The seven sins in acquisitions… - ValueWalk...P&G Gillette Piglet: No SynergyPiglet: Synergy...

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Thesevensinsinacquisitions…

Aswath Damodaran

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1. RiskTransference:Attributingacquiringcompanyriskcharacteristicstothetargetfirm.

2. Debtsubsidies:Subsidingtargetfirmstockholdersforthestrengthsoftheacquiringfirm.

3. Auto-pilotControl:The“20%controlpremium” andothermyth…

4. ElusiveSynergy:Misidentifyingandmis-valuingsynergy.5. Itsallrelative:Transactionmultiples,exitmultiples…6. Verdictfirst,trialafterwards:Pricefirst,valuationtofollow7. It’snotmyfault:Holdingnooneresponsiblefordelivering

results.

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Testingsheet

Aswath Damodaran

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Test Passed/Failed Rationalization

Risk transference

Debt subsidies

Control premium

The value of synergy

Comparables and Exit MultiplesBias

A successful acquisition strategy

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Letsstartwithatargetfirm

Aswath Damodaran

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¨ Thetargetfirmhasthefollowingincomestatement:Revenues 100OperatingExpenses 80= OperatingIncome 20Taxes 8=After-taxOI 12

¨ Assumethatthisfirmwillgeneratethisoperatingincomeforever(withnogrowth)andthatthecostofequityforthisfirmis20%.Thefirmhasnodebtoutstanding.Whatisthevalueofthisfirm?

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Test1:RiskTransference…

Aswath Damodaran

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¨ Assumethatasanacquiringfirm,youareinamuchsaferbusinessandhaveacostofequityof10%.Whatisthevalueofthetargetfirmtoyou?

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Lesson1:Don’ttransferyourriskcharacteristicstothetargetfirm

Aswath Damodaran

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¨ Thecostofequityusedforaninvestmentshouldreflecttheriskoftheinvestmentandnottheriskcharacteristicsoftheinvestorwhoraisedthefunds.

¨ Riskybusinessescannotbecomesafejustbecausethebuyerofthesebusinessesisinasafebusiness.

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Test2:Cheapdebt?

Aswath Damodaran

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¨ Assumeasanacquirerthatyouhaveaccesstocheapdebt(at4%)andthatyouplantofundhalftheacquisitionwithdebt.Howmuchwouldyoubewillingtopayforthetargetfirm?

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Lesson2:Renderuntothetargetfirmthatwhichisthetargetfirm’sbutnotapennymore..

Aswath Damodaran

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¨ Asanacquiringfirm,itisentirelypossiblethatyoucanborrowmuchmorethanthetargetfirmcanonitsownandatamuchlowerrate.Ifyoubuildthesecharacteristicsintothevaluationofthetargetfirm,youareessentiallytransferringwealthfromyourfirm’sstockholdertothetargetfirm’sstockholders.

¨ Whenvaluingatargetfirm,useacostofcapitalthatreflectsthedebtcapacityandthecostofdebtthatwouldapplytothefirm.

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Test3:ControlPremiums

Aswath Damodaran

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¨ Assumethatyouarenowtoldthatitisconventionaltopaya20%premiumforcontrolinacquisitions(backedupbyMergerstat).Howmuchwouldyoubewillingtopayforthetargetfirm?

¨ WouldyouranswerchangeifItoldyouthatyoucanrunthetargetfirmbetterandthatifyoudo,youwillbeabletogeneratea30%pre-taxoperatingmargin(ratherthanthe20%marginthatiscurrentlybeingearned).

¨ Whatifthetargetfirmwereperfectlyrun?

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Lesson3:Bewareofrulesofthumb…

Aswath Damodaran

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¨ Valuationisclutteredwithrulesofthumb.Afterpainstakinglyvaluingatargetfirm,usingyourbestestimates,youwillbeoftenbetoldthat¤ Itiscommonpracticetoaddarbitrarypremiumsforbrandname,qualityofmanagement,controletc…

¤ Thesepremiumswillbeoftenbebackedupbydata,studiesandservices.Whattheywillnotrevealistheenormoussamplingbiasinthestudiesandthestandarderrorsintheestimates.

