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Creating Value By Acquisitions
Objectives & issues
January 2000
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Contents
• Introduction• The right price• Valuing a business• Valuing synergies• Emotional factors• Assessing competition• Acquirer’s stock price• NZ lines industry• Conclusions• Sources
Introduction
• Businesses exist to create wealth for their shareholders.
• Thirty years of evidence suggests that most merger activity has actually destroyed shareholder wealth, for a variety of reasons.
• The key reason for this destruction of wealth is simply that the price paid was too high.
• A key factor for these high prices has been the emotional involvement and attachment of senior executives.
Introduction
• This slide show discusses acquisitions in a wide context, and then poses the question “what does all this mean in the context of the NZ electricity lines industry ??”.
• It is noted that politics may significantly effect the final outcomes of an acquisition however no detailed comments are made on this.
• It is also recognised that managing organisational culture is a key to making any acquisition succeed (again, detailed comment is beyond the scope of this slide show).
The right price
• So what is the right price for an acquisition ??• Any acquisition must improve the shareholders
wealth or it shouldn’t be undertaken.• Rule of thumb is that the acquisition must be
worth more to the acquirer than the purchase price (stating the obvious !!).
• Competitive tendering adds an additional complication which will also be discussed.
• Following slide identifies the various values that can be placed on an acquisition.
The right price
Intrinsic value
Market value
Purchase value
Synergy value
Value captured by acquirer’s shareholders
Value captured by target’s
shareholders
The right price
• Most obvious feature is that a higher than necessary purchase price erodes the value captured by the acquirer (fairly intuitive conclusion !!).
• Value captured by the target shareholders is known as the value gap.
• We will explore these four values further, which will then be illustrated by a case study.
• We will also explore five key areas of synergy in detail.
Valuing a business
• Previous chart indicates that a business can have four values, and indeed the purchase value and synergy value can vary between purchasers.
• These four values are….• Intrinsic value• Market value• Purchase value• Synergy value
Intrinsic value
• Intrinsic value of a business is based on the NPV of future earnings.
• Assumes that status-quo performance will continue into the future.
• Excludes any premium due to other market participant’s interest.
Market value
• Market value of a business is the intrinsic value plus a premium reflecting market participants interest.
• Represented by the share price or the current market capitalisation.
Purchase value
• Purchase value of a business is the price a bidder anticipates having to pay to acquire the target.
• Referred to as “anticipated takeout value” by Wall St.
Synergy value
• Synergy value of a business is the NPV of the cashflows arising from improvements made when the businesses are amalgamated.
• These are improvements above and beyond those that could be made by either business separately, as these are priced into the intrinsic value of each business.
• The five aspects of synergy will be discussed in detail in subsequent slides.
Synergy value
• It will be apparent that each acquirer in a given acquisition will be able to generate different synergies.
• This in turn will limit the price that each acquirer should pay, suggesting that there is no single “right price” for an acquisition.
Case study
• Consider Vodafone’s bid for AirTouch Communications.
• Prior to Bell Atlantic’s bid for AirTouch being announced on 3/1/99, AirTouch’s closing stock price had been $68 on 31/12/98.
• Bell Atlantic’s bid was $73 per share, a 7% premium.
• Vodafone entered the scene on 7/1/99 with a bid of $89 per share, a 31% premium.
• Vodafone’s final offer was $97 per share, a 43% premium.
Case study
• This premium of $29 over the intrinsic value required Vodafone to identify and implement synergies worth at least $20 billion just to break even.
• The valuation of AirTouch’s stock is shown in the following slide.
Case study
Intrinsic value ($68)
Market value after Bell
Atlantic’s bid ($73)
Vodafone’s purchase
price ($97)
Synergy value to
Vodafone
Value captured by Vodafone’s shareholders
Value captured by AirTouch’s shareholders ($20 billion)
Case study
• The sources of synergy captured by Vodafone as a result of the acquisition are.…• Complementary geographical markets in Europe that
when combined would significantly reduce roaming and interconnection fees.
• Savings in high-volume purchases of network hardware.
• A single, pan-European flat-rate pricing plan based on the Euro that will put downward pressure on other cellular operators.
Valuing synergies
• Previously mentioned 5 sources of synergy, which are….• Cost savings• Revenue enhancements• Process improvements• Financial structure• Tax benefits
• Discussion indicates that most sources of synergy are difficult to calculate accurately, and should be excluded from the final estimate.
Cost savings
• Usually arise from eliminating facilities, jobs and related expenses by consolidation or improved scale.
• Usually the easiest to estimate of the five categories of synergy.
• Cost savings are likely to be highest when the acquirer and target are in the same industry with geographically close markets.
• Often referred to as hard synergies, and have a high certainty of being achieved.
Cost savings
• Three common pitfalls in identifying cost savings.…• Varying definitions of costs categories that may lead
to double-counting eg. is after-sales service included in production or sales ??
• Costs may occur in different areas of the two businesses - essential work may be being done in other places.
• Eliminating positions doesn’t necessarily reduce the head-count as some individuals must be re-deployed to perform on-going tasks.
