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Merger Rationales and Strategy
P.V. Viswanath
Class Notes for EDHEC course on Mergers and
Acquisitions
Growth
 A reason that is often given for an acquisition is growth.
 However, there is no clear evidence that growth through
acquisitions is necessarily value-increasing.
 In fact, mergers based on the need for growth often end up
being undone, later.
 The size of the firm that maximizes firm value isn’t
necessarily the size that maximizes CEO compensation.
 There is some evidence that CEO compensation is
increasing in firm size; further CEO compensation is greater
for multi-division firms.
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Why mergers are good for CEOs
 If you think of CEOs as having human capital that is tied to
the firm that they operate, then
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they’d want to reduce the probability of bankruptcy
keeping the firm alive can be often inconsistent with taking risks and
maximizing firm value.
Returning money to shareholders can certainly reduce the probability
of a manager being able to collect long-term promised payoffs, such
as pensions, etc.
A manager with fixed claims on the firm is like a writer of a put;
since the value of an option is increasing in volatility, it’s optimal for
the manager to try and reduce firm return volatility by keeping firm
risk low.
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More on growth
 The market rewards growth. The standard formula for firm
value is P = CF1/(r-g). The higher the value of g, the higher
is P!
 However, this has to be growth in CF, i.e. in cash flows, not
in revenues or in assets alone.
 Organic growth, that is growth through internal expansion
and internal investment can also be mere growth in
revenues.
 This can happen if the firm objective is to maximize
revenues or market share or size instead of profits.
 However, this is gradual and there is usually time for the
CEO, the board and the shareholders to reconsider.
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Inorganic Growth
 The other kind of growth is inorganic growth – growth
through mergers and expansion.
 In this case, the firm is buying cashflows in return for
compensation.
 In any acquisition, there will be growth in assets and growth
in revenues, as well as (presumably), growth in cashflows.
 The question is – what is the purchase price? If the
acquisition is a negative NPV deal, the acquisition is bad.
 Sometimes acquisitions can be used to generate growth
because the nature of the industry is such that there are no
opportunities for organic growth. In such a case, an
acquisition can simply be an acknowledgement of the lack
of growth. If this is news to the market, the share price will
drop.
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Synergy
 Another reason often given for a merger is the
exploitation of synergies.
 Net Acquisition Value of a merger = VAB – (VA+VB)
– (Acquisition Expenses)
 If VAB > (VA+VB), there is synergy.
 Broadly speaking, there are cost synergies and
revenue synergies.
 Cost synergies are often referred to as operating
synergies.
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Operating Synergies
 Economies of Scale: as output levels rise, per-unit costs
decline. This is called spreading overhead.
 Gains result from increased specialization of labor and
management, as well as the more efficient use of capital
equipment, which is not possible at low output levels.
 However, after a given point, there are diseconomies of
scale – problems of coordinating a larger-scale operation.
 Example is the cruise industry -- ability to leverage national
television, radio and print advertising campaigns.
 In the banking industry, there is evidence that mergers work
better when there is a geographical overlap between the
areas of operation of the two merging banks.
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Revenue Enhancing Synergies
 Cost cutting is easier than obtaining revenue-enhancing
synergies.
 Revenue-enhancing synergies work if when two companies
merge, A’s products can be sold to B and B’s products to A.
 Sears’ acquisition of real estate and brokerage businesses
didn’t work very well. Sears thought that its clientele was
loyal and would be willing to buy other goods.
 The merger of Northrop Grumman and TRW worked.
Together, they had the capabilities to bid for some jobs that
they would not have been able to bid for separately.
 Diverse construction and design capabilities were required.
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Revenue Synergies
 http://www.businessweek.com/magazine/content/04_10/b3873078_mz017.htm
 The ink was barely dry on Northrop Grumman Corp.'s
(NOC) December, 2002, acquisition of TRW Inc. when the
company began marshaling its newly acquired troops for
their first big campaign.
 The target was an eight-year contract to build the
Pentagon's new Kinetic Energy Interceptor, a Star Wars-like
antimissile system that aims to destroy enemy rockets
shortly after takeoff.
 Separately, Northrop and TRW had both passed on the
project, thinking they couldn't compete head to head with
missile-defense leaders Boeing Co. (BA ) and Lockheed
Martin Corp. (LMT).
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Revenue Synergies
 That changed with the merger. Northrop put together a
team of people from six of its seven divisions, including
specialists in defense electronics, information
technology, satellites, and shipbuilding.
 A former TRW office in Virginia was put in command of
the project, and reinforcements were sent from across
the country.
 The effort paid off: Northrop scored a surprise victory,
winning the $4.5 billion contract last December and
vaulting the company past its own sales targets.
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Access to resources
 In some industries, there are huge capital demands, which
are difficult to undertake for small firms. The
pharmaceutical industry and the water utilities industries are
cases in point.
 Example: McCaw Cellular and AT&T.
 Question: if the projects are worthwhile, why not just go to
the capital markets for funds?
 Information Asymmetry
 Cost of accessing capital markets
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Access to Resources
 In Craig McCaw, AT&T gets one of the leading visionaries of a
future teeming with untethered, low-cost communication and
service platforms, ranging from pocket phones to personal
electronic gadgets.
 Combined with Bell Labs (which invented cellular) and AT&T's
financial resources (which help neutralize the almost $5 billion of
debt McCaw generated to fund its expansion), McCaw may be
able to bring his vision to market far sooner than he could have
otherwise.
