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March 31, 1996

Cable Plant Characteristics:
Plant miles 34,429
Fiber route miles 3,015
Fiber strand miles 65,020
Fiber nodes 1,948
Homes passed per ¬ber node 1,273
Channel Capacity (plant miles):
Less than 400 Mhz 8,592
400 Mhz up to 550 Mhz 15,724
550 Mhz or more 10,113
Total plant miles 34,429
Channel Capacity (percent of plant miles):
Less than 400 Mhz 25.0%
400 Mhz up to 550 Mhz 45.6%
550 Mhz or more 29.4%
Total plant miles 100.0%
Services Capability (as a percent
of total plant miles):
Digital video 100.0%
Interactive video 23.4%
One-way data transmission 100.0%
Two-way data transmission 23.4%
Residential telephone 9.0%
15
15 Mer g e rs an d Ac q u is it io n s
chapter



M ergers and acquisitions have long been a popular form of corpo-
rate investment, particularly in countries with Anglo-American forms of capital markets.
There is no question that these transactions provide a healthy return to target stockhold-
ers. However, their value to acquiring shareholders is less understood. Many skeptics
point out that given the hefty premiums paid to target stockholders, acquisitions tend to
Business Analysis and
3

be negative-valued investments for acquiring stockholders.1
Valuation Applications

A number of questions can be examined using ¬nancial analysis for mergers and ac-
quisitions:
• Securities analysts can ask: Does a proposed acquisition create value for the acquir-
ing firm™s stockholders?
• Risk arbitrageurs can ask: What is the likelihood that a hostile takeover offer will
ultimately succeed, and are there other potential acquirers likely to enter the bid-
ding?
• Acquiring management can ask: Does this target fit our business strategy? If so,
what is it worth to us, and how can we make an offer that can be successful?
• Target management can ask: Is the acquirer™s offer a reasonable one for our stock-
holders? Are there other potential acquirers that would value our company more
than the current bidder?
• Investment bankers can ask: How can we identify potential targets that are likely to
be a good match for our clients? And how should we value target firms when we
are asked to issue fairness opinions?
In this chapter we focus primarily on the use of ¬nancial statement data and analysis
directed at evaluating whether a merger creates value for the acquiring ¬rm™s stockhold-
ers. However, our discussion can also be applied to these other merger contexts.
Our discussion of whether acquisitions create value for acquirers focuses on evaluat-
ing motivations for acquisitions, the pricing of offers, and the methods of ¬nancing, as
well as assessing the likelihood that an offer will be successful. Throughout the chapter
we use AT&T™s $7.5 billion acquisition of NCR in 1991 to illustrate how ¬nancial analy-
sis can be used in a merger context.2


MOTIVATION FOR MERGER OR ACQUISITION
There are a variety of reasons that ¬rms merge or acquire other ¬rms. Some acquiring
managers may want to increase their own power and prestige. Others, however, realize