¤ Ifyouhavedoneyourvaluationright,thosepremiumsshouldalreadybeincorporatedinyourestimatedvalue.Payingapremiumwillbedoublecounting.

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Test4:Synergy….

Aswath Damodaran

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¨ Assumethatyouaretoldthatthecombinedfirmwillbelessriskythanthetwoindividualfirmsandthatitshouldhavealowercostofcapital(andahighervalue).Isthislikely?

¨ Assumenowthatyouaretoldthattherearepotentialgrowthandcostsavingssynergiesintheacquisition.Wouldthatincreasethevalueofthetargetfirm?

¨ Shouldyoupaythisasapremium?

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TheValueofSynergy

Aswath Damodaran

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Synergy is created when two firms are combined and can be either financial or operating

Operating Synergy accrues to the combined firm as Financial Synergy

Higher returns on new investments

More newInvestments

Cost Savings in current operations

Tax BenefitsAdded Debt Capacity Diversification?

Higher ROC

Higher Growth Rate

Higher Reinvestment

Higher Growth RateHigher Margin

Higher Base-year EBIT

Strategic Advantages Economies of Scale

Longer GrowthPeriod

More sustainableexcess returns

Lower taxes on earnings due to - higher depreciaiton- operating loss carryforwards

Higher debt raito and lower cost of capital

May reducecost of equity for private or closely heldfirm

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ValuingSynergy

Aswath Damodaran

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(1)thefirmsinvolvedinthemergerarevaluedindependently,bydiscountingexpectedcashflowstoeachfirmattheweightedaveragecostofcapitalforthatfirm.(2)thevalueofthecombinedfirm,withnosynergy,isobtainedbyaddingthevaluesobtainedforeachfirminthefirststep.(3)Theeffectsofsynergyarebuiltintoexpectedgrowthratesandcashflows,andthecombinedfirmisre-valuedwithsynergy.

ValueofSynergy=Valueofthecombinedfirm,withsynergy-Valueofthecombinedfirm,withoutsynergy

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Synergy- Example1Highergrowthandcostsavings

Aswath Damodaran

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P&G Gillette Piglet: No Synergy Piglet: SynergyFree Cashflow to Equity $5,864.74 $1,547.50 $7,412.24 $7,569.73 Annual operating expenses reduced by $250 millionGrowth rate for first 5 years 12% 10% 11.58% 12.50% Slighly higher growth rateGrowth rate after five years 4% 4% 4.00% 4.00%Beta 0.90 0.80 0.88 0.88Cost of Equity 7.90% 7.50% 7.81% 7.81% Value of synergyValue of Equity $221,292 $59,878 $281,170 $298,355 $17,185

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Synergy:Example3TaxBenefits?

Aswath Damodaran

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¨ AssumethatyouareBestBuy,theelectronicsretailer,andthatyouwouldliketoenterthehardwarecomponentofthemarket.YouhavebeenapproachedbyinvestmentbankersforZenith,whichwhilestillarecognizedbrandname,isonitslastlegsfinancially.Thefirmhasnetoperatinglossesof$2billion.Ifyourtaxrateis36%,estimatethetaxbenefitsfromthisacquisition.

¨ IfBestBuyhadonly$500millionintaxableincome,howwouldyoucomputethetaxbenefits?

¨ IfthemarketvalueofZenithis$800million,wouldyoupaythistaxbenefitasapremiumonthemarketvalue?

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Lesson4:Don’tpayforbuzzwords

Aswath Damodaran

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¨ Throughtime,acquirershavealwaysfoundwaysofjustifyingpayingforpremiumsoverestimatedvaluebyusingbuzzwords- synergyinthe1980s,strategicconsiderationsinthe1990sandrealoptionsinthisdecade.

