Dr. P.V. Viswanath

 

pviswanath@pace.edu

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Introduction to Mergers and Acquisitions

 
 

P.V. Viswanath, 2006


Conglomerate Mergers

In 1986, GE acquired Kidder Peabody. This is an example of a conglomerate deal; one that was not successful. Below is a paragraph from the 1994 G.E. Annual Report (http://www.scripophily.net/kidpeabcotra.html):

The Kidder story, and its $1.2 billion loss, is not a pleasant one;

Whether or not it was a good idea to buy Kidder in 1986 is academic -- in the end, it simply didn't work out. In 1994, weak trading markets lowered Wall Street earnings by billions of dollars from the levels of 1993, and Kidder was not immune to the weaknesses in these markets. But Kidder had another problem: a phantom trading scheme by a single employee, directed not against customers but against the firm itself, which cost it $210 million in net income. The combination of the two circumstances -- a downturn in earnings, and an employee's wrongdoing -- made it clear to us that it was time to get out; thus the sale of the brokerage assets of Kidder to PaineWebber, in return for 25% equity in that firm, and the liquidation of the trading operation.


Sheridan Square Entertainment and Hirsch International Corporation

http://www.hirschintl.com/news_index.cfm?newssel=21

  • Who acquired whom?
  • What is the purpose of the additional agreement to purchase the Series B convertible preferred stock of Sheridan Square at a price per share of $25,000?

Takeover Premiums

Have Dealmakers Wised up? (Businessweek article, February 21, 2005)

Why large takeover premiums? (Prof. Stephen Bainbridge, UCLA, http://www.professorbainbridge.com/2005/09/mannes_primer_o.html)

In standard economic theory, a control premium is not inconsistent with the efficient capital markets hypothesis. The pre bid market price represented the consensus of all market participants as to the present discounted value of the future dividend stream to be generated by the target—in light of all currently available public information. Put another way, the market price represents the market consensus as to the present value of the stream of future cash flows anticipated to be generated by present assets as used in the company's present business plans. A takeover bid represents new information. It may be information about the stream of future earnings due to changes in business plans or reallocation of assets. In any event, that pre bid market price will not have impounded the value of that information. To the extent the bidder has private information, moreover, the market will be unable to fully adjust the target's stock price.


Two-tiered transactions

http://www.findarticles.com/p/articles/mi_qa4048/is_200401/ai_n9382758

Campeau's two-tier bid
(from notes of Prof. Levent Koçkesen, Koç University, Istanbul)

Example 1.9 (Hostile Takeovers). During the 1980s there was a huge wave of mergers and acqui-sitions
in the Uniter States. Many of the acquisitions took the form of “hostile takeovers,” a term used to describe takeovers that are implemented against the will of the target company’s management. They usually take the form of direct tender offers to shareholders, i.e., the acquirer publicly offers a price to all the shareholders. Some of these tender offers were in the form of what is known as “two-tiered tender offer.”

Such was the case in 1988 when Robert Campeau made a tender offer for Federated Department Stores. Let us consider a simplified version of the actual story. Suppose that the pre-takeover price of a Federated share is $100. Campeau offers to pay $105 per share for the first 50% of the shares, and $90 for the remainder. All shares, however, are bought at the average price of the total shares tendered. If the takeover succeeds, the shares that were not rendered are worth $90 each.

For example, if 75% of the shares are tendered, Campeau pays $105 to the first 50% and pays $90 to the remaining 25%. The average price that Campeau pays is then equal to p = 105×(50/75 +90×(25/75) = 100
In general, if s percent of the shares are tendered the average price paid by Campeau, and thus the price of a tendered share, is given by p = 105 if s <= 50 and p = 105 × (50/s) + 90 x ((s-50)/s) if s > 50
Notice that if everybody tenders, i.e., s =100, then Campeau pays $97.5 per share which is less than the current market price. So, this looks like a good deal for Campeau, but only if sufficiently high number of shareholders tender.

The actual unfolding of events were quite unfortunate for Campeau. Macy’s joined the bidding and this increased the premium quite significantly. Campeau finally won out (not by a two-tiered tender offer, however) but paid $8.17 billion for the stock of a company with a pre-acquisition market value of $2.93 billion. Campeau financed 97 percent of the purchase price with debt. Less than two years later, Federated filed for bankruptcy and Campeau lost his job.


Leveraged Buyouts

Article by Greg Jarrell
http://www.econlib.org/library/Enc/TakeoversandLeveragedBuyouts.html

Trends in LBOs
http://www.oycf.org/Perspectives/18_093002/Leveraged_Buyouts.htm

Case study, with example
http://mba.tuck.dartmouth.edu/pecenter/research/pdfs/LBO_Note.pdf


Strategy

Two useful models:

Shapiro's approach:

A project can be reliably identified as being positive NPV only if we can also identify the sources of that positive NPV. In general, the sources of such value enhancement represent some deviation from perfect competition in the product market, such as the existence of barriers to entry in the firm's industry, due to:

  1. the availability of economies of scale in production
    Lesson: Investments that are structured to exploit economies of scale are more likely to be successful than those that are not.
  2. the possibility of product differentiation
    Lesson: Investments designed to create a position at the high end of anything, including the high end of the low end, differentiated by a quality or service edge, will generally be profitable.
  3. cost advantages
    Lesson: Investments aimed at achieving the lowest delivered cost position in the industry, coupled with a pricing policy to expand market share, are likely to succeed, especially if the cost reductions are proprietary.
  4. monopolistic access to distribution channels
    Lesson: Investments devoted to gaining better product distribution often lead to higher profitability.
  5. protective government regulation
    Lesson: Investments in project protected from competition by government regulation can lead to extraordinary profitability. However, what the government gives, the government can take away!

