Chapter_1

Introduction to Mergers, Acquisitions, & Other Restructuring Activities*

If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a life time. Lao Tze*

Cross-BorderTransactions*

Course Learning ObjectivesDefine what corporate restructuring is and why it occursIdentify commonly used valuation techniquesDescribe how corporate restructuring creates/destroys value Identify commonly used takeover tactics and defensesDevelop a highly practical planning based approach to managing the M&A processIdentify challenges and solutions associated with each phase of the M&A process Describe advantages and disadvantages of alternative M&A deal structuresDescribe how to plan, structure, and manage JVs, partnerships, alliances, licensing arrangements, equity partnerships, franchises, and minority investments*

Current Chapter Learning ObjectivesPrimary objective: What corporate restructuring is and why it occursSecondary objective: Provide students with an understanding ofM&A as a form of corporate restructuringAlternative ways of increasing shareholder valueM&A activity in an historical contextThe primary motivations for M&A activityKey empirical findingsPrimary reasons some M&As fail to meet expectations*

Motivations for M&AStrategic realignmentTechnological changeDeregulationSynergyEconomies of scale/scopeCross-sellingDiversification (Related/Unrelated)Financial considerationsAcquirer believes target is undervaluedBooming stock marketFalling interest ratesMarket power dominate pricingEgo/Hubris I can do itTax considerations-tax free, NOLs*

Why Do Most M&As Fail? Acquirers do not think systematically about what they are buying and what it might do for them.Extend business but not fundamentally change how you compete. Reinvent your business, need a new business model to complement, extend or replace. Inadequate Due DiligenceInadequate Integration The New M&A Playbook, Christensen, HBR March 2011 See website*

Five Myths About Emerging MarketsEmerging markets growing much faster but stock market losses much stepper. Growth Market Losses US 1.8% -0.9%Brazil 3.1% -16.5%Russia 4.5% -10.9%India 7.3% -23.0%China 9.0% -22.2% Myth 1 High valuations less important in fast growing economies. Expensive vs. valuation measures PE ratios Pollock, Five Myths About Emerging Markets, Wall Street Journal, December 5, 2011, Page C5 *

Five Myths About Emerging MarketsMyth 2 EM stocks well insulated global financial problems. Not so today-NY & London; consider risk = small cap Myth 3 EM growth strategy only Bonds & dividend paying stocks Wisdom 8.5%Myth 4 EM currencies as $ declines. Long term maybe but weak vs $Myth 5 Concentrate on few of strongest emerging nations. Piled into country specific ETFs, less diversification, liquid, easy to trade. Use broad based EM. *

M&As as a Form of Corporate RestructuringRestructuring ActivityCorporate RestructuringBalance Sheet

Assets Only

Financial Restructuring (liabilities only)

Operational RestructuringPotential StrategyRedeploy AssetsMergers, Break-Ups, & Spin-OffsAcquisitions, divestitures, etc.Increase leverage to lower cost of capital or as a takeover defenseDivestitures, widespread employee reduction, or reorganization*

Alternative Ways of Increasing Shareholder ValueSolo venture (AKA going it alone or organic growth)Partnering (Marketing/distribution alliances, JVs, licensing, franchising, and equity investments)Mergers and acquisitionsMinority investments in other firms. (EMC discussion)Asset swaps (Real Estate)Financial restructuringOperational restructuring

*

Discussion QuestionsWhat factors do you believe are most likely to impact senior managements selection of one strategy (e.g., solo venture, M&A) to increase shareholder value over the alternatives? Be specific.In your opinion, how might the conditions of the business (e.g., profitability) and the economy affect the choice the strategy?

*

Remembering the PastThose who do not remember the past are condemned to relive it. Alexis De Tocqueville*

Merger Waves1(Boom Periods)Horizontal Consolidation (1897-1904)Increasing Concentration (1916-1929)The Conglomerate Era (1965-1969)The Retrenchment Era (1981-1989)Age of Strategic Megamerger (1992-2000)Age of Cross Border and Horizontal Megamergers (2003-2007)1Periods characterized by robust increases in the number and value of transactions.*

Causes and Significance of M&A WavesFactors contributing to merger waves:Shocks (e.g., technological change, deregulation, and escalating commodity prices)Ample liquidity and low cost of capitalOvervaluation of acquirer share prices relative to target share prices Why it is important to anticipate M&A waves:Financial markets reward firms pursuing promising (often undervalued) opportunities early on and penalize those that follow later in the cycle.Acquisitions made early in the wave often earn substantially higher financial returns than those made later in the cycle.*

Horizontal Consolidation (1897-1904)Spurred by Drive for efficiency, Lax enforcement of antitrust lawsWestward migration, and Technological changeResulted in concentration metals, mining and transportation industry. (GM/DuPont)M&A boom ended by 1904 stock market crash and fraudulent financing*