¨ Whileallofthesecanhavevalue,theonusshouldbeonthosepushingfortheacquisitionstoshowthattheydoandnotonthosepushingagainstthemtoshowthattheydonot.

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Test5:ComparablesandExitMultiples

Aswath Damodaran

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¨ Nowassumethatyouaretoldthatananalysisofotheracquisitionsrevealsthatacquirershavebeenwillingtopay5timesEBIT..GiventhatyourtargetfirmhasEBITof$20million,wouldyoubewillingtopay$100millionfortheacquisition?

¨ WhatifIestimatetheterminalvalueusinganexitmultipleof5timesEBIT?

¨ Asanadditionalinput,yourinvestmentbankertellsyouthattheacquisitionisaccretive.(YourPEratiois20whereasthePEratioofthetargetisonly10…Therefore,youwillgetajumpinearningspershareaftertheacquisition…)

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Biasedsamples=Poorresults

Aswath Damodaran

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¨ Biasedsamplesyieldbiasedresults.Basingwhatyoupayonwhatotheracquirershavepaidisarecipefordisaster.Afterall,weknowthatacquirer,onaverage,paytoomuchforacquisitions.Bymatchingtheirprices,weriskreplicatingtheirmistakes.

¨ Evenwhenweusethepricingmetricsofotherfirmsinthesector,wemaybebasingthepriceswepayonfirmsthatarenottrulycomparable.

¨ Whenweuseexitmultiples,weareassumingthatwhatthemarketispayingforcomparablecompaniestodayiswhatitwillcontinuetopayinthefuture.

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Lesson5:Don’tbealemming…

Aswath Damodaran

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¨ Alltoooften,acquisitionsarejustifiedbyusingoneofthefollowingtwoarguments:¤ Everyoneelseinyoursectorisdoingacquisitions.Youhavetodothesametosurvive.

¤ Thevalueofatargetfirmisbaseduponwhatothershavepaidonacquisitions,whichmaybemuchhigherthanwhatyourestimateofvalueforthefirmis.

¨ Withtherightsetofcomparablefirms,youcanjustifyalmostanyprice.

¨ EPSaccretionisameaninglessmeasure.Afterall,buyingancompanywithaPElowerthanyourswillleadmathematicallytoEPSaccretion.

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Test6:TheCEOreallywantstodothis…ortherearecompetitivepressures…

Aswath Damodaran

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¨ NowassumethatyouknowthattheCEOoftheacquiringfirmreally,reallywantstodothisacquisitionandthattheinvestmentbankersonbothsideshaveproducedfairnessopinionsthatindicatethatthefirmisworth$100million.Wouldyoubewillingtogoalong?

¨ Nowassumethatyouaretoldthatyourcompetitorsarealldoingacquisitionsandthatifyoudon’tdothem,youwillbeatadisadvantage?Wouldyoubewillingtogoalong?

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Lesson6:Don’tletegosorinvestmentbankersgetthebetterofcommonsense…

Aswath Damodaran

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¨ Ifyoudefineyourobjectiveinabiddingwaraswinningtheauctionatanycost,youwillwin.Butbewarethewinner’scurse!

¨ Thepremiumspaidonacquisitionsoftenhavenothingtodowithsynergy,controlorstrategicconsiderations(thoughtheymaybeprovidedasthereasons).TheymayjustreflecttheegosoftheCEOsoftheacquiringfirms.Thereisevidencethat“overconfident”CEOsaremorelikelytomakeacquisitionsandthattheyleaveatrailacrossthefirmsthattheyrun.

¨ Pre-emptiveordefensiveacquisitions,whereyouoverpay,eitherbecauseeveryoneelseisoverpayingorbecauseyouareafraidthatyouwillbeleftbehindifyoudon’tacquirearedangerous.Iftheonlywayyoucanstaycompetitiveinabusinessisbymakingbadinvestments,itmaybebesttothinkaboutgettingoutofthebusiness.