Lessons for M&A from the Shapiro approach:

  • Horizontal Mergers can reduce costs through economies of scale
  • Merging vertically downwards to acquire distribution channels can procure better product distribution
  • Acquiring firms with R&D capabilities can help generate products with quality edge (Yahoo’s acquisition of Inktomi in 2003 which had a superior crawler)
  • The flip side is to deny competitors such an ability – cf. Yahoo’s acquisition of Altavista in 2003 to deny MSN access to a ready-made search engine.
  • Acquiring targets with R&D to reduce production costs; for example, integrated steel producers acquiring minimills.

Porter Model:

  1. Barriers to Entry can make it more difficult for new entrants into industry
    1. Regulatory restrictions (e.g. banking license),
    2. brand names (e.g. Xerox, McDonalds – can develop customer loyalty; hard to develop and/or imitate)
      patents (illegal to exploit without ownership; e.g. new drugs – cf. also RIM)
    3. and unique know-how (e.g. WalMart’s “hot docking” technique of logistics management)
    4. Accumulated experience (cf. learning curve)
  2. Customer Power (monopsony)
    1. Powerful customers can influence prices and product quality.
      Examples are WalMart (consumer goods) and the US government (US defense industry)
    2. If customers are weak, suppliers can keep prices rising, e.g. in filmed entertainment, cigarettes and education.
  3. Supplier Power
    1. Powerful suppliers can extract high prices from firms.
    2. In contrast, in the 1990s, weak suppliers allowed auto manufacturers to extract price concession.
  4. Threat of Substitutes
    1. Substitutes limit the pricing power of competitors in an industry.
    2. The price of coal for electric power generators is influenced by the price of oil and natural gas.
  5. Rivalry Conduct
    1. Balance of competitive advantage can be altered by investments in
      • new product or new process innovation,
      • opening new channels of distribution and
      • entry into new geographic markets
    2. Cartels keep competition low
    3. Predatory pricing can keep profits variable and low.
    4. Rivalry is sharper where
      • players are similar in size,
      • the barriers to exit from an industry are high,
      • fixed costs are high,
      • growth is slow, and
      • products/ services are not differentiated

Lessons for M&A from Porter

  1. Firms can look for targets to enhance resistance to new entrants – e.g. smaller firms with proprietary intellectual property or R&D capabilities.
  2. Where competitor conduct promotes rivalry, mergers may be undertaken to reduce susceptibility to competition – e.g.
    • horizontal mergers can increase market share
    • Targets with new products or new processes
    • vertically merging downward to obtain new channels of distribution
    • Merging with targets that permit entry into new geographic markets
  3. Where supplier/ consumer power is high, mergers can be used to counter supplier power.
  4. Where supplier/ consumer power is low, horizontal mergers can be used to exploit supplier weakness.
  5. If there are threats from substitutes, firms could
    • Acquire targets in the “substitutes” industry
    • Acquire targets with R&D to counter the attractiveness of substitutes
  6. Acquire targets in related industries that are regulated
    • For example, a coal producer could integrate vertically and acquire an electricity producer.

Categories of Strategic Acquisition (Kauppi List):

  1. Acquire Customers
    where the target is in the same business in a different geography (or in a different context)
  2. Operating Leverage
    improving profit margins through higher utilization rates for plant and equipment
  3. Capitalize on a company's strength
  4. Cover a weakness
  5. Buy a low-cost supplier
  6. Improving or completing a product line
  7. Technology -- build or buy?
  8. Acquisition to provide scale and access to capital markets
  9. Protect and expand mature product lines
  10. Protect customer base from competition
  11. Acquisition to remove barriers to entry
  12. Opportunistic acquisition for when the market turns

 

Application to the Mittal-Arcelor merger

  • First, find a description of the two companies -- this can often be obtained by looking at the profiles on Yahoo or similar sites. wsj.online also has these descriptions. In the case of Arcelor, I found a profile description on yahoo.fr
  • Then, get some information on the industry. You can search the web, but you need to evaluate sites cautiously. One location that is very useful for this is the Pace library website (library.pace.edu). Go to NetAdvantage and get information about the industry.
  • A third and very important source of information is the 10-K filings of the companies. In our case, Arcelor does not trade on a US exchange -- hence we will not find SEC filings. Mittal does trade on the NYSE, but it is a foreign company -- hence it does not file 10-Ks, but rather a 20-F filing.
  • Use the information on the firm's websites (http://www.mittalsteel.com/Investor+Relations/Annual+Report+2004/Regions/)
  • Get information on the organizational structure of the industry.
    Who are the leaders? What are their market shares?
  • What are the geographical areas where the merger parties operate? In our case, operate can have two meanings -- one, where they produce, and two, where they sell.
  • What are the production economics?
  • What can you say about the product mix between Mittal and Arcelor?
  • What is the evaluation of the market?