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Merger Strategy

One plus one makes three is the main idea behind a Merger or an Acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies. Especially, when times are tough, strong companies will act to buy other companies to create a more competitive and costefficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Target companies will often agree to be purchased when they know they cannot survive alone.

Merger Strategy
This chapter focuses on the strategic motives and determinants of mergers and acquisitions (M&As). It begins with a discussion of two of the most often cited motives for mergers and acquisitionsGrowth and Synergy. Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. The different types of synergy: Operating and Financial synergy

Operating synergy has the most economically sound basis. Financial synergy is a more questionable motive for a merger or an acquisition. Companies often merge in an attempt to diversify into another line of business. The history of mergers is replete with diversification transactions. The track record of these diversifications, with notable exceptions, is not very impressive. However, certain types of diversifying transactions, those that do not involve a movement to a very different business category, have a better track record. Companies experience greater success with horizontal combinations, which result in an increase in market share, and even with some vertical transactions, which may provide other economic benefits. Unfortunately, a less noble motive such as hubris, or pride of the management of the bidder, also may be a motive for an acquisition.

I. Growth
One of the most fundamental motives for M&As is growth. Companies seeking to expand are faced with a choice between internal or organic growth and growth through M&As. Internal growth may be a slow and uncertain process. Growth through M&As may be a much more rapid process, although it brings with it its own uncertainties. A. If a company seeks to expand within its own industry they may conclude that internal growth is not an acceptable alternative. For example, if a company has a window of opportunity that will remain open for only a limited period of time, slow internal growth may not suffice. .

As the company grows slowly through internal expansion, competitors may respond quickly and take market share. Advantages that a company may have can dissipate over time. The only solution may be to acquire another company that has the resources, such as established offices and facilities, management, and other resources, in place. There are many opportunities that must be acted on immediately lest they disappear. Eg.1. It could be that a company has developed a new product or process and has a time advantage over competitors. Even if it is possible to patent the product or process, this does not prevent competitors from possibly developing a competing product or process that does not violate the patent. Eg. 2. Another example would be if a company developed a new merchandising concept. Being first to develop the concept provides a certain limited time advantage. If not properly taken advantage of, it may slip by and become an opportunity for larger competitors with greater resources

Case study 1
An American multinational medical devices, pharmaceutical and consumer packaged goods manufacturer founded in 1886 A manufacturer and marketer of a wide range of health care products Over 1995- 2005, it engineered over 50 acquisitions as part of its growth through acquisitions strategy It sought to pursue those companies who had developed successful products in order to not waste time and resources in unsuccessful internal development attempts In 1996, it acquired Cordis but it failed to place it in the lead in the market In 2005, it resorted to M&A again by bidding for market leader Guidant for $ 25.4 billion (initially). It would have been the largest deal in its long history of M&A but then Guidants litigation liabilities became known and then it was outbid by Boston Scientific. Then it acquired Pfizers consumer products division for $ 16 billion. Throughout, it acquired following businesses: 1. Alza for drug delivery 2. Depuy for orthopedic devices 3. Neutrogena for skin and hair care 4. Peninsula pharmaceuticals for life threatening infections etc.

J&Js brands include numerous household names of medications and first aid supplies. Among its well-known consumer products are the Band-Aid Brand line of bandages, Tylenol medications, Johnson's baby products, Neutrogena skin and beauty products, Clean & Clear facial wash and Acuvuecontact lenses

B. Another example of growth strategy is when a company wants to expand to another geographic region. It can be another region of the same country or another country or continent. Incase of international expansion, the company needs to understand the new market, recruit new personnel and encounter other hurdles like language and culture barriers. Then, mergers, acquisitions or JVs may be the fastest and lowest risk alternative. Interestingly, exchange rates play an important role in international deals. When the currency of a bidder appreciates relative to that of a target, a buyer holding the more highly valued currency may be able to afford a higher premium which would be attractive for the target.
Eg. A sample from 1970- 1987 shows that foreign acquirers paid 10% higher premiums.