Revenue enhancements
• Possible for an amalgamated business to achieve a higher revenue growth than either business could have achieved independently.
• Primary means would be applying a targets premium product to the acquirer’s distribution channel.
• Very difficult to estimate - many external factors such as customer response to new products or services.
• Consider evaluating but probably exclude from the final synergy estimate.
Process improvements
• Creates synergy by transferring best practice and core competencies between the acquirer and the target.
• Acquirer may be seeking the targets processes, procedures and controls rather than their products or markets.
• Acquirer may also identify an undervalued business that can be enhanced by the acquirer’s processes and procedures.
• Consider evaluating but probably exclude from the final synergy estimate.
Financial structure
• Capital restructuring to lower the overall WACC can be undertaken independently of any acquisition, hence should not be used to justify an acquisition.
• It may be possible to take advantage of a targets more favorable cost of debt.
• May also be possible to pool working capital and surplus cash.
• Probably should be included in the synergy estimate if benefits can be calculated accurately enough.
Tax benefits
• Often difficult to assess, but generally fall into two broad categories….• One-off tax costs such as capital and transfer duties,
or the inability to carry forward tax losses.• On-going tax costs.
• Goal is to obtain a lower tax rate for the amalgamated business.
• Global acquisitions may provide opportunities to move tax liabilities to low-tax jurisdictions.
• Consider evaluating but probably exclude from the final synergy estimate.
Emotional factors
• No doubt that acquisitions are very exciting !!• This leads to intense emotional involvement
that may override commercial sense - common theme is “we just have to have it”.
• Requires strong restraint and a clear focus on the numbers that give a maximum price.
• Essential to remember that another potential acquirer may be able to create more synergies, and is hence able to bid more.
• Know your maximum price, and don’t pay a penny more !!
Assessing competition
• Sale of a business by competitive tender adds a large element of uncertainty to the whole acquisition process.
• In general terms, a competitive process will push the purchase price up, meaning that the acquirers shareholders will capture less of the synergy value (eroding the very reason for undertaking the acquisition).
• Again, it comes back to knowing your maximum price, and not paying a penny more.
Assessing competition
• Quite likely that some bidders will give all the synergy and some of their own shareholders wealth to the target shareholders, clearly defeating the purpose of the acquisition.
• Having said all this, it may merit increasing the bid to maximise the chances of winning but again it requires a value judgement on just how much additional synergy to give away.
• Part of this value judgement will be assessing who the likely competing bidders are, and what synergies they can derive.
Assessing competition
• In reality, unless there is detailed inside knowledge of other competitors, these judgements are unlikely to be more than educated guesses.
• The next slide indicates the following….• Acquirer B can create significantly higher synergies
than Acquirer A.• Acquirer B can afford to offer a higher purchase
price than Acquirer A.
Assessing competition
Intrinsic value of target
Market value of target)
Acquirer A purchase
price
Synergy value to
acquirer A
Acquirer B purchase price
Synergy value to acquirer B
Assessing competition
• A key conclusion is that Acquirer B’s purchase price needn’t be any greater than Acquirer A’s total synergy value.
• In reality, B’s purchase (offer) price could actually be less than A’s total synergy value because A’s purchase (offer) price will be less than their own synergy value in order to capture at least some synergy.
• Precisely how much less than A’s total synergy value will again be a value judgement !!
Assessing competition
• From A’s perspective, knowing B’s synergy value may assist in knowing when to abandon the chase and avoid additional costs (and avoid revealing strategic intentions).
• Again, all this assumes that the other potential bidders can be identified in the first place.
Acquirer’s stock price
• Referring back to the case study, Bell Atlantic’s stock price declined 5% when its intended acquisition of AirTouch was announced.
• Conversely, Vodafone’s stock price rose 14% during its bid.
• So why did the market express its disapproval of Bell Atlantic’s modest premium and yet conversely applaud Vodafone’s substantial premium ??
Acquirer’s stock price
• The answer comes down to synergy - Vodafone were able to create significantly more synergies than Bell Atlantic, which the market recognised.
• Hence the acquirers stock price is a very good reflection of the likely value to be created from an acquisition.
NZ lines industry
• So what does all this mean for the NZ energy industry, and more specifically for the lines businesses ??
• The retailing scene is seeing some significant acquisition activity by private-sector players such as TransAlta and AGL.
• The lines sector of the industry is certainly less active at the moment (but not totally dead) - there was a flurry of mergers & acquisitions around 1993 and again around 1999 due to structural changes in the industry.
NZ lines industry
• This section seeks to apply the issues discussed so far to the context of the lines business to identify guidelines, opportunities and warnings.
• These issues are….• Valuing a business• Valuing synergies• Assessing competition• Acquirer’s stock price
Valuing a business
• Just like any other business, the four values can be applied to a lines business.
• The intrinsic value is simply the NPV of the cash flows over time - our experience indicates that this is about 0.6 to 0.75 of the ODV.
• The market value can be represented by the ODV in the absence of a listed NZSE price.
• The purchase price is simply the price offered by an interested buyer.
• The synergy value is sum of the intrinsic value plus the synergies available to each buyer.
