m&a june 2008. 2 outline n a look at an acquisition n the diversification discount n synergies...
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M&AJUNE 2008
JUNE 2008 2
OUTLINE
A look at an acquisitionA look at an acquisition The diversification discountThe diversification discount Synergies in valuationsSynergies in valuations Value and use of financial researchValue and use of financial research
JUNE 2008 3
AN ACQUISITIONAN ACQUISITION
JUNE 2008 4
AN ACQUISITIONThe companies
Same industrySame industry Target 40% the size of AcquirerTarget 40% the size of Acquirer Acquirer publicly traded, Target privately Acquirer publicly traded, Target privately
held held Both Dollar and Euro cash flow and assetsBoth Dollar and Euro cash flow and assets Both companies profitable in 2007 and Both companies profitable in 2007 and
financially healthyfinancially healthy
JUNE 2008 5
AN ACQUISITIONThe environment
Weak economy, but somewhat shieldedWeak economy, but somewhat shielded Dollar deteriorate 20%Dollar deteriorate 20% Acquirer’s stock doubled in valueAcquirer’s stock doubled in value M&A market weakened by liquidity crisisM&A market weakened by liquidity crisis
JUNE 2008 6
AN ACQUISITIONThe questions
What is Target’s value?What is Target’s value? How should we evaluate purchase prices for How should we evaluate purchase prices for
Target?Target? What are the major risks in this acquisition?What are the major risks in this acquisition? How should we structure and finance the How should we structure and finance the
acquisition?acquisition? How should we negotiate the acquisition?How should we negotiate the acquisition?
JUNE 2008 7
AN ACQUISITIONWhat is Target’s value?
Strategic imperativesStrategic imperatives Fit with strategic business planFit with strategic business plan Ability to absorb acquisitionAbility to absorb acquisition Timing in light of economy and financial Timing in light of economy and financial
marketsmarkets Comparison to alternative investment Comparison to alternative investment
opportunitiesopportunities Consistency with Board and shareholder Consistency with Board and shareholder
objectivesobjectives
JUNE 2008 8
AN ACQUISITIONWhat is Target’s value?
Financial criteriaFinancial criteria Net present value using cost of capital and/or Net present value using cost of capital and/or
investment hurdle rateinvestment hurdle rate Implicit EBITDA, EBIT and EPS multiples Implicit EBITDA, EBIT and EPS multiples
compared to “market”compared to “market”
JUNE 2008 9
AN ACQUISITIONWhat is Target’s value?
Important financial considerations Important financial considerations influencing valuationinfluencing valuation Vertical consistency (integrated manufacturer Vertical consistency (integrated manufacturer
or outsourcer or other)or outsourcer or other) Profitability concentrations (product lines or Profitability concentrations (product lines or
customers or markets)customers or markets) Long term stability/sustainability (historical Long term stability/sustainability (historical
profitability)profitability) Future growth potentialFuture growth potential CAPEX requirementsCAPEX requirements
JUNE 2008 10
AN ACQUISITIONWhat is Target’s value?
Important financial considerations Important financial considerations influencing valuation (continued)influencing valuation (continued) Normalization of income (extraordinary and Normalization of income (extraordinary and
non-recurring)non-recurring) Synergies versus cannibalizationSynergies versus cannibalization Incremental reporting, control, SARBOX costsIncremental reporting, control, SARBOX costs Foreign exchangeForeign exchange Income tax ratesIncome tax rates
JUNE 2008 11
AN ACQUISITIONHow do we evaluate purchase prices?
Income and cash flow:Income and cash flow: Return on capital:Return on capital: How does the return on capital How does the return on capital
compare to the company’s cost of capital and/or compare to the company’s cost of capital and/or investment hurdle rate.investment hurdle rate.
EPS.EPS. How much earnings accretion will there be? How much earnings accretion will there be? EBITDA multiple.EBITDA multiple. What are the implicit EBITDA, What are the implicit EBITDA,
EBIT and EPS multiples and how do these compare to EBIT and EPS multiples and how do these compare to “market”?“market”?
Consolidated income reporting.Consolidated income reporting. Will the acquisition Will the acquisition have an adverse impact on margins, return on capital have an adverse impact on margins, return on capital employed, or other financial metrics?employed, or other financial metrics?
JUNE 2008 12
AN ACQUISITIONHow do we evaluate purchase prices?