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Mergers and Acquisitions




that business combinations provide an opportunity to create new economic value for
their stockholders. New value can be created in the following ways:
1. Taking Advantage of Economies of Scale. Mergers are often justified as a means
of providing the two participating firms with increased economies of scale. Econ-
omies of scale arise when one firm can perform a function more efficiently than
two. For example, AT&T and NCR both design and manufacture UNIX-based per-
sonal computers. Following a merger, they will probably be able to take advantage
of economies of scale in research and development by reducing the number of re-
searchers working on similar new products. The combined firm may also be able
to economize on management costs, including accounting and corporate finance
functions and corporate management.
2. Improving Target Management. Another common motivation for acquisition is to
improve target management. A firm is likely to be a target if it has systematically
underperformed its industry. Historical poor performance could be due to bad
luck, but it could also be due to the firm™s managers making poor investment and
operating decisions, or deliberately pursuing goals which increase their personal
power but cost stockholders.
3. Combining Complementary Resources. Firms may decide that a merger will cre-
ate value by combining complementary resources of the two partners. For exam-
ple, a merger between a firm with a strong research and development unit, such as
AT&T, and a firm in the same industry with a strong distribution unit, such as NCR,
may benefit both firms. Of course, they could both separately invest to strengthen
their respective distribution and R&D units. However, it may well be cheaper to
combine resources through a merger.
4. Capturing Tax Benefits. In the U.S. the 1986 Tax Reform Act eliminated many of
the tax benefits from mergers and acquisitions. However, several merger tax ben-
efits remain. The major benefit is the acquisition of operating tax losses. If a firm
does not expect to earn sufficient profits to fully utilize operating loss carryfor-
ward benefits, it may decide to buy another firm which is earning profits. The op-
erating losses and loss carryforwards of the acquirer can then be offset against the
target™s taxable income.3 A second tax benefit often attributed to mergers is the
tax shield that comes from increasing leverage for the target firm. This was par-
ticularly relevant for leveraged buyouts in the 1980s.4
5. Providing Low-Cost Financing to a Financially Constrained Target. If capital
markets are imperfect, perhaps because of information asymmetries between
management and outside investors, firms can face capital constraints. Information
problems are likely to be especially severe for newly formed, high-growth firms.
These firms can be difficult for outside investors to value since they have short
track records, and their financial statements provide little insight into the value of
their growth opportunities. Further, since they typically have to rely on external
funds to finance their growth, capital market constraints for high-growth firms are
likely to affect their ability to undertake profitable new projects. Public capital
markets are therefore likely to be costly sources of funds for these types of firms.
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Mergers and Acquisitions




15-3 Part 3 Business Analysis and Valuation Applications




An acquirer that understands the business and is willing to provide a steady source
of finance may therefore be able to add value.5
6. Increasing Product-Market Rents. Firms also can have incentives to merge to in-
crease product-market rents. By merging and becoming a dominant firm in the in-
dustry, two smaller firms can collude to restrict their output and raise prices,
thereby increasing their profits. This circumvents problems that arise in cartels of
independent firms, where firms have incentives to cheat on the cartel and increase
their output.
While product-market rents make sense for firms as a motive for merging, the
two partners are unlikely to announce their intentions when they explain the merg-
er to their investors, since most countries have antitrust laws which regulate
mergers between two firms in the same industry. For example, in the U.S. there
are three major antitrust statutes”The Sherman Act of 1890, The Clayton Act of
1914, and The Hart Scott Rodino Act of 1976.
While many of the motivations for acquisitions are likely to create new economic
value for shareholders, some are not. Firms that are ¬‚ush with cash but have few new
pro¬table investment opportunities are particularly prone to using their surplus cash to
make acquisitions. Stockholders of these ¬rms would probably prefer that managers pay
out any surplus or “free” cash ¬‚ows as dividends, or use the funds to repurchase their
¬rm™s stock. However, these options reduce the size of the ¬rm and the assets under
management™s control. Management may therefore prefer to invest the free cash ¬‚ows
to buy new companies, even if they are not valued by stockholders. Of course, managers
will never announce that they are buying a ¬rm because they are reluctant to pay out
funds to stockholders. They may explain the merger using one of the motivations dis-
cussed above, or they may argue that they are buying the target at a bargain price.
Another motivation for mergers that is valued by managers but not stockholders is
diversi¬cation. Diversi¬cation was a popular motivation for acquisitions in the 1960s
and early 1970s. Acquirers sought to dampen their earnings volatility by buying ¬rms
in unrelated businesses. Diversi¬cation as a motive for acquisitions has since been
widely discredited. Modern ¬nance theorists point out that in a well functioning capital
market, investors can diversify for themselves and do not need managers to do so for
them. In addition, diversi¬cation has been criticized for leading ¬rms to lose sight of
their major competitive strengths and to expand into businesses where they do not have
expertise.6