 Alone, McCaw faced constant trade-offs: Should he invest in
more capacity in metropolitan areas, in broader geographic
coverage (including overseas), in new digital technology or in
wireless data? Each represents a lucrative market.
 Now he can go after them all.
 http://www.findarticles.com/p/articles/mi_m0REL/is_n11_v92/ai_13218026
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Value Drivers in Diversification/Focus
 Efficiency of Internal Capital Markets
 The diversified firm internalizes the capital market by acting
as an allocator of resources among businesses in the
portfolio.
 Pro: Closer proximity to the companies and access to better
information about them permits the internal capital market
to operate more efficiently than external markets.
 Con: Behavioral and Agency considerations intervene to
make the internal capital markets less efficient.
 People avoid unpleasant decisions about starving or selling
unprofitable businesses and therefore tend to subsidize
poorly performing units from the resources of highperforming units.
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Value Drivers in Diversification
 Costs of Information and Agency Costs
 Multidivisional firms are complicated to understand;
investors require more information to value these firms.
However, firms usually only provide aggregated
information. Opacity creates greater information asymmetry
that leads investors to discount the value of these firms.
 Opacity also shelters managers of diversified firms from the
scrutiny and discipline of capital markets. This leads to
greater agency costs and the manager’s expropriation of
private benefits.
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SWOT Analysis
 What are the resources of the firm?
 How can the firm use these resources to generate
capabilities?
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Capabilities integrate resources to reach an objective – e.g. to
produce custom-designed furniture, a firm must integrate across
marketing, design, purchasing, manufacturing, and finance.
 Core competencies are strategic capabilities – those skills
and activities that translate resources into special advantage
for the firm – e.g. Home Depot has a strategic capability in
site location and store openings.
 Competitive advantage is sustainable, if competitors cannot
or will not try to duplicate it.
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Shapiro’s sources of economic value
1. Availability of economies of scale in production
Investments that are structured to exploit
economies of scale are more likely to be
successful than those that are not.
2. Possibility of product differentiation
Investments designed to create a position at the
high end of anything, including the high end of
the low end, differentiated by a quality or
service edge, will generally be profitable.
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Shapiro’s sources of economic value
3. Cost advantages
Investments aimed at achieving the lowest delivered
cost position in the industry, coupled with a pricing
policy to expand market share, are likely to succeed,
especially if the cost reductions are proprietary.
4. Monopolistic access to distribution channels
Investments devoted to gaining better product
distribution often lead to higher profitability.
5. Protective government regulation
Investments in project protected from competition by
government regulation can lead to extraordinary
profitability. However, what the government gives, the
government can take away!
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Shapiro Model: Lessons for M&A
 Horizontal Mergers can reduce costs through economies of
scale
 Merging vertically downwards to acquire distribution
channels can procure better product distribution
 Acquiring firms with R&D capabilities can help generate
products with quality edge (Yahoo’s acquisition of Inktomi
in 2003 which had a superior crawler)
 The flip side is to deny competitors such an ability – cf.
Yahoo’s acquisition of Altavista in 2003 to deny MSN
access to a ready-made search engine.
 Acquiring targets with R&D to reduce production costs; for
example, integrated steel producers acquiring minimills.
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Porter Model: Industry Attractiveness
 Barriers to Entry can make it more difficult for new
entrants into industry
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Regulatory restrictions (e.g. banking license),
brand names (e.g. Xerox, McDonalds – can develop
customer loyalty; hard to develop and/or imitate)
patents (illegal to exploit without ownership; e.g. new
drugs – cf. also RIM)
and unique know-how (e.g. WalMart’s “hot docking”
technique of logistics management)
Accumulated experience (cf. learning curve)
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Porter Model: Industry Attractiveness
 Customer Power (monopsony)
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Powerful customers can influence prices and product quality.
Examples are WalMart (consumer goods) and the US government
(US defense industry)
If customers are weak, suppliers can keep prices rising, e.g. in filmed
entertainment, cigarettes and education.
 Supplier Power
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Powerful suppliers can extract high prices from firms.
In contrast, in the 1990s, weak suppliers allowed auto manufacturers
to extract price concession.
 Threat of Substitutes
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Substitutes limit the pricing power of competitors in an industry.
The price of coal for electric power generators is influenced by the
price of oil and natural gas.
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Porter Model: Industry Attractiveness
 Rivalry Conduct
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Balance of competitive advantage can be altered by investments in
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new product or new process innovation,
opening new channels of distribution and
entry into new geographic markets
Cartels keep competition low
Predatory pricing can keep profits variable and low.
Rivalry is sharper where
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players are similar in size,
the barriers to exit from an industry are high,
fixed costs are high,
growth is slow, and
products/ services are not differentiated.
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Porter Model: Lessons for M&A
 Firms can look for targets to enhance resistance to
new entrants – e.g. smaller firms with proprietary
intellectual property or R&D capabilities.
 Where competitor conduct promotes rivalry,
mergers may be undertaken to reduce susceptibility
to competition – e.g.
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horizontal mergers can increase market share
Targets with new products or new processes
vertically merging downward to obtain new channels of
distribution
Merging with targets that permit entry into new
geographic markets
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Porter Model: Lessons for M&A
 Where supplier/ consumer power is high, mergers can be
used to counter supplier power.
 Where supplier/ consumer power is low, horizontal mergers
can be used to exploit supplier weakness.
 If there are threats from substitutes, firms could
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Acquire targets in the “substitutes” industry
Acquire targets with R&D to counter the attractiveness of substitutes
 Acquire targets in related industries that are regulated
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For example, a coal producer could integrate vertically and acquire
an electricity producer.
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