Balance sheet and capitalization:Balance sheet and capitalization: Consolidated balance sheets.Consolidated balance sheets. Will the acquisition have Will the acquisition have
an adverse impact on leverage, capital employed or an adverse impact on leverage, capital employed or other financial metrics?other financial metrics?
Dilution:Dilution: If financed partially or fully with common If financed partially or fully with common stock, how much ownership dilution will there be? stock, how much ownership dilution will there be?
Goodwill.Goodwill. How much goodwill is being paid both in How much goodwill is being paid both in dollars and as a percentage of the total purchase price?dollars and as a percentage of the total purchase price?
Capitalization:Capitalization: Can the company afford the price being Can the company afford the price being paid for the acquisition?paid for the acquisition?
JUNE 2008 13
AN ACQUISITIONWHAT ARE THE RISKS?
Foreign exchangeForeign exchange: The acquisition of Target, with non-: The acquisition of Target, with non-dollar cash flow and assets, exposed Acquirer to economic, dollar cash flow and assets, exposed Acquirer to economic, transaction and translation foreign exchange risks.transaction and translation foreign exchange risks.
ManagementManagement. Private companies have higher risks of . Private companies have higher risks of inadequate management.inadequate management.
Economic.Economic. The global economic uncertainty was a The global economic uncertainty was a concern.concern.
Lack of vertical integration.Lack of vertical integration. Target was not as Target was not as integrated as Acquirer.integrated as Acquirer.
Long term profitability.Long term profitability. Target did not have a long-term Target did not have a long-term history of stable profitability.history of stable profitability.
Concentrations. Concentrations. Target was highly concentrated in one Target was highly concentrated in one central “platform” product.central “platform” product.
JUNE 2008 14
AN ACQUISITIONHOW SHOULD IT BE STRUCTURED
Will the shareholders of Target pay taxes? Will the shareholders of Target pay taxes? This argues for purchase of their stock.This argues for purchase of their stock.
What do the sellers want?What do the sellers want? Do contingent payments fit? (earn-outs)Do contingent payments fit? (earn-outs) Management incentive compensation set-asideManagement incentive compensation set-aside Five year non-competition paymentsFive year non-competition payments How should we define debtHow should we define debt
Normalized operating working capitalNormalized operating working capital Customer depositsCustomer deposits Contingent liabilities Contingent liabilities
JUNE 2008 15
AN ACQUISITIONHOW SHOULD IT BE FINANCED
What is the cheapest currency? What is the cheapest currency? Cash earning 4-6%, orCash earning 4-6%, or New debt issued at 4-6%, or New debt issued at 4-6%, or Common stock with a P/E of 25.Common stock with a P/E of 25.
Do we offer XXX shares of stock or some total Do we offer XXX shares of stock or some total value of the stock?value of the stock?
Can we afford an all-cash purchase?Can we afford an all-cash purchase? Will the shareholders of Target pay taxes? Will the shareholders of Target pay taxes?
This argues for use of Acquirer common stock.This argues for use of Acquirer common stock. What do the sellers want?What do the sellers want? FX hedges if appropriate.FX hedges if appropriate.
JUNE 2008 16
AN ACQUISITIONHOW SHOULD IT BE NEGOTIATED?
Are they ready to sell?Are they ready to sell? Are there multiple decision makers?Are there multiple decision makers? How sophisticated are the sellers?How sophisticated are the sellers?
Do they have experienced representation?Do they have experienced representation? Have they tested the market?Have they tested the market?
How are the sellers evaluating the offer?How are the sellers evaluating the offer? Multiples or total price?Multiples or total price? What currency?What currency?
Do the sellers value the upside of Acquirer’s common Do the sellers value the upside of Acquirer’s common stock?stock?
Do the sellers have a price in mind?Do the sellers have a price in mind? What are the sellers’ realistic alternatives?What are the sellers’ realistic alternatives?
JUNE 2008 17
DIVERSIFICATION DIVERSIFICATION
DISCOUNTDISCOUNT
JUNE 2008 18
DIVERSIFICATION DISCOUNT
Definitional statements:Definitional statements: Diversified firms trade at a discount relative Diversified firms trade at a discount relative
to what they would be worth if they had to what they would be worth if they had not, or were not, diversified.not, or were not, diversified.
The total value of a diversified firm is less The total value of a diversified firm is less than the sum of its diversified parts.than the sum of its diversified parts.
