Getting the prices right

Getting the prices right

When no precedent exists to guide analysts in assessing the value of an alliance, the task of justifying a price to shareholders falls to those who lead the deal.

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Getting the prices right

When AOL and Time Warner announced plans to merge in January 2000, the deal was worth $166 billion on paper to Time Warner. By December of the same year, a dip in AOL stock had reduced the Internet giantÆs offer by about a third. The fact that the deal closed, despite this price cut, stands as a tribute to the way Steve Case and Gerald Levine communicated their strategy for the combined company. When no precedent exists to guide analysts in assessing the value of an alliance, the task of justifying a price to shareholders falls to those who lead the deal.

Increasingly, companies see mergers and acquisitions as a strategic tool and expect to benefit from synergiesùimprovements in competitiveness, customer value or product innovationù that can be achieved by integrating two entities. This added complexity means executives have a more difficult task trying to identify, value, and negotiate closure on attractive deals. Also, as investment banks pitch deals more aggressively, executives fear being trumped by competitors and thus feel more pressured to act. Successful buyers are those who approach deals proactively and are driven by strategic intent. Successful buyers court targets early to develop an understanding of what value the acquisition will add and how it will do soùand they are able to explain this to investors. Successful buyers also understand the perspectives of competing bidders and the negotiating stance of all players involved.

Why do so many executives find themselves unprepared for merger and acquisition opportunities, thus missing deals or executing them poorly? Why do half to three-quarters of mergers and acquisitions fail to create shareholder value? The answer lies in a failure to align the process of generating and executing transactions with strategic goals, and adapt valuation methods accordingly.

For some, particularly leveraged-buyout firms, the strategic goal is to ôsqueeze the lemonö through active investing: to manage the acquired business more effectively and help the business achieve its full profit potential. For others, the acquired company may help to build scale or provide a stepping-stone into businesses or customer segments related to the buyerÆs core activities. In other cases, the acquisition may broaden the scope of the acquirerÆs business by adding new capabilities. Or the deal might result in a fundamental change in the business of the combined company, or its sector. Whatever the rationale, buyers need to keep focused as they move through the deal, from screening to negotiating a close. This will help them zero in on the few companies critical to their rationale, accurately value them, and negotiate a successful transaction.

Screening strategically
Corporate acquirers should take a page from financial buyers and investment bankers and screen acquisition candidates based on strategic goals. This will establish a focused search that not only identifies the right targets, but also gives buyers a head start on the due-diligence process.

Further, it pays to consider several options simultaneously and to court likely prospects months or even years ahead of a sale. With this approach, a buyer has a head start on other bidders regarding due diligence, as well as an inside link that can help build enthusiasm for the deal within the target company. One branded consumer-products company maintains files on all potential players in its business. These files contain details of companiesÆ performance histories, likely strategies, and even employee morale. The database helps the consumer-products company assess the fit of potential acquisitions and prepares the chief executive for frequent meetings that form part of the ongoing courtship.

Setting a price
Once a buyer has zeroed in on acquisitions in line with its strategic goals, the buyer needs to assess price tags. Every corporate buyer knows the formula for valuing business is: stand-alone value, plus the value of synergies, less the cost of closing the deal and integrating the acquisition. The challenge lies in putting numbers into this equation.

With time short, and management egos and adviser fees at stake, one can easily overestimate the benefits of a merger and underestimate the costs of integrating the acquisition. The more complex the strategic rationaleùand the vision for the combined company ùthe more work required to determine the right price, and the more leverage one has to transform the rules of the valuation.

Check the cash flow
Valuations for all acquisitions start by predicting the full potential of the business on a stand-alone basis and projecting the cash flows the new business will generate. To ascertain a companyÆs soundness requires rigorous analysis of competitive environment and strategic positioning, market trends, cost structures, employee issues, capital requirements and many other factors. The degree of risk that each factor presents needs to be reflected by adjusting cash-flow forecasts.

More often than not, the management of the selling company provides rosy forecasts inconsistent with historical performance. Such forecasts ignore threats like competitor rivalry, new entrants, or new technology that could render products obsolete. Worse, these forecasts rarely offer sound rationale for performance improvement, nor do they budget the cost required for implementing changes.

The lesson for buyers? Build your own projections. Standard market multiples do not reflect an individual companyÆs position, and a low price does not necessarily indicate a bargain.

In the mid-90s, value-added computer resellers, such as Vanstar or Entex, looked cheapùmarket valuations had declined 50%. But they werenÆt a bargain: the economic rules of reselling were being rewritten, and valuations tumbled a further 50%.

