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A merger adds value only if synergies, better management, or other changes
make the two firms worth more together than apart.

It would be convenient if we could say that certain types of mergers are usually suc-
cessful and other types fail. Unfortunately, there are no such simple generalizations.
Many mergers that appear to make sense nevertheless fail because managers cannot
handle the complex task of integrating two firms with different production processes,
accounting methods, and corporate cultures. Moreover, the value of most businesses de-
pends on human assets”managers, skilled workers, scientists, and engineers. If these
people are not happy in their new roles in the acquiring firm, the best of them will leave.
Beware of paying too much for assets that go down in the elevator and out to the park-
ing lot at the close of each business day.
With this caveat in mind, we will now consider possible sources of synergy.


ECONOMIES OF SCALE
Just as most of us believe that we would be happier if only we were a little richer, so
managers always seem to believe their firm would be more competitive if only it were
just a little bigger. They hope for economies of scale, that is, the opportunity to spread
fixed costs across a larger volume of output. The banking industry provides many ex-
amples. By the 1970s, it was clear that the United States had too many small, local
banks. Some (now very large) banks grew by systematically buying up smaller banks
and streamlining their operations. Most of the cost savings came from consolidating
“backoffice” operations, such as computer systems for processing checks and credit-
card transactions and payments.
These economies of scale are the natural goal of horizontal mergers. But they have
been claimed in conglomerate mergers, too. The architects of these mergers have
pointed to the economies that come from sharing central services such as accounting,
financial control, and top-level management.


ECONOMIES OF VERTICAL INTEGRATION
Large industrial companies commonly like to gain as much control and coordination as
possible over the production process by expanding back toward the output of the raw
material and forward to the ultimate consumer. One way to achieve this is to merge with
a supplier or a customer. Consider Du Pont™s purchase of an oil company, Conoco. This
was vertical integration because petroleum is the ultimate raw material for much of Du
Pont™s chemical production.
Do not assume that more vertical integration is necessarily better than less. Carried
to extremes, it is absurdly inefficient. For example, before the Polish economy was re-
structured, LOT, the Polish state airline, found itself raising pigs to make sure that its
employees had fresh meat on their tables. (Of course, in a centrally managed economy
it may prove necessary to grow your own meat, since you can™t be sure you™ll be able to
buy it.)
Vertical integration is less popular recently. Many companies are finding it more ef-
ficient to outsource the provision of many activities. For example, Du Pont seems to
have become less convinced of the benefits of vertical integration, for in 1999 it sold
off Conoco.
574 SECTION SIX


COMBINING COMPLEMENTARY RESOURCES
Many small firms are acquired by large firms that can provide the missing ingredients
necessary for the firm™s success. The small firm may have a unique product but lack the
engineering and sales organization necessary to produce and market it on a large scale.
The firm could develop engineering and sales talent from scratch, but it may be quicker
and cheaper to merge with a firm that already has ample talent. The two firms have
complementary resources”each has what the other needs”so it may make sense for
them to merge. Also the merger may open up opportunities that neither firm would pur-
sue otherwise. Federal Express™s purchase of Caliber System, a trucking company, is an
example. Federal Express specializes in shipping packages by air, mostly for overnight
delivery. Caliber™s RMS subsidiary moves nonexpress packages by truck. RMS greatly
increases Federal Express™s capability to move packages on the ground. At the same
time, RMS-originated business can move easily on the Federal Express system when
rapid or distant delivery is essential.


Complementary Resources
EXAMPLE 1
Of course two large firms may also merge because they have complementary resources.
Consider the 1989 merger between two electric utilities, Utah Power & Light and
PacifiCorp, which serves customers in California. Utah Power™s peak demand comes in
the summer, for air conditioning. PacifiCorp™s peak comes in the winter, for heating.
The savings from combining the two firms™ generating systems were estimated at $45
million annually.