Diversification results in a discount in Diversification results in a discount in value.value.
JUNE 2008 19
DIVERSIFICATION DISCOUNT
Justification and basis:Justification and basis: Fact based argument:Fact based argument:
Empirical evidence exists that demonstrates the Empirical evidence exists that demonstrates the discount discount
Common sense based arguments:Common sense based arguments: Diversity is difficult to manageDiversity is difficult to manage Different businesses require different skill setsDifferent businesses require different skill sets
Opinion based arguments:Opinion based arguments: ““Grass is greener on the other side of the fence”Grass is greener on the other side of the fence”
JUNE 2008 20
DIVERSIFICATION DISCOUNT
But there are counter-arguments to support the But there are counter-arguments to support the case that diversification case that diversification increasesincreases value: value:
Diversified customer bases Diversified customer bases Diversified product mixesDiversified product mixes Diversified locationsDiversified locations Diversified suppliersDiversified suppliers Diversified management skillsDiversified management skills Diversified capital sourcesDiversified capital sources Counter-cyclicalityCounter-cyclicality
JUNE 2008 21
DIVERSIFICATION DISCOUNT
Then, why does there appear to be a Then, why does there appear to be a diversification discount?diversification discount?
Arguments on slide 19 are validArguments on slide 19 are valid But, perhaps diversification also: But, perhaps diversification also:
Conjures up bad memories.Conjures up bad memories. Is associated with bad managers.Is associated with bad managers. Has never been effectively tested.Has never been effectively tested. Has never been properly isolated in research.Has never been properly isolated in research.
JUNE 2008 22
DIVERSIFICATION DISCOUNT
Maybe past diversifications conjure up bad Maybe past diversifications conjure up bad memories in those who value companiesmemories in those who value companies
The market has a memoryThe market has a memory Analysts have memoriesAnalysts have memories ““Once burned, twice shy.”Once burned, twice shy.”
JUNE 2008 23
DIVERSIFICATION DISCOUNT
Maybe diversification is associated with Maybe diversification is associated with bad managers.bad managers.
Empire and resume buildersEmpire and resume builders ““Deal” addiction peopleDeal” addiction people ““Job” creatorsJob” creators Greedy charlatansGreedy charlatans
JUNE 2008 24
DIVERSIFICATION DISCOUNT
Maybe diversification has never been Maybe diversification has never been effectively testedeffectively tested in the market.in the market.
Difficult to find good examples.Difficult to find good examples. Perfect business “fits” rarely occur because Perfect business “fits” rarely occur because
people and reality get in the way.people and reality get in the way.
JUNE 2008 25
DIVERSIFICATION DISCOUNT
Maybe diversification has never been Maybe diversification has never been properly isolated in research.properly isolated in research.
Myriads of factors influence valueMyriads of factors influence value Isolating the impact of diversification is Isolating the impact of diversification is
difficult to dodifficult to do
JUNE 2008 26
DIVERSIFICATION DISCOUNT
Valuations are influenced by many factors:Valuations are influenced by many factors: People issuesPeople issues
Quality of managementQuality of management Quality of governanceQuality of governance
Company issuesCompany issues Degree of diversificationDegree of diversification PerformancePerformance SynergiesSynergies StrategiesStrategies
JUNE 2008 27
DIVERSIFICATION DISCOUNT
Valuations are influenced by many factors:Valuations are influenced by many factors: • Capitalization issuesCapitalization issues
Degree of over-leverageDegree of over-leverage Degree of over payment in a dealDegree of over payment in a deal
Environmental issuesEnvironmental issues Business cycleBusiness cycle Market perceptionMarket perception Market confusionMarket confusion Market “greed of the moment”Market “greed of the moment”
JUNE 2008 28
DIVERSIFICATION DISCOUNT
Valuations are influenced by many factors:Valuations are influenced by many factors: Industry issuesIndustry issues Type of businessType of business Margin structureMargin structure Capital intensityCapital intensity Counter cyclicality or otherwiseCounter cyclicality or otherwise
JUNE 2008 29
DIVERSIFICATION DISCOUNT
Conclusions and observations:Conclusions and observations: The diversification discount needs to be The diversification discount needs to be
kept in context. Understand the concepts, kept in context. Understand the concepts, but don’t apply them indiscriminately. but don’t apply them indiscriminately.
Remember that valuations are not simple. Remember that valuations are not simple. Focused strategies and implementation are Focused strategies and implementation are required.required.