Key Analysis Questions
In evaluating a proposed merger, analysts are interested in determining whether
the merger creates new wealth for acquiring and target stockholders, or whether it
is motivated by managers™ desires to increase their own power and prestige. Key
questions for ¬nancial analysis are likely to include:
600 Mergers and Acquisitions




15-4
Mergers and Acquisitions




• What is the motivation(s) for an acquisition and any anticipated benefits
through public disclosures by acquirers or targets?
• What are the industries of the target and acquirer? Are the firms related hor-
izontally or vertically? How close are the business relations between them?
If the businesses are unrelated, is the acquirer cash-rich and reluctant to re-
turn free cash flows to stockholders?
• What are the key operational strengths of the target and the acquirer? Are
these strengths complementary? For example, does one firm have a re-
nowned research group and the other a strong distribution network?
• Is the acquisition a friendly one, supported by target management, or hos-
tile? A hostile takeover is more likely to occur for targets with poor-perform-
ing management who oppose the acquisition to preserve its job.
• What is the premerger performance of the two firms? Performance metrics
are likely to include ROE, gross margins, general and administrative expenses
to sales, and working capital management ratios. On the basis of these mea-
sures, is the target a poor performer in its industry, implying that there are op-
portunities for improved management? Is the acquirer in a declining industry
and searching for new directions?
• What is the tax position of both firms? What are the average and marginal
current tax rates for the target and the acquirer? Does the acquirer have oper-
ating loss carryforwards and the target taxable profits?
This analysis should help the analyst understand what speci¬c bene¬ts, if any, the
merger is likely to generate.




Motivation for AT&T™s Acquisition
Prior to 1984, AT&T was a regulated utility providing telephone services and manufac-
turing-related equipment. However, in 1982 the company signed a Consent Agreement
with the Department of Justice (DOJ) to divest its Bell operating companies, which pro-
vided short-distance telephone services. This agreement followed eight years of negoti-
ations with the DOJ over allegations that AT&T monopolized the telephone services and
telephone equipment industries. In return for agreeing to this divestiture, AT&T was
granted permission to enter the computer industry, which had previously been off-limits
to the company.
Management argued that the Consent Agreement permitted the ¬rm to concentrate on
linking its telecommunications with computer and information services. The company
could ¬nally begin to take advantage of advances in computer science, particularly the
development of UNIX operating systems that had been made at its renowned research
park, Bell Labs. However, prior to 1990, the company had not been particularly success-
ful in implementing this strategy. The ¬nancial press estimated that the ¬rm™s computer
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Mergers and Acquisitions




15-5 Part 3 Business Analysis and Valuation Applications




operations lost at least $2 billion between 1984 and 1990. Losses for 1990 alone were
estimated at between $10 million and $300 million on sales of $1.5 billion.
AT&T™s management decided that the best approach to its computer problems in-
volved increasing its presence in computer operations and began searching for a suitable
acquisition candidate. NCR, which had a corporate culture similar to AT&T™s, emerged
as the ideal target from this search. It also had compatible product lines and a similar
policy of using UNIX operating systems. However, NCR was stronger than AT&T in net-
working and had an international computer marketing presence and customer base. Con-
sistent with its desire to use NCR to develop its expertise in computer operations, AT&T
announced that it would combine both companies™ computer operations under NCR™s
management.
In summary, given AT&T™s strategy of combining telecommunications and computer
technologies and services, the acquisition of NCR appeared to make some economic
sense. However, some analysts who were critical of AT&T™s overall strategy argued that
the acquisition would probably not create value for AT&T™s stockholders, and that AT&T
should concede that its entry into the computer business was a costly mistake.


ACQUISITION PRICING
A well thought-out economic motivation for a merger or acquisition is a necessary but
not suf¬cient condition for it to create value for acquiring stockholders. The acquirer
must be careful to avoid overpaying for the target. Overpayment makes the transaction
highly desirable and pro¬table for target stockholders, but it diminishes the value of the

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