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Toillustrate:Abaddealismade,andjustifiedbyaccountants&bankers

Aswath Damodaran

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TheCEOstepsin…anddigsahole…

Aswath Damodaran

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¨ LeoApothekerwastheCEOofHPatthetimeofthedeal,broughtintoreplaceMarkHurd,thepreviousCEOwhowasforcedtoresignbecauseofa“sex”scandal.

¨ InthefaceofalmostuniversalfeelingthatHPhadpaidtoomuchforAutonomy,Mr. Apotheker addressing a conference at the time of the deal: “We have a pretty rigorous process inside H.P. that we follow for all our acquisitions, which is a D.C.F.-based model,”he said, in a reference to discounted cash flow, a standard valuation methodology. “And we try to take a very conservative view.”

¨ Apotheker added, “Just to make sure everybody understands, Autonomy will be, on Day 1, accretive to H.P….. “Just take it from us. We did that analysis at great length, in great detail, and we feel that we paid a very fair price for Autonomy. And it will give a great return to our shareholders.

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Ayearlater…HPadmitsamistake…andexplainsit…

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Test7:Isithopeless?

Aswath Damodaran

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¨ Theoddsseemtobeclearlyweightedagainstsuccessinacquisitions.Ifyouweretocreateastrategytogrow,baseduponacquisitions,whichofthefollowingoffersyourbestchanceofsuccess?

This OrthisSoleBidder BiddingWarPublictarget PrivatetargetPaywithcash PaywithstockSmalltarget LargetargetCostsynergies Growthsynergies

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Bettertoloseabiddingwarthantowinone…

Aswath Damodaran

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Returns in the 40 months before & after bidding warSource: Malmendier, Moretti & Peters (2011)

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Youarebetteroffbuyingsmallratherthanlargetargets…withcashratherthanstock

Aswath Damodaran

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Andfocusingonprivatefirmsandsubsidiaries,ratherthanpublicfirms…

Aswath Damodaran

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GrowthvsCostSynergies

Aswath Damodaran

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Synergy:Oddsofsuccess

Aswath Damodaran

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¨ Studiesthathavefocusedonsynergieshaveconcludedthatyouarefarmorelikelytodelivercostsynergiesthangrowthsynergies.

¨ Synergiesthatareconcreteandplannedforatthetimeofthemergeraremorelikelytobedeliveredthanfuzzysynergies.

¨ Synergyismuchmorelikelytoshowupwhensomeoneisheldresponsiblefordeliveringthesynergy.

¨ Youaremorelikelytogetashareofthesynergygainsinanacquisitionwhenyouareasinglebidderthanifyouareoneofmultiplebidders.

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Lesson7:Foracquisitionstocreatevalue,youhavetostaydisciplined..

Aswath Damodaran

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1. Ifyouhaveasuccessfulacquisitionstrategy,stayfocusedonthatstrategy.Don’tletsizeorhubrisdriveyouto“expand” thestrategy.

2. Realisticplansfordeliveringsynergyandcontrolhavetobeputinplacebeforethemergeriscompleted.Byrealistic,wehavetomeanthatthemagnitudeofthebenefitshavetobereachableandnotpipedreamsandthatthetimeframeshouldreflecttherealitythatittakesawhilefortwoorganizationstoworkasone.

3. Thebestthingtodoinabiddingwaristodropout.4. Someone(preferablythepersonpushinghardestforthemerger)

shouldbeheldtoaccountfordeliveringthebenefits.5. Thecompensationforinvestmentbankersandothersinvolvedin

thedealshouldbetiedtohowwellthedealworksratherthanforgettingthedealdone.

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AReallyBigDeal!