II. Synergy
The word SYNERGY is derived from ancient Greek words SUNERGIA and SUNERGOS which mean COOPERATION and WORKING TOGETHER. In business environment, it signifies that the combined efforts of two or more agents create such effects which are greater than the sum of their individual effects. Technically, Synergy is the ability of the merged company to generate higher shareholders wealth than the standalone entities. Economically, it is the ability of the combined entity to further limit the competitors abilities to contest against their or the targets current input markets, processes or output markets. Failure to achieve this will result in the failure of the acquisition. Synergies create the following benefits to justify a particular M&A: 1. Cost reduction 2. Tax benefits 3. Unused debt capacity 4. Surplus funds 5. Asset write-ups

1. Cost reduction: economies of scale and economies of vertical integration 2. Tax benefits: unabsorbed losses of the target company can be written off. 3. Unused debt capacity: if the target firm has lower debt-equity ratio than the bidding firm, combining can lead to incremental tax shields. 4. Surplus funds: excess funds in the target firm may be turned into positive NPV in the combined organisation. 5. Asset write-ups: assets of the target firm may be revalued at higher market value and the resulting incremental depreciation may produce a tax shield.

Operating Synergy
Operating Synergy or Operating economies may be involved in horizontal and vertical mergers. For horizontal mergers the source of operating economies must represent a form of economies of scale. These economies, in turn, may reflect indivisibilities and better utilization of capacity after the merger. Or important complementarities in organizational capabilities may be present that result in gains not attainable from internal investments in the short run. In vertical mergers, combining firms at different stages of an industry may achieve more efficient coordination of the different levels. The argument is that costs of communication and various forms of bargaining, and opportunistic behaviour can be avoided by vertical integration.

Operating Synergy assumes that :

Economies of Scale and Scope do exist

Economies of scale: refer to increasing efficiencies with a corresponding decrease in average cost of production due to spreading of fixed costs over more number of goods or services produced. -Reduction in fixed components of marketing, selling and distribution, warehousing, after-sales services costs etc. Economies of scope: refer to increased revenues and profits rather than reduced unit average cost of individual products. The total cost of producing and selling several products by the multi-product firm is less than the sum of the costs of producing and selling the same products by individual firms specialising in each of those products. -Include costs of R&D, single brand umbrella to sell several products, selling several products through common distribution channels etc.

Economies of learning?

Financial Synergy
Financial synergy implies that the cost of capital may be lowered. FS refers to increase in the value of the firm that accrues to the combined firm from financial factors such as better use of cash slack or tax benefits etc. This theory holds that bidders have excess cash flows but lack good investment opportunities and targets need additional funds to finance an abundance of good available growth investment opportunities.
Eg. Acquisition by Philip Morris of General Foods in 1987 and of Kraft Foods in 1988. - Philip Morris had large cash flows from their tobacco operations which appeared to be shrinking because of the efforts to achieve Smoke-free society. The food industry offered opportunities for growth.

Therefore, through achieving financial synergies, the payoff can take the form of either higher cash flows or lower cost of capital.
1. The merger of a firm with excess cash or cash slack, with another firm with high return projects. Eg. Large firm acquiring small firm, public listed firm acquiring private firm etc. 2. When two firms combine, their earnings and cash flows may become more stable and so, debt capacity can increase. So they can borrow more creating tax shield. This takes the form of lower cost of capital. 3. Tax benefits arise from acquisition of a losing firm with huge accumulated loss in its books, reducing the tax burden.

By merging, the companies hope to benefit from the following:

Staff reduction: mergers tend to mean job losses, mostly from reducing the number of staff members from accounting, marketing or other support functions. Job cuts may also include the CEO, who would typically leave with a compensation package. Economies of scale: a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies- when placing larger orders, companies have a greater ability to negotiate prices with their suppliers. Acquiring new technology: to stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge. Improved market reach and industry visibility: a merger may expand two companies marketing and distribution, giving them new sales opportunities. Due to improved financial standing, bigger firms have an easier time raising capital than smaller ones.

