Larry Selden and Geoffrey Colvin Step one Build your customer profitability portfolio Step two Build the target company’s customer profitability portfolio (May be guesstimate or could be a detail analysis if the target co. agrees to it) Step three Rationalize target co.’s customer portfolio and assess the value Step four Rationalize combined cust. portfolio and assess the value add to both your customers and the target co.’s customers. Acquisition Strategy Framework eF
- 89. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Case Study – Cisco Systems Acquisition strategy framework Conclusion
- 90. 90 A few pointsworth thinking Slide 8.1 Final facts of M&A BIG may not be Bogus but it’s surely dangerous (Though investment bankers love big deals) Acquiring publicly traded companies is more complicated (and expensive) than private companies (Though investment bankers love the former) In Knowledge industry acquisition success depends a lot on employee retention of the acquired firm (friendly takeovers) Practice makes the man (and companies) perfect; Experienced acquirers perform relatively better – only when they codify the experience/ process Transformation M&A’s have higher chance of failure than Expansion M&A (shareholders can diversify themselves)
- 91. 91 Slide 8.2 Final facts ofM&A High performers are good to admire, but not so good to acquire Successful acquirers have learnt the art of walking away from deals viii.The uncertainty in M&A is mostly about culture and operations (Post deal, when I-Bankers are not around), involving people, from both sides, who know the culture and operations is a good way to hedge such risks Winners of bidding war may face the winner’s curse A detailed rationalization plan is needed before the deal is finalized (with a built in exit plan) A few points worth thinking
- 92. 92 Slide 8.3 Final facts ofM&A There are other innovative ways to M&A • Venture investment oriented M&A • Buying/ partnering in the venture funded deals • JVs with built in buy out options • Buying small and private companies that are under performing • Buying out leftovers from big deals • And many more… A few points worth thinking
- 93.
- 94. 94 Deals thatare part of an “expansion program” in which company seek to boost its market share by consolidating. • NOT the deals that are “transformative” deals, those that seek to move companies into new lines of business or to remove the chunk of an otherwise healthy portfolio What Does the market Prefer Source: McKinsey quarterly 2001 Number 1. Some empirical evidences
- 95. 95 Acquisition createthe most market value overall, despite the well known “winner’s curse”. What Does the market Prefer Source: McKinsey quarterly 2001 Number 1. Some empirical evidences
- 96. 96 Finally, ifa company competes in a growing or fragmented industry, or if the performance of the company has recently lagged behind that of its peers, some signs indicate that the market may reward its transaction more than those of stronger performers. What Does the market Prefer Source: McKinsey quarterly 2001 Number 1. Some empirical evidences
- 97. By: Abhishek Breja feb2004CreatingCreating ValueValue throughthrough M&AM&A Defining M&A and value Mgmt. thought leadership Some empirical evidences High-tech industry trends Vignette – Cisco Systems Common biases in valuation Acquisition strategy framework Conclusion
Editor's Notes
- #34 Relatedness of resources between target and acquirer does not affect performance. Quality of the target has a negative effect on performance Relatedness encourages replacement and integration, while quality discourages both. Replacement of leadership has a negative effect on performance Integration has a positive effect on performance Experience has a positive effect on performance, but only if built on homogeneous acquisitions The fit between codification and integration has a very strong positive effect on performance Both experience and codification encourage acquirers to achieve higher levels of integration and replacement
- #57 In terms of turnover, we examined all the acquisitions with a greater than 5 percent annualized turnover for either total employees or engineers to see if there were any commonalties (Table 2). The first commonality was that, with the exception of one firm, all high-turnover firms were acquired in 1998 or later. There are a number of possible explanations for this. The first explanation is that turnover is highest during the first year of acquisition. The second explanation does not exclude the first, but adds that during 1999 and most of 2000 the labor market for experienced employees in the data communication equipment industry was torrid making job-hopping pervasive. Though our evidence is anecdotal and speculative, it is possible that many of these firms were, in the terminology of the period, “built to flip,” and the entrepreneurs upon selling their firms, resigned and took as many of their team as possible to start another firm. These explanations are only partial, but likely explain a portion of the turnover story.