Increasing Concentration (1916-1929)Spurred by Entry of U.S. into WWIPost-war boomBoom ended with1929 stock market crashPassage of Clayton Act which more clearly defined monopolistic practices

*

The Conglomerate Era (1965-1969)Conglomerates buy earnings streams to boost share price (diversified portfolio) LTV,UTCOvervalued firms acquired undervalued high growth firmsNumber of high-growth undervalued firms declined as conglomerates bid up their pricesHigher purchase price for target firms and increasing leverage of conglomerates brought era to a close. Supply and demand

*

The Retrenchment Era (1981-1989)Strategic U.S. buyers and foreign multinationals dominated first half of decadeSecond half dominated by financial buyersBuyouts often financed by junk bondsDrexel Burnham provided market liquidityEra ended with bankruptcy of several large LBOs and demise of Drexel Burnham (Michael Milken)

*

Age of Strategic Megamerger (1992-2000)Dollar volume of transactions reached record in each year between 1995 and 20001Purchase prices reached record levels due toSoaring stock marketConsolidation in many industriesTechnological innovation Benign antitrust policiesPeriod ended with the collapse in global stock markets and worldwide recession1The cumulative dollar value of M&As during this period in the U.S. was $6.5 trillion, With $3.5 trillion taking place in the last two years (55%).*

Age of Cross Border and Horizontal Megamergers (2003 2007)Average merger larger than in 1980s and 1990s, mostly horizontal, and cross borderConcentrated in banking, telecommunications, utilities, healthcare, and commodities (e.g., oil, gas, and metals)Spurred byContinued globalization to achieve economies of scale and scope; Ongoing deregulation;Low interest rates; Increasing equity prices, and Expectations of continued high commodity pricesPeriod ended with global credit market meltdown and 2008-2009 recession*

Debt Financed 2003-2007 M&A BoomLow Interest Rates & Declining Risk Aversion Drive Increasing--Sub-Prime Mortgage Lending--LBO Financing & Other Highly Leveraged TransactionsInvestment Banks:Repackage &Underwrite--Mortgage Backed --High Yield BondsBanks & Hedge Funds Create:--Collateralized Debt Obligations (CDOs)--Collateralized Loan Obligations CLOs)Foreign Investors Buy HighestRated DebtHedge FundsBuy LowerRated debtInvestment Banks Lend to Hedge Funds*

Similarities and Differences Among Merger WavesSimilaritiesOccurred during periods of sustained high economic growthLow or declining interest ratesRising stock marketAccess to cash corporate cash - $2 trillionDifferencesEmergence of new technology (e.g., railroads, Internet)Industry focusType of transaction (e.g., horizontal, vertical, conglomerate, strategic, or financial) Per President Obama, December 2012-13*

PwC - M & A Activity

*

M & A Activity 2012Uncertain global economyVolatile equity marketsSurprise- uptick in M&A, more strategicExecute target growth strategiesReshape business prosper current economyClose deals in pipelineCorporate cash reserves S&P - $1.5T Dealmakers in Pursuit of Strategic M&A Opportunities, PwC, July 18, 2012*

M & A Activity 2012Specifics disclosed dealsFirst half 2012 - 3,870 deals, $350B value First half 2011- 4,606 deals, $592B valueQ 2 2012, 1,891 deals, $218BQ 1 2012, 1,979 deals, $132BJune 2012, $76B, best month since 2011Midmarket deals 35%value, 98% volumeWhere the market is, value driven upChallenging debt market, through process and due diligenceWe expect deal activity to increase 2nd half

*

M & A Activity YTD 2012Divestitures increasing - 28% versus 22%Sell off orphansNon strategic assetsSell side due diligence to enhance valuePrivate Equity activity increasingPursuing middle market deals17% deal valueDoes contribute to IPO activity by exiting. 40% CEOs planning emerging market deal28% CEOs planning other deals

*

Discussion QuestionsWhat can senior management learn by studying historical merger waves?What can government policy makers learn by studying historical merger waves?What can investors learn by studying historical merger waves?*

2013 and Beyond per KPMGOptimism on Deal Environment

Significantly more optimistic

More optimistic

About the same

Less optimistic

Significantly less optimistic 0% 10% 20% 30% 40% 50%

2 Multiple responses permitted.

*

Factors Facilitating Deal Activity*Large cash reserves/commitments

Availability of credit on favorable terms

Opportunities in emerging markets

Improved consumer confidence

Resolution of European economic crisis

Improving equity markets

Improved employment numbers

Recovery of financial services sector

Other

Illustrating Economies of ScalePeriod 1: Firm A (Pre-merger)Assumptions:Price = $4 per unit of output soldVariable costs = $2.75 per unit of outputFixed costs = $1,000,000Firm A is producing 1,000,000 units of output per yearFirm A is producing at 50% of plant capacity

Profit = price x quantity variable costs fixed costs = $4 x 1,000,000 - $2.75 x 1,000,000 - $1,000,000 Revenue $4,000,000 = $250,000 V/C ( 2,750,000) F/C ( 1,000,000) Profit $ 250,000Profit margin (%)1 = $250,000 / $4,000,000 = 6.25%Fixed costs per unit = $1,000,000/1,000,000 = $1