People who do deals are self serving. They People who do deals are self serving. They can argue either side dependent upon which can argue either side dependent upon which makes them money at the time.makes them money at the time.
JUNE 2008 30
SYNERGIES IN M&ASYNERGIES IN M&A
JUNE 2008 31
SYNERGIES
Definition number 1: Increase in profits Definition number 1: Increase in profits through combination of entities.through combination of entities. Eliminate G&AEliminate G&A Absorb then increase middleman’s profitAbsorb then increase middleman’s profit
Definition number 2: Increase in value Definition number 2: Increase in value through strategic fit of two entities based on through strategic fit of two entities based on industry, channel, product or other factors.industry, channel, product or other factors. Sell more through same sales effortSell more through same sales effort Product enhancementsProduct enhancements Achieve dominant market shareAchieve dominant market share
JUNE 2008 32
SYNERGIES-EXAMPLES Banking: Elimination of duplicative G&A.Banking: Elimination of duplicative G&A. Retail: Increase in sales and margins Retail: Increase in sales and margins
through elimination of middlemen.through elimination of middlemen.• Telecom: Develop dominant market share.Telecom: Develop dominant market share.• OPEC: Collaboration leading to monopoly.OPEC: Collaboration leading to monopoly.• Internet sales: Increased volume through Internet sales: Increased volume through
channel (Amazon).channel (Amazon).• Distribution: Elimination of duplicative Distribution: Elimination of duplicative
G&A.G&A.• Manufacturing: Reduction of capital Manufacturing: Reduction of capital
employed.employed.
JUNE 2008 33
SYNERGIES-MACADAM CAPITAL We always normalize incomeWe always normalize income
Eliminate duplication (Sarbanes, audit, executive Eliminate duplication (Sarbanes, audit, executive salaries, etc.)salaries, etc.)
Reflect operating cost savingsReflect operating cost savings
We model enhanced contribution in our sale We model enhanced contribution in our sale transactionstransactions Incremental channel gross profits Incremental channel gross profits Elimination of duplicate logistics costsElimination of duplicate logistics costs Elimination of duplicate sales costsElimination of duplicate sales costs
We value market dominance and industry We value market dominance and industry consolidationconsolidation
JUNE 2008 34
SYNERGIES-CAUTIONS
Synergies can be real, but are vastly over-Synergies can be real, but are vastly over-ratedrated
Implementation is critical to achieving any Implementation is critical to achieving any synergistic benefitssynergistic benefits
There must be an acquirer and an acquiree There must be an acquirer and an acquiree to have much in the way of synergistic to have much in the way of synergistic savingssavings
Overpaying is too often the norm, and most Overpaying is too often the norm, and most of the incremental value is lost, despite of the incremental value is lost, despite comments to the contrarycomments to the contrary
JUNE 2008 35
VALUE AND USE OF VALUE AND USE OF RESEARCHRESEARCH
JUNE 2008 36
VALUE OF RESEARCH
Scientific methodology rather than opinions Scientific methodology rather than opinions and “MSU” approachand “MSU” approach
Foundation for practical actionsFoundation for practical actions Reduce complexities to manageable issuesReduce complexities to manageable issues Learning and training for futureLearning and training for future Proof that BS is not the only answerProof that BS is not the only answer
JUNE 2008 37
USE OF RESEARCH
Corporate financial decisionsCorporate financial decisions Investment banking engagements (valuations Investment banking engagements (valuations
and execution)and execution) Consulting engagementsConsulting engagements
JUNE 2008 38
PRACTICAL VIEW
Financial research:Financial research: Must be understandableMust be understandable Must be delivered succinctlyMust be delivered succinctly Must make common sense or be thoroughly Must make common sense or be thoroughly
and completely provenand completely proven
JUNE 2008 39
EXAMPLE OF RESEARCH
Measuring diversification discount:Measuring diversification discount: Ability to isolate is questionable and Ability to isolate is questionable and
measurement is even tougher measurement is even tougher But raising, analyzing and debating the But raising, analyzing and debating the
subject are invaluable steps subject are invaluable steps Debunk common sense Debunk common sense Demonstrate lack of simplicity surrounding Demonstrate lack of simplicity surrounding
issuesissues Provides ammunition for good CFO’s to force Provides ammunition for good CFO’s to force
companies to think before they actcompanies to think before they act