Once the buyer determines the future cash flow of a stand-alone business, he or she needs to value the benefits of combining the targetÆs operations with its own. Deals founded on increasing scale often fail to create value because the acquirer has misguided expectations of the economies in store. To achieve success in a scale-driven acquisition, determine which aspects of scale really countùi.e., what allows the company to take advantage of joint revenues and costs. Different businesses achieve the benefits of scale differently. Some, such as automotive, derive the highest profitability from global scale. Others, such as supermarkets, gain the most profitability from regional or local scale. And some, such as medical products, find profitability from scale within a distribution channel. Further, in some sectors, such as cosmetic products, branding has a stronger impact on margins.

When consumer-products maker Philip Morris acquired a series of food-service distributors in the 80s, the company intended to build national scale. Philip Morris did achieve the No. 2 position nationally, but it overlooked a key factor of success: In the food-service sector, profitability chiefly depends on the efficient use of local distribution centers and routes, which in turn depend on local market share, not national scale. Philip MorrisÆs shopping spree bought a leading position in only one city, while most of the acquisitions were trailers in third, fourth or fifth place. The results were miniscule margins and disappointing performance, which led Philip Morris to sell off its food-service business.

Once the acquirer understands how and where to capitalize on scale, he needs to predict the financial impact of combining two companies: How much scale buys how much cost reduction? Industry experience curves help here, because they chart how average production costs fall as volume accumulates. And benchmarks allow comparison with competitor cost structures.

Ideally, these analyses should be combined with detailed information on the targetÆs cost structureùand detail is key. For each function the buyer must ask: Where can I save on head count; how many employees should be offered severance or redeployed? Which plants, distribution centers or stores can be closed, and which activities can be moved to more efficient locations? Which contracts can be renegotiated at advantageous rates? What savings will these changes yield after deducting lost sales, closure and severance costs?

Then, there are further questions related to the balance sheet: What capital equipment or property can be sold as consolidation progresses? What cash can be freed up through inventory reduction? What benefits that can boost revenue, such as a broadened product mix or more effective advertising budget, may also derive from scale? The answers to these questions create inputs for a more reliable cash-flow model for valuing the target company, far superior to models that use industry acquisition multiples or comparisons with top-performing companies.

Finally, check your assumptionsùespecially the ones that drive the most benefit. Furniture manufacturer Mity-Lite2 recently bought CenterCore, planning to save costs by folding the targetÆs New Jersey operations into one of its plants in Arkansas that was operating below capacity. The value of the deal was destroyed when none of CenterCoreÆs employees agreed to move south. Mity-Lite would have avoided this error if it had tested employeesÆ willingness to relocate ahead of time.

Test related business opportunities
All valuations need to undertake the painstaking, detailed work of predicting cost savings. But companies moving into highly related, or ôadjacent,ö businesses need to add to the equation a calculation of potential revenue synergies.3 Incremental revenue is more elusive than people thinkùparticularly those responsible for sales and marketing. To grow sales from existing customer and product assets, a company usually needs to change its customersÆ behaviors; not a simple task. For example, additional revenue may depend on cross-selling new products or persuading consumers to buy bundles of goods or higher-priced brands and services. These objectives are tough to achieve when sales forces, brands and pricing also may be changing. To value incremental revenue correctly companies need to rigorously test whether the new entityÆs combined offerings would hold more appeal for customers than stand-alone offerings.

Just ask brewer Anheuser-Busch. When the company first moved into snacks, the synergies were clear: The firm bought a nut company to provide snacks as a service to beer-establishment customers. Snacks, an easy drop-off alongside the beer, made sense as a niche related to the core business. Busch steadily grew its peanut distribution on the back of its beverage distribution. But problems arose in 1992, when the company decided to move from peanuts to a full snack business. Busch strayed far outside its core, acquiring several food and snack companies to extend its product line. Succeeding as a major player in snacks demanded a presence in grocery stores, where Busch had weak distribution. Busch mistakenly assumed economies of distribution scale in the retail channel between beverages and newly acquired food products. In fact, supermarkets order these goods on different schedules, and the products have different delivery needs. BuschÆs expected synergies never materialized. The beverage company suffered from price retaliation by the snacks market leader, Frito-Lay, leading the brewer eventually to withdraw from the market and refocus on beer.

By contrast, Getty Images, the leading marketer of reproduction rights to still photographic images, identified an opportunity to leverage its customer base, content and sales capabilities through early entry into an emerging channelùthe Internet. With online delivery of photographs set to grow, and barriers to entry high compared to traditional channels, the company saw the benefits of moving quickly. Getty determined its customers would value the opportunity to source photographs online. So, the company forecast growth in this digital channel at the expense of the traditional analog one. Getty acquired the leading online player, converted its content to digital format, and invested heavily to offer unrivaled services to its online customers. An early lead positioned the company to grow rapidly, surpassing and then acquiring Image Bank, a subsidiary of Kodak and the historic leader in stock photography.