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TheAcquirer(ABInBev)

LatinAmerica42%

Africa0%

AsiaPacific11%

Europe11%

NorthAmerica36%

RevenueBreakdown(2014)

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TheTarget(SABMiller)

CapitalMix Operating MetricsInterest-bearingDebt $12,550 Revenues $22,130.00LeaseDebt $368 OperatingIncome(EBIT) $4,420.00MarketCapitalization $75,116 OperatingMargin 19.97%DebttoEquityratio 17.20% Effectivetaxrate 26.40%DebttoCapitalratio 14.67% After-taxreturnoncapital 10.32%BondRating A3 ReinvestmentRate= 16.02%

LatinAmerica35%

Africa31%

AsiaPacific14%

Europe19%

NorthAmerica

1%

RevenueBreakdown(2015)

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Settingupthechallenge

¨ SABMiller’smarketcapitalizationwas$75billiononSeptember15,2015,thedayABInBev announceditsintenttoacquireSABMiller.

¨ Thedealwascompleted(pendingregulatoryapproval)amonthlater,withABInBev agreeingtopay$104billionforSABMiller.

¨ CanABInBev create$29billioninadditionalvaluefromthisacquisitionandifsowherewillitfindthevalue?¤ Themarketseemstothinkso,adding$33billioninmarketvaluetothecombinedcompany.

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TheThree(Value)ReasonsforAcquisitions

¨ Undervaluation:Youbuyatargetcompanybecauseyoubelievethatthemarketismispricingthecompanyandthatyoucanbuyitforlessthanits"fair"value.

¨ Control:Youbuyacompanythatyoubelieveisbadlymanaged,withtheintentofchangingthewayitisrun.Ifyouarerightonthefirstcountandcanmakethenecessarychanges,thevalueofthefirmshouldincreaseunderyourmanagement

¨ Synergy:Youbuyacompanythatyoubelieve,whencombinedwithabusiness(orresource)thatyoualreadyown,willbeabletodothingsthatyoucouldnothavedoneasseparateentities.Thissynergycanbe¤ Offensivesynergy:Highergrowthandincreasedpricingpower¤ Defensivesynergy:Costcutting,consolidation&preemptingcompetitors.¤ Taxsynergy:Directlyfromtaxclausesorindirectlythroughdent

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Fournumberstowatch

1. AcquisitionPrice:Thisisthepriceatwhichyoucanacquirethetargetcompany.Ifitisaprivatebusiness,itwillbenegotiatedandprobablybasedonwhatothersarepayingforsimilarbusinesses.Ifitisapubliccompany,itwillbeatapremiumoverthemarketprice.

2. StatusQuoValue:Valueofthetargetcompany,runbyexistingmanagement.

3. RestructuredValue:Valueofthetargetcompany,withchangestoinvesting,financinganddividendpolicies.

4. Synergyvalue:Valueofthecombinedcompany(withthesynergybenefitsbuiltin)– (Valueoftheacquiringcompany,asastandaloneentity,andtherestructuredvalueofthetargetcompany)

¨ TheAcidTest¤ Undervaluation:Pricefortargetcompany<StatusQuoValue¤ Control:Pricefortargetcompany<RestructuredValue¤ Synergy:Pricefortargetcompany<RestructuredValue+ValueofSynergy

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SABMillerStatusQuoValue

SABMiller +CoorsJV +ShareofAssociates SABMillerConsolidatedRevenues $22,130.00 $5,201.00 $6,099.00OperatingMargin 19.97% 15.38% 10.72%OperatingIncome(EBIT) $4,420.00 $800.00 $654.00InvestedCapital $31,526.00 $5,428.00 $4,459.00Beta 0.7977 0.6872 0.6872ERP 8.90% 6.00% 7.90%CostofEquity= 9.10% 6.12% 7.43%After-taxcostofdebt= 2.24% 2.08% 2.24%DebttoCapitalRatio 14.67% 0.00% 0.00%Costofcapital= 8.09% 6.12% 7.43%

After-taxreturnoncapital= 10.33% 11.05% 11.00%ReinvestmentRate= 16.02% 40.00% 40.00%Expectedgrowthrate= 1.65% 4.42% 4.40%Numberofyearsofgrowth 5 5 5ValueoffirmPVofFCFFinhighgrowth= $11,411.72 $1,715.25 $1,351.68Terminalvalue= $47,711.04 $15,094.36 $9,354.28Valueofoperatingassetstoday= $43,747.24 $12,929.46 $7,889.56 $64,566.26+Cash $1,027.00- Debt $12,918.00- MinorityInterests $1,183.00Valueofequity $51,492.26

