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Merger Strategy

One plus one makes three is the main idea behind a Merger oran Acquisition.

The key principle behind buying a company is to createshareholder value over and above that of the sum of the two

companies. Two companies together are more valuable than twoseparate companies.

Especially, when times are tough, strong companies will act tobuy other companies to create a more competitive and cost-efficient 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 theyknow they cannot survive alone.

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Merger Strategy This chapter focuses on the strategic motives and determinants

of mergers and acquisitions (M&As). It begins with a discussionof two of the most often cited motives for mergers andacquisitionsGrowth and Synergy.

Synergy is the magic force that allows for enhanced cost

efficiencies of the new business. Synergy takes the form ofrevenue enhancement and cost savings.

The different types of synergy:

Operating and Financial synergy

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Operating synergy has the most economically sound basis.Financial synergy is a more questionable motive for a mergeror an acquisition.

Companies often merge in an attempt to diversify into anotherline of business. The history of mergers is replete withdiversification transactions. The track record of thesediversifications, with notable exceptions, is not veryimpressive. However, certain types of diversifyingtransactions, those that do not involve a movement to a verydifferent business category, have a better track record.Companies experience greater success with horizontalcombinations, which result in an increase in market share,

and even with some vertical transactions, which may provideother economic benefits. Unfortunately, a less noble motivesuch as hubris, or pride of the management of the bidder, alsomay be a motive for an acquisition.

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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 organicgrowth 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 itbrings with it its own uncertainties.

A. If a company seeks to expand within its own industry they mayconclude 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

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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 throughacquisitions strategy

It sought to pursue those companies who had developed successful products in order tonot 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 thenGuidants 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 care4. 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, Tylenolmedications, Johnson's baby products, Neutrogena skin and beauty products, Clean & Clear facial wash and Acuvuecontact lenses

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B. Another example of growth strategy is when a company wants to expandto another geographic region. It can be another region of the same country oranother country or continent. Incase of international expansion, the companyneeds to understand the new market, recruit new personnel and encounter

other hurdles like language and culture barriers. Then, mergers, acquisitionsor 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 buyerholding the more highly valued currency may be able to afford a higherpremium which would be attractive for the target.

Eg. A sample from 1970- 1987 shows that foreign acquirers paid 10%higher premiums.

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Operating Synergy Revenue-Enhancing Operating Synergy Revenue-enhancing operating synergy may be more difficult to achieve than cost reduction synergies. It may come

from new opportunities that are presented as a result of the combination of the two merged companies.[10] Thereare many potential sources of revenue enhancements, and they may vary greatly from deal to deal. They maycome from a sharing of marketing opportunities by cross-marketing each merger partners products. With abroader product line, each company could sell more products and services to their product base.

[10] Mark N. Clemente and David S. Greenspan, Winning at Mergers and Acquisitions: The Guide to Market-FocusedPlanning and Integration (New York: John Wiley & Sons, 1998), p. 46.

Cross-marketing has the potential to enhance the revenues of each merger partner, thereby enabling eachcompany to expand its revenues quickly. The multitude of ways in which revenue-enhancing synergies may beachieved defies brief descriptions. It may come from one company with a major brand name lending its reputationto an upcoming product line of a merger partner. Alternatively, it may arise from a company with a strongdistribution network merging with a firm that has products of great potential but questionable ability to get themto the market before rivals can react and seize the period of opportunity. Although the sources may be great,revenue-enhancing synergies are sometimes difficult to achieve. Such enhancements are more difficult to quantifyand build into valuation models. This is why cost-related synergies are often highlighted in merger planning,whereas the potential revenue enhancements may be discussed but not clearly defined. It is easier to say we havecertain specific facilities that are duplicative and can be eliminated than to specifically show how revenues can beincreased through a combination of two companies. Potential revenue enhancements often are vaguely referredto as merger benefits but are not clearly quantified. This is one reason some deals fail to manifest the anticipatedbenefits. The reason can be found in poor premerger planning caused by failing to specifically quantify revenueenhancements. Probably the most dramatic example of such vague and generally poor merger planning is thelargest deal of all timethe disastrous 2002 merger of AOL and Time Warner.

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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 thethird merger wavethe conglomerate era. During the late 1960s, firms oftensought to expand by buying other companies rather than through internalexpansion. This outward expansion was often facilitated by some creative financialtechniques that temporarily caused the acquiring firms stock price to rise whileadding little real value through the exchange. The legacy of the conglomerates hasdrawn poor, or at least mixed, reviews. Indeed, many of the firms that grew intoconglomerates in the 1960s were disassembled through various spinoffs anddivestitures in the 1970s and 1980s. This process ofdeconglomerization raisesserious doubts as to the value of diversification based on expansion.

Although many companies have regretted their attempts at diversification, otherscan 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 anelectronics-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.

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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 tothe 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 buyersellerrelationship.

Horizontal Integration

Combinations that result in an increase in market share may have a significant impact on thecombined firms market power. Whether market power actually increases depends on the size ofthe merging firms and the level of competition in the industry. Economic theory categorizesindustries within two extreme forms of market structure. On one side of this spectrum is purecompetition, which is a market that is characterized by numerous buyers and sellers, perfectinformation, and homogeneous, undifferentiated products. Given these conditions, each seller is aprice taker with no ability to influence market price. On the other end of the industry spectrum ismonopoly, which is an industry with one seller. The monopolist has the ability to select the price-output 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 notearn a profit, depending on the magnitude of its costs relative to revenues at the optimal profit -maximizing price-output combination. Within these two ends of the industry structure spectrum ismonopolistic 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 adifferentiated product. Horizontal integration involves a movement from the competitive end of thespectrum toward the monopoly end.

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By merging, the companies hope to benefit from

the following:

Staff reduction: mergers tend to mean job losses, mostly from reducing thenumber 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 officesupplies- 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 oftechnological 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 twocompanies marketing and distribution, giving them new sales opportunities. Due

to improved financial standing, bigger firms have an easier time raising capital

than smaller ones.

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Overcoming the entry barriers: Mergers and acquisitions is one of the waysfor 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 establishedbusiness 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.

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Synergy

The word SYNERGY is derived from ancient Greek words SUNERGIA andSUNERGOS which mean COOPERATION and WORKING TOGETHER.

In business environment, it signifies that the combined efforts of two or moreagents create such effects which are greater than the sum of their individualeffects. Technically, Synergy is the ability of the merged company to generatehigher shareholders wealth than the standalone entities. Economically, it is the

ability of the combined entity to further limit the competitors abilities to contestagainst 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

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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.

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Operating economies are also possible in generic management functionssuch 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 theindustry value chain also helps achieve operating economies. This is

because vertical integration reduces the costs of communication andbargaining.