- #63 Test 1: Risk Tolerance The target firm has the following income statement: Revenues 100 - Operating Expenses 80 = Operating Income 20 - Taxes 8 = After-tax OI 12 Assume that this firm will generate this operating income forever (with no growth) and that the cost of equity for this firm is 20%. The firm has no debt outstanding. What is the value of this firm? Could not be simpler: Value of the firm = 12/.20 = 60 million Assume that as an acquiring firm, you are in a much safer business and have a cost of equity of 10%. What is the value of the target firm to you? Does not change. You cannot make the argument (though many do) that since it is your equity that is being used to fund the acquisition, you can use your cost of equity (which would lead you to double the value of the target firm).
- #64 Test 2: Cheap debt? Assume as an acquirer that you have access to cheap debt (at 4%) and that you plan to fund half the acquisition with debt. How much would you be willing to pay for the target firm? This is a tougher one and you may be tempted to argue that the new cost of capital for the target firm will be: Cost of capital = 20% (.5) + 4% (.5) = 12% This would lead you to value the target firm at 100. What is the problem with doing this? Remember that the reason you are able to borrow money is because you as the acquiring firm have excess debt capacity and you are able to borrow at low rates because you have no default risk. If you use this lower cost of capital, you are in effect subsidizing the target firm stockholders with your excess debt capacity. How about if the target firm could have afforded to have a 50% debt ratio and a 4% cost of debt? That is a different question and can be considered a value for control. If you pay 100, though, you do all the work of bringing them to their optimal debt ratio and the target firm stockholders walk away with all of the benefits.
- #65 Test 3: Control Premiums Assume that you are now told that it is conventional to pay a 20% premium for control in acquisitions and that you are still okay because you will be paying only 6 times EBITDA. How much would you be willing to pay for the target firm? Wrong on both counts. Control can be worth nothing (or 50%) and rules of thumb are useless.
- #66 A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth), relative to their competitors, after takeovers. McKinsey and Co. examined 58 acquisition programs between 1972 and 1983 for evidence on two questions – Did the return on the amount invested in the acquisitions exceed the cost of capital? Did the acquisitions help the parent companies outperform the competition? They concluded that 28 of the 58 programs failed both tests, and 6 failed at least one test. KPMG in a more recent study of global acquisitions concludes that most mergers (&gt;80%) fail - the merged companies do worse than their peer group. Large number of acquisitions that are reversed within fairly short time periods. bout 20.2% of the acquisitions made between 1982 and 1986 were divested by 1988. In studies that have tracked acquisitions for longer time periods (ten years or more) the divestiture rate of acquisitions rises to almost 50%.
- #67 Test 5: Comparables and Exit Multiples Now assume that you are told that an analysis of other acquisitions reveals that acquirers have been willing to pay 5 times EBIT. Given that your target firm has EBIT of $ 20 million, would you be willing to pay $ 100 million for the acquisition? Two basic problems here: Sampling bias: Looking at transaction multiples (on other acquisitions), you are looking a sample of firms that are likely to have over paid. If you are going to do relative valuation, at least look at how other publicly traded companies in the sector are trading at. Better still, try to control for differences between your firm and these comparable firms. If the market is, on average, wrong and overpaying for stocks in a sector, you will end up overpaying as well. This problem becomes even worse when you use the industry average to estimate terminal value in acquisition valuations. If the market is wrong, it is likely to correct well before you get to your terminal year.
- #71 Test 3: Control Premiums Assume that you are now told that it is conventional to pay a 20% premium for control in acquisitions and that you are still okay because you will be paying only 6 times EBITDA. How much would you be willing to pay for the target firm? Wrong on both counts. Control can be worth nothing (or 50%) and rules of thumb are useless.