Price on September 15, 2015: $75 billion > $51.5 billion

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SABMiller:PotentialforControl

SABMiller ABInBevGlobal Alcoholic Beverage Sector

Pre-taxOperatingMargin 19.97% 32.28% 19.23%

EffectiveTaxRate 26.36% 18.00% 22.00%

Pre-taxROIC 14.02% 14.76% 17.16%

ROIC 10.33% 12.10% 13.38%

ReinvestmentRate 16.02% 50.99% 33.29%

DebttoCapital 14.67% 23.38% 18.82%

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SABMiller:ValueofControl

Status Quo Value Optimal valueCost of Equity = 9.10% 9.37%After-tax cost of debt = 2.24% 2.24%Cost of capital = 8.09% 8.03%

After-tax return on capital = 10.33% 12.64%Reinvestment Rate = 16.02% 33.29%Expected growth rate= 1.65% 4.21%

Value of firmPV of FCFF in high growth = $11,411.72 $9,757.08Terminal value = $47,711.04 $56,935.06Value of operating assets today = $43,747.24 $48,449.42+ Cash $1,027.00 $1,027.00+ Minority Holdings $20,819.02 $20,819.02- Debt $12,918.00 $12,918.00- Minority Interests $1,183.00 $1,183.00 Value of Control

Value of equity $51,492.26 $56,194.44 $4,702.17Price on September 15, 2015: $75 billion > $51.5 + $4.7 billion

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TheSynergies?

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)LeveredBeta 0.85 0.8289 0.84641 0.84641Pre-taxcostofdebt 3.0000% 3.2000% 3.00% 3.00%Effectivetaxrate 18.00% 26.36% 19.92% 19.92%DebttoEquityRatio 30.51% 23.18% 29.71% 29.71%

Revenues $45,762.00 $22,130.00 $67,892.00 $67,892.00

OperatingMargin 32.28% 19.97% 28.27% 30.00%OperatingIncome(EBIT) $14,771.97 $4,419.36 $19,191.33 $20.368

After-taxreturnoncapital 12.10% 12.64% 11.68% 12.00%ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%ExpectedGrowthRate 6.17% 4.21% 5.09% 6.00%

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Thevalueofsynergy

Inbev SABMiller

Combined firm (status

quo)Combined firm

(synergy)CostofEquity= 8.93% 9.37% 9.12% 9.12%After-taxcostofdebt= 2.10% 2.24% 2.10% 2.10%Costofcapital= 7.33% 8.03% 7.51% 7.51%

After-taxreturnoncapital= 12.10% 12.64% 11.68% 12.00%

ReinvestmentRate= 50.99% 33.29% 43.58% 50.00%

Expectedgrowthrate= 6.17% 4.21% 5.09% 6.00%

Value of firmPVofFCFFinhighgrowth= $28,733 $9,806 $38,539 $39,151Terminalvalue= $260,982 $58,736 $319,717 $340,175Valueofoperatingassets= $211,953 $50,065 $262,018 $276,610

Value of synergy = 276,610 – 262,018 = 14,592 million

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PassingJudgment

¨ Ifyouadduptherestructuredfirmvalueof$56.2billiontothesynergyvalueof$14.6billion,yougetavalueofabout$70.8billion.

¨ Thatiswellbelowthe$104billionthatABInBev isplanningtopayforSABMiller.

¨ Oneofthefollowinghastobetrue:¤ Ihavemassivelyunderestimatedthepotentialforsynergyinthismerger(eitherintermsofhighermarginsorhighergrowth).

¤ ABInBev hasoverpaidsignificantlyonthisdeal.Thatwouldgoagainsttheirhistoryasagoodacquirerandagainstthehistoryof3GCapitalasagoodstewardofcapital.