Check the fit of acquisitions that increase scope
Some companies, most notably fast-growing technology outfits such as Cisco, Microsoft and Intel, have used acquisitions as a principal source of growth. They target companies with capabilities that would be either too expensive or too slow to develop internally, or that would dilute managementÆs focus on their existing businesses. For these acquirers, potential for cost savings or revenue growth are important factors in the valuation, but the make-or-break issue is whether the new outfit has high-quality employees who can be integrated into the acquiring company. The cost of retaining such employeesùin terms of compensation raises, stock options and other incentive schemesùremains an important factor in arriving at a deal price.

The head of CiscoÆs acquisition team, Mike Volpi, searches for start-ups to fill gaps in CiscoÆs portfolio of technical expertise. He says, ôWe look at a companyÆs vision; its short-term success with customers; its long-term strategy; the chemistry of the people with ours; and its geographic proximity.ö His goal is to hide the seams between the acquired company and Cisco within a hundred days. CiscoÆs continued success at picking businesses that meld with the parent has earned Volpi Fortune magazineÆs crown of ôSilicon ValleyÆs shrewdest shopper.ö

Assess the potential value of transactions that transform the business
Some companies use mergers and acquisitions fundamentally in their business or even in their sector. These deals are often based on a vision thatÆs difficult to prove or express in numbers. As a result, theyÆre risky and hard to justify to the markets.

When Ted Turner incurred almost crippling debt buying the worldÆs largest cache of vintage cartoons and classic movies, commentators dubbed him a loony tune.4 In fact, the gamble paid off: As the cable-TV market took hold, the value of vintage content jumped. The asset positioned Turner to compete profitably with Disney and Nickelodeon in cartoon cable and opened up new revenue streams in videos and classic-movie remakes. Although Turner did not disclose the libraryÆs purchase valuation, competitive collections have gained as much as 100 times their value over the years with the advent of VCRs and cable. TurnerÆs video distribution rights, originally purchased from MGMÆs library for $125 million, were sold for a whopping $225 million in 1999.

Some mergers aim to remake a company in the image of another. When Nortel bought Bay Networks and a host of other optical-network companies, Nortel clearly intended to transform itself into an Internet infrastructure company to match Cisco. NortelÆs concrete vision not only helped convince the market of the wisdom of the plan, but also gave the company, and external analysts, at least one benchmark for judging the value of the deals.

In other cases, companies set out to create something entirely new, which makes realistic projections difficult. Acquirers can do the basic work of anticipating scale and revenue synergies, but valuing these deals remains hard, the margin for error huge, and success elusive. In sectors such as media and telecommunications, where outcomes are difficult to predict, a scenario-based approach can help manage the complexity. For example, acquirers can use Monte Carlo analysis or other econometric modeling tools to calculate a reasonable value.

In other industries, biotechnology for example, where acquirers such as Merck bet on the successful application of a new technology, others tools are useful. Binomial pricing and the Black-Scholes option valuation method can help account for the diverse possibilities of success and failure. Whatever the methods used, one of the most critical elements in these difficult-to-predict transactions is clearly and confidently communicating to the market the strategic rationale and approach used to pick a price. Indeed, the very process of determining which scenarios might exist and which outcomes might prevailùincluding competitive responsesù will make for better decision-making and valuation.

Negotiate preemptively
An acquirer who courts potential targets well ahead of a deal, forming relationships with management and understanding the culture of the organization, has a good chance of preempting an auction. By the time an acquirer approaches a target, it should have a clear idea of the acquisitionÆs worth, to itself and to others. Knowing what value competing bidders will place on the acquisition is essential in determining whether there is a price that will trump others without overpaying for synergies.

Consider how each playerÆs competitive position would be altered by each possible outcome and how that would affect their bid price. At this stage, the strategic rationale should be clear to all concerned and a valuation team poised to collect the internal data needed to complete due diligence. In deals where integrating and retaining talent is vital, make friends with the targetÆs key executives and signal their roles. Retaining stars not only improves the odds of a smooth transition, but also garners further insights into the workings of the company.

Even among strategically driven mergers there will be some spectacular failures. Journalists will look back in five years and shake their heads at the misguided alliances that shareholders optimistically approved. Nevertheless, some of the next decadeÆs greatest success stories should spring from hard-to-value strategic alliances that effectively change the rules of valuation. A clear, strategic vision, well-articulated and linked to rigorous valuation and informed negotiation, will be a strong predictor of success.

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* Orit Gadiesh is chairman of Bain & Co. Dan Haas is a vice president in Bain's Boston office and Geoffrey Cullinan is a vice president in London.

Source: Submitted by Bain & Co to the EIU ebusiness forum. Bain & Co is a sponsor of the EIU ebusiness forum.


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