Overcoming the entry barriers: Mergers and acquisitions is one of the ways for smooth market entry, as the goodwill of the other company and the brand gets transferred to new entities without initial hurdles. These costly barriers to entry, otherwise would make start-ups economically unattractive. Eliminating the cost of new product development: buying established business reduces risk of start-up ventures. Low risk as compared to developing new products. Increased feasibility and speed of diversification. It is a quick way to move into businesses when the firm lacks experience and depth in the industry. Acquisition is intended towards avoiding excessive competition and improve competitive balance of the industry and thereby increased market power. Acquisition is also used to restrict the dependence of the firm on a single or a few products or markets.

Diversification Diversification means growing outside a companys current industry category. This motive played a major role in the acquisitions and mergers that took place in the third merger wavethe conglomerate era. During the late 1960s, firms often sought to expand by buying other companies rather than through internal expansion. This outward expansion was often facilitated by some creative financial techniques that temporarily caused the acquiring firms stock price to rise while adding little real value through the exchange. The legacy of the conglomerates has drawn poor, or at least mixed, reviews. Indeed, many of the firms that grew into conglomerates in the 1960s were disassembled through various spinoffs and divestitures in the 1970s and 1980s. This process of deconglomerization raises serious doubts as to the value of diversification based on expansion. Although many companies have regretted their attempts at diversification, others can claim to have gained significantly. One such firm is General Electric (GE). Contrary to what its name implies, for many years now GE is no longer merely an electronics-oriented company. Through a pattern of acquisitions and divestitures, the firm has become a diversified conglomerate with operations in insurance, television stations, plastics, medical equipment, and so on.

Other Economic Motives In addition to economies of scale and diversification benefits, there are two other economic motives for M&As: horizontal integration and vertical integration. Horizontal integration refers to the increase in market share and market power that results from acquisitions and mergers of rivals. Vertical integration refers to the merger or acquisition of companies that have a buyerseller relationship. Horizontal Integration Combinations that result in an increase in market share may have a significant impact on the combined firms market power. Whether market power actually increases depends on the size of the merging firms and the level of competition in the industry. Economic theory categorizes industries within two extreme forms of market structure. On one side of this spectrum is pure competition, which is a market that is characterized by numerous buyers and sellers, perfect information, and homogeneous, undifferentiated products. Given these conditions, each seller is a price taker with no ability to influence market price. On the other end of the industry spectrum is monopoly, which is an industry with one seller. The monopolist has the ability to select the priceoutput combination that maximizes profits. Of course, the monopolist is not guaranteed a profit simply because it is insulated from direct competitive pressures. The monopolist may or may not earn a profit, depending on the magnitude of its costs relative to revenues at the optimal profitmaximizing price-output combination. Within these two ends of the industry structure spectrum is monopolistic competition, which features many sellers of a somewhat differentiated product. Closer to monopoly, however, is oligopoly, in which there are a few (i.e., 3 to 12) sellers of a differentiated product. Horizontal integration involves a movement from the competitive end of the spectrum toward the monopoly end.

Operating Synergy
The operating synergy theory of mergers states that economies of scale exist in industry and that before a merger takes place, the levels of activity that the firms operate at are insufficient to exploit the economies of scale. Operating economies of scale are achieved through horizontal, vertical and conglomerate mergers. Operating economies occur due to indivisibilities of resources like people, equipment and overhead. The productivity of such resources increases when they are spread over a large number of units of output. Eg., expensive equipment in manufacturing firms should be utilised at optimum levels so that cost per unit of output decreases. Operating economies in specific management functions such as production, R&D, marketing or finance may be achieved through a merger between firms, which have competencies in different areas. For instance, when a firm, whose core competence is in R&D merges with another having a strong marketing strategy, the two businesses would complement each other.

Operating economies are also possible in generic management functions such as, planning and control. According to the theory, even medium-sized firms need a minimum number of corporate staff. The capabilities of corporate staff responsible for planning and control are under-utilized. When such a firm acquires another firm, which has just reached the size at which it needs to increase its corporate staff, the acquirers corporate staff would be fully utilized, thus achieving economies of scale. Vertical integration, i.e. combining of firms at different stages of the industry value chain also helps achieve operating economies. This is because vertical integration reduces the costs of communication and bargaining.