MERGERS AS A USE FOR SURPLUS FUNDS
Suppose that your firm is in a mature industry. It is generating a substantial amount of
cash, but it has few profitable investment opportunities. Ideally such a firm should dis-
tribute the surplus cash to shareholders by increasing its dividend payment or by repur-
chasing its shares. Unfortunately, energetic managers are often reluctant to shrink their
firm in this way.
If the firm is not willing to purchase its own shares, it can instead purchase some-
one else™s. Thus firms with a surplus of cash and a shortage of good investment oppor-
tunities often turn to mergers financed by cash as a way of deploying their capital.
Firms that have excess cash and do not pay it out or redeploy it by acquisition often
find themselves targets for takeover by other firms that propose to redeploy the cash for
them. During the oil price slump of the early 1980s, many cash-rich oil companies
found themselves threatened by takeover. This was not because their cash was a unique
asset. The acquirers wanted to capture the companies™ cash flow to make sure it was not
frittered away on negative-NPV oil exploration projects. We return to this free-cash-
flow motive for takeovers later.
We have discussed how mergers may make economic sense, but things can still go
wrong when managers don™t do their homework. That was the case for Converse Inc.,
which produces athletic shoes. In May 1995 Converse announced that it was acquiring
Apex One, a leading maker of sportswear. Apex brought with it a number of valuable
licenses for professional and college teams. As one enthusiast observed, “By letting
them outfit athletes from head to toe, the Apex deal potentially puts them on an even
Mergers, Acquisitions, and Corporate Control 575


keel with Nike and Reebok.” However, 85 days later Converse closed down Apex One
after incurring a $46 million loss on its investment.
What went wrong? The problem appears to have begun when Apex was several
months late in introducing its fall product lines. Converse™s management complained
that, in light of these delays, Apex™s $100 million revenue projection at the time of the
purchase had been unrealistic and over the next 3 months projections were progres-
sively scaled back to $40 million. Inevitably, the closure of Apex was followed by a vol-
ley of legal suits.4



Dubious Reasons for Mergers
The benefits that we have described so far all make economic sense. Other arguments
sometimes given for mergers are more dubious. Here are two.

DIVERSIFICATION
We have suggested that the managers of a cash-rich company may prefer to see that
cash used for acquisitions. That is why we often see cash-rich firms in stagnant indus-
tries merging their way into fresh woods and pastures new. What about diversification
as an end in itself? It is obvious that diversification reduces risk. Isn™t that a gain from
merging?
The trouble with this argument is that diversification is easier and cheaper for the
stockholder than for the corporation. Why should firm A buy firm B to diversify when
the shareholders of firm A can buy shares in firm B to diversify their own portfolios?
It is far easier and cheaper for individual investors to diversify than it is for firms to
combine operations.

THE BOOTSTRAP GAME
During the 1960s some conglomerate companies made acquisitions which offered no
evident economic gains. Nevertheless, the conglomerates™ aggressive strategy produced
several years of rising earnings per share. To see how this can happen, let us look at the
acquisition of Muck and Slurry by the well-known conglomerate World Enterprises.


The Bootstrap Game
EXAMPLE 2
The position before the merger is set out in the first two columns of Table 6.2. Notice
that because Muck and Slurry has relatively poor growth prospects, its stock sells at a
lower price-earnings ratio than World Enterprises (line 3). The merger, we assume, pro-
duces no economic benefits, so the firms should be worth exactly the same together as
apart. The value of World Enterprises after the merger is therefore equal to the sum of
the separate values of the two firms (line 6).
Since World Enterprises stock is selling for double the price of Muck and Slurry stock

4 This description of the Apex One purchase draws on M. Maremount, “How Converse Got Its Laces All Tan-
gled,” Business Week, September 4, 1995, p. 37, and A. Bernstein, “Converse, Apex Sellers Point Fingers in
Court Battle,” Sporting Goods Business, May 1996, p. 8.
576 SECTION SIX


TABLE 6.2
World Enterprises
Impact of merger on market
World Enterprises Muck (after acquiring
value and earnings per share
(before merger) and Slurry Muck and Slurry)
of World Enterprises
1. Earnings per share $2.00 $2.00 $2.67
2. Price per share $40.00 $20.00 $40.00
3. Price-earnings ratio 20 10 15
4. Number of shares 100,000 100,000 150,000
5. Total earnings $200,000 $200,000 $400,000
6. Total market value $4,000,000 $2,000,000 $6,000,000
7. Current earnings per
dollar invested in stock
(line 1 divided by line 2) $.05 $.10 $.067

Note: When World Enterprises purchases Muck and Slurry, there are no gains. Therefore, total earnings and
total market value should be unaffected by the merger. But earnings per share increase. World Enterprises
issues only 50,000 of its shares (priced at $40) to acquire the 100,000 Muck and Slurry shares (priced at
$20).