Period 2: Firm A (Post-merger)Assumptions:Firm A acquires Firm B which is producing 500,000 units of the same product per yearFirm A closes Firm Bs plant and transfers production to Firm As plantPrice = $4 per unit of output soldVariable costs = $2.75 per unit of outputFixed costs = $1,000,000

Profit = price x quantity variable costs fixed costs = $4 x 1,500,000 - $2.75 x 1,500,000 - $1,000,000 = $6,000,000 - $4,125,000 - $1,000,000 = $875,000

Profit margin (%)2 = $875,000 / $6,000,000 = 14.58%Fixed costs per unit = $1,000,000/1.500,000 = $.67Key Point: Profit margin improvement is due to spreading fixed costs over more units of output.1Margin per $ of revenue = $4.00 - $2.75 - $1.00 = $.252Margin per $ of revenue = $4.00 - $2.75 - $.67 = $.58*

Illustrating Economies of ScopePre-Merger:

Firm As data processing center supports 5 manufacturing facilitiesFirm Bs data processing center supports 3 manufacturing facilitiesAssume capacity

Post-Merger:

Firm As and Firm Bs data processing centers are combined into a single operation to support all 8 manufacturing facilities By combining the centers, Firm A is able to achieve the following annual pre-tax savings:Direct labor costs = $840,000.Telecommunication expenses = $275,000Leased space expenses = $675,000General & administrative expenses = $230,000

Key Point: Cost savings due to expanding the scope of a single center to support all 8 manufacturing facilities of the combined firms.*

Empirical Findings Around transaction announcement date, abnormal returns average20% for target shareholders in friendly transactions; 30-35% in hostile transactions. Bondholders also benefit. Bidders shareholders (and bondholders) on average earn zero to slightly negative returns. Enterprise values (EV) for target & bidders volatile.EV targets surge after announcement; EV bidders - negativePositive abnormal returns to bidders often are situational and include the following:Target is a private firm or a subsidiary of another firmThe acquirer is relatively small (large firm management subject to hubris)The target is small relative to the acquirerCash rather than equity used to finance the transaction ??Transaction occurs early in the M&A cycleNo evidence that alternative strategies (e.g., solo ventures, alliances) to M&As are likely to be more successful Branch, Mergers and Acquisitions and the Universal Investor, Investor Responsibility Research Center Institute, January 2012-3*

Primary Reasons Some M&As Fail to Meet ExpectationsOverpayment due to over-estimating synergy (price tag), goodwill ??

Slow pace of integration

Poor strategy

*

Discussion QuestionsDiscuss whether you believe current conditions in the U.S. and global markets are conducive to high levels of M&A activity? Be specific.Of the factors potentially contributing to current conditions, which do you consider most important and why?Speculate about what you believe will happen to the number of M&As over the next several years in the U.S.? Globally? Defend your arguments.*

Application: Xerox Buys ACSIn late 2009, Xerox, traditionally an office equipment manufacturer, acquired Affiliated Computer Systems (ACS) for $6.4 billion. With annual sales of about $6.5 billion, ACS handles paper-based tasks such as billing and claims processing for governments and private companies. With about one-fourth of ACS revenue derived from the healthcare and government sectors through long-term contracts, the acquisition gives Xerox a greater penetration into markets which should benefit from the 2009 government stimulus spending and 2010 healthcare legislation. There is little customer overlap between the two firms.Previous Xerox efforts to move beyond selling printers, copiers, and supplies and into services achieved limited success due largely to poor management execution. While some progress in shifting away from the firms dependence on printers and copier sales was evident, the pace was far too slow. Xerox was looking for a way to accelerate transitioning from a product driven company to one whose revenues were more dependent on the delivery of business services.More than two-thirds of ACS revenue comes from the operation of client back office operations such as accounting, human resources, claims management, and other outsourcing services, with the rest coming from providing technology consulting services. ACS would also triple Xeroxs service revenues to $10 billion. Xerox chose to run ACS as a separate standalone business.

Discussion Questions: 1.What alternatives to a merger do you think they could have considered?2.Why do you think they chose a merger strategy? (Hint: Consider the advantages and disadvantages of alternative implementation strategies.)3.How are Xerox and ACS similar and how are they different? In what way will their similarities and differences help or hurt the long-term success of the merger?4.How might the decision to manage ACS as a separate business affect realizing the full value of the transaction?*

Things to RememberMotivations for acquisitions:Strategic realignmentSynergyDiversificationFinancial considerationsHubrisCommon reasons M&As fail to meet expectationsOverpayment due to overestimating synergySlow pace of integrationPoor strategyM&As typically reward target shareholders far more than bidder shareholdersSuccess rate of M&A not significantly different from alternative ways of increasing shareholder value*

****************************