Valuing a business
• Important to remember that the synergy value will be different for each potential buyer.
• Recent lines business purchases range from 1.2 x ODV to 2.2 x ODV, reflecting the synergies available and the degree of competition in each transaction.
Valuing synergies
• As noted previously, the five sources of synergy are.…• Cost savings• Revenue enhancements• Process improvements• Financial structure• Tax benefits
Cost savings
• Forms the majority of synergies, under the following broad categories….• Governance• Management• Planning• Operations• Fault restoration• Maintenance• Network assets• Facilities
Governance
• Amalgamation should reduce the number of executive directors, however a larger business may involve higher remuneration and maybe one or two additional directors.
• Amalgamation may also allow rationalisation of share registries, statutory reporting etc.
• Cost savings in this area are unlikely to be huge.
Management
• Amalgamation obviously allows for a single management team, leading to reduced costs.
• However an enlarged business may require senior executives to be paid more, and may require additional executives to manage the enlarged business.
• Redundancy costs for executives on high salaries may wipe out any cost savings.
Planning
• Amalgamation will obviously reduce the number of activities required eg. one asset management plan instead of two.
• However, work content in each activity may well increase.
• Some scale may occur if these activities can be contracted out.
• Costs of achieving compatible information systems may be significant - don’t underestimate these costs !!
Operations
• Combining network control rooms may lead to significant cost savings after the initial cost of relocation and combining systems.
• Local knowledge of the network is critical to effective operations, hence staff reduction will very likely cause difficulties for an introductory period.
Fault restoration
• Fault workload won’t change for the amalgamated business unless policy changes regarding network engineering details are made.
• Local knowledge is very critical to fault restoration, hence service levels may decline if staff are dismissed.
• Rationalisation of geographical fault areas may enable improved response time and possibly reduction of staff.
Maintenance
• Amalgamation of lines businesses won’t (or at least shouldn’t) reduce the maintenance workload unless policy changes lead to a reduced underlying maintenance requirement.
• However amalgamation may enable better coordination of resources, or alternatively separation of work into an internally-resourced baseload and a peak work load that can be contracted out.
Network assets
• Cross-boundary synergies may exist if the separate businesses share a close common boundary.
• Most obvious synergy arises from taking cross-boundary supply from lightly-loaded neighboring feeders and substations instead of installing additional capacity.
• May also be possible to provide additional reliability to substations and individual feeders.
Facilities
• Amalgamation will generally allow one head office to be vacated and sold (unless social or political concessions require a second office to be retained).
• Leased offices may incur on-going costs if the lease prohibits sub-letting or early termination.
• Operational facilities can be combined if they are physically close enough.
• Important to note ratio of fixed to variable costs of facilities such as depots - reducing staff may not reduce fixed facility costs by much.
Revenue enhancements
• Unlikely that an amalgamated lines business could increase revenues beyond what the two separate businesses could have unless some cross-boundary connection allows a premium to be charged for alternative supplies.
• Not to be confused with acquisition of a high-growth target (which would increase revenues regardless of any acquisition).
• Price regulation will very likely be a key revenue issue (refer subsequent slide on price regulation).
Process improvements
• Unlikely that any one lines business has processes superior enough to merit acquiring them solely for that reason.
• Generally high level of communication between lines companies at operational levels has meant that best practice is generally discussed and shared openly.
Financial structure
• Previously stated that acquisitions should not be used as a justification for financial restructuring if the opportunity already exists.
• Cost of lines business equity varies minimally throughout NZ, however use of debt financing has created a noticeable spread in WACC.
• May be possible to create some synergy through refinancing at the lower WACC (in reality, it may lower a debt financing rate by a fraction of a percent).
Tax benefits
• Obviously little opportunity for exploiting low tax jurisdictions in the global sense.
• Unlikely that the amalgamated business would achieve a more favorable tax position.
• One-off tax issues can be very significant, especially if capital repayments to shareholders are involved.
• Best seek specialist tax advice very early in the process to identify the tax implications of each acquisition option.
Price regulation
• Much recent talk of line price regulation - likely to become a reality.
• Most likely form of regulation will be incentive (CPI-X), which requires revenues to be reduced by a certain percentage from last years revenues.
• Although incentive regulation doesn’t deliberately allocate wealth back to the customers (in terms of lower prices), eventually all efficiencies will be exhausted meaning that revenue reduction will erode profits.
Conclusions
• Amalgamation of lines businesses may not reduce costs as much as expected.
• Savings are unlikely to occur in big licks, rather it will take a thorough analysis of the amalgamated business to identify small cost savings that all add up.
• Fairly obviously, non-contiguous acquisitions will yield lower synergies as many cost savings cannot be applied.
• Obtain tax advice very early in the process !!
Sources
• Are you paying too much for that acquisition ? - Harvard Business Review, July - August 1999.
• Strategy as a portfolio of real options - Harvard Business Review, September - October 1998.
• Analysis of NZ electricity company sale prices in relation to ODV - Utility Consultants, August 1999.
• CEO’s giant egos get in way of mergers - NZ Herald, 20 January 2000.
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