(line 2), World Enterprises can acquire the 100,000 Muck and Slurry shares for 50,000
of its own shares. Thus World will have 150,000 shares outstanding after the merger.
World™s total earnings double as a result of the acquisition (line 5), but the number
of shares increases by only 50 percent. Its earnings per share rise from $2.00 to $2.67.
We call this a bootstrap effect because there is no real gain created by the merger and
no increase in the two firms™ combined value. Since World™s stock price is unchanged
by the acquisition of Muck and Slurry, the price-earnings ratio falls (line 3).
Before the merger, $1 invested in World Enterprises bought 5 cents of current earn-
ings and rapid growth prospects. On the other hand, $1 invested in Muck and Slurry
bought 10 cents of current earnings but slower growth prospects. If the total market
value is not altered by the merger, then $1 invested in the merged firm gives World
shareholders 6.7 cents of immediate earnings but slower growth than before the merger.
Muck and Slurry shareholders get lower immediate earnings but faster growth. Neither
side gains or loses provided that everybody understands the deal.
Financial manipulators sometimes try to ensure that the market does not understand
the deal. Suppose that investors are fooled by the exuberance of the president of World
Enterprises and mistake the 33 percent postmerger increase in earnings per share for
sustainable growth. If they do, the price of World Enterprises stock rises and the share-
holders of both companies receive something for nothing.


You should now see how to play the bootstrap game. Suppose that you manage a
company enjoying a high price-earnings ratio. The reason it is high is that investors an-
ticipate rapid growth in future earnings. You achieve this growth not by capital invest-
ment, product improvement, or increased operating efficiency, but by purchasing slow-
growing firms with low price-earnings ratios. The long-run result will be slower growth
and a depressed price-earnings ratio, but in the short run earnings per share can increase
dramatically. If this fools investors, you may be able to achieve the higher earnings per
share without suffering a decline in your price-earnings ratio. But in order to keep fool-
ing investors, you must continue to expand by merger at the same compound rate. Ob-
viously you cannot do this forever; one day expansion must slow down or stop. Then
earnings growth will cease, and your house of cards will fall.
Mergers, Acquisitions, and Corporate Control 577



Buying a firm with a lower P/E ratio can increase earnings per share. But the
increase should not result in a higher share price. The short-term increase in
earnings should be offset by lower future earnings growth.



Suppose that Muck and Slurry has even worse growth prospects than in our example
Self-Test 2
and its share price is only $10. Recalculate the effects of the merger in this case. You
should find that earnings per share increase by a greater amount, since World Enter-
prises can now buy the same current earnings for fewer shares.




Evaluating Mergers
If you are given the responsibility for evaluating a proposed merger, you must think
hard about the following two questions:
1. Is there an overall economic gain to the merger? In other words, is the merger value-
enhancing? Are the two firms worth more together than apart?
2. Do the terms of the merger make my company and its shareholders better off? There
is no point in merging if the cost is too high and all the economic gain goes to the
other company.
Answering these deceptively simple questions is rarely easy. Some economic gains can
be nearly impossible to quantify, and complex merger financing can obscure the true
terms of the deal. But the basic principles for evaluating mergers are not too difficult.


MERGERS FINANCED BY CASH
We will concentrate on a simple numerical example. Your company, Cislunar Foods, is
considering acquisition of a smaller food company, Targetco. Cislunar is proposing to
finance the deal by purchasing all of Targetco™s outstanding stock for $19 per share.
Some financial information on the two companies is given in the left and center
columns of Table 6.3.

TABLE 6.3
Combined
Cislunar Foods is
Cislunar Foods Targetco Companies
considering an acquisition of
Revenues $150 $ 20 $172 (+2)
Targetco. The merger would
Operating costs 118 16 132 (“2)
increase the companies™
Earnings $ 32 $4 $ 40 (+4)
combined earnings by $4
Cash $ 55 $ 2.5
million.
Other assets™ book value 185 17.0
Total assets $240 $ 19.5
Price per share $ 48 $ 16
Number of shares 10.0 2.5
Market value $480 $ 40

Note: Figures in millions except price per share.

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