Synergies

M&A Analysis

January 12

Synergies - Outline

Introduction: Definition and classification of synergies Required level of synergies Classification of Synergies Measurement of Synergies Using Macro Statistics Measurement of Synergies Using Detailed Analysis Reference: Studies of Merger Savings Reference: Examples of Synergies

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Basic Success in M&A and Synergies

Recall that synergies drive the success of M&A for Buying Companies  Same or Related Industry
 Know how to manage costs  Can possibly reduce competition

 Acquiring Company has Higher ROIC

 Acquiring company can use best practices to reduce costs

The implications of this finding is that synergies come from imposing best practices and improving cost efficiency of the target company and if there is a possibility to increase prices in a merger.

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Introduction to Measurement of Synergies

Focus on measurement rather than strategic theory There are virtually no textbooks that discuss the mechanics of how to measure specific synergies. Instead, there is a general discussion of strategic behavior and extending products or expanding market coverage. In measuring synergies, the calculations must account for how the synergy can actually be achieved for example, if there are staff reductions, will the reductions come from voluntary reduction, attrition etc. Given, the problems with no generic formulas for synergy, the discussion includes: Definition of the synergy Examples of the synergy estimation Formulas for measuring the synergy

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Real World Problems in Measuring Synergies

There is no template or simple formula  The academic literature uses strategic theory and statistical analysis of market power.  There is virtually no literature on how to measure cost savings in practice. General points on measuring related to measuring synergies:  The synergy measurement depends on specific knowledge of the business and industry  Synergies and their measurement is specific to a company or an industry and the computation is also specific to the company or industry  Data is very limited when evaluating a transaction not only do you not have little data on the target, but your own staff cannot evaluate the data (e.g. you may not be able to ask your IT staff to evaluate cost savings.)

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Definition of Synergies

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Synergy a Quest for Holy Grail

Definition: the increase in performance of the combined firm over what the two firms are already expected to accomplish as independent firms. Popular definition: 1 + 1 = 3 PV (A+B) > PV(A) + PV(B)  Roundabout definition: If am I willing to pay 6 for the business market-valued at 5 there has to be the Synergy justifying that  More technical definition: Synergy is ability of merged company to generate higher shareholders wealth than the standalone entities  Efficiencies based upon the close integration of specific, hard-totrade assets owned by the merging parties. If cost savings or revenue enhancements can be obtained without a merger, synergies do not exist.

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Types of Synergies and Value Allocation

If synergies do exist, then the next issue is whether the buying company or the target company achieves the synergies (recall the formula fundamental equation that synergies > premium). The allocation depends on the relative bargaining power. Universal: Value to Target Company in Premium  Available to any acquirer. Examples are administrative costs, eliminating obvious value drains and cutting waste Endemic: Value to Target or Buyer  Available to a few acquirers. Generally in the same industry and/or geographic area. Examples are economies of scale and redundant sales force Unique: Value to Buyer  Available to only one buyer (co-ownership of plant). Combination of geographic, industry and product lines.

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January 12

Operating Synergies
Marketing gains  Advertising  Distribution network  Product mix Strategic benefits Market power Under-managed target Efficiency gains Economies of scale, economies of scope, critical mass Opportunities for restructuring Sell unproductive assets that are retained by management who cannot or will not shed such value destroying businesses

M&A Analysis

January 12

Negative Synergies

Competitive response to sales force reductions Competitor response when integration is occurring High integration costs and limited savings  Overoptimistic appraisal of market potential and synergies (e.g. assume that product markets for acquirer will turn around or unrealistic vision about the value of corporate strategies)  Poor Due Diligence (over looking problems because of deadlines, in-experience or ignoring bad news)

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General Valuation Issues

Synergies should be:  After tax  Discounted at a rate that reflects risk
 Risk free synergies for things like contract adjustments  Venture capital type discount rate for speculative revenue increases

 Account for the lifetime of the synergies and terminal valuation  Account for cost to achieve

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Required Level of Synergies

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Sirower Formula

Investors pay what a firm is worth. Therefore, the value of playing the acquisition game is  NPV = Synergy - Premium

If you believe a firm is mis-valued, just buy shares in the company on the market.  Synergy > Premium : Success  0 > Synergy < Premium : Failure  Synergy < 0 : Disaster

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Basic Valuation Formula in M&A

Added Value From Acquisition =  Value of acquirer and acquired firm after the acquisition Value before

Acquirer Value = Value Added - Cost Cost = Transaction Cost + Acquisition Premium  Investments can be made without acquisition  Paying a premium means there must be expected synergies that more than off-set the premium

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Synergy a Quest for Holy Grail

Paying unjustified premiums is tantamount to making charitable contributions to random passers-by, never to be recouped by the buying company no matter how long the acquisition is held. SIROWER: Suppose you are running at 3 mph, but are required to run 4 mph next year and 5 mph the year after. Synergy would mean running even harder than this expectation while competitors supply a head wind. Paying a premium for synergy that is, for the right to run harder is like putting on a heavy pack. Meanwhile, the more you delay running harder, the higher the incline is set. This is the acquisition game.

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Synergy Puzzle

Why do executives, investment bankers and consultants so often recommend that acquiring firms pay more for a target company than anyone else would pay. Over-bidding for Synergies (in the heat of the deal; can find benchmarks that justify the valuation; the winners curse) Post-Acquisition Integration

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Exercise Find Premium and Required Level of Synergies Relative to Reported Synergies
What was premium
 Share price x shares x premium percent

What was the reported level of synergies pre-tax

 Present value of synergies  Subtract cost to achieve  Compute on after tax basis to compare to premium

How do the level of synergies compare to the premium

 Net value of merger

See slides below

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Comparable Synergy Analysis

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Comparable Synergy Analysis

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Premium in BP-Amoco Merger

Morgan Stanley reviewed eleven selected comparable merger transactions and compared the implied premium to the relative market capitalization of the smaller entity. This analysis evidenced premiums in a range from 5.0% to 15.0% based on closing share prices on the day before the announcement of the transaction. The implied premium received by Amoco Shareholders upon receiving 40.0% ownership of the combined entity is 13.3%, also based on closing share prices on the day before announcement of the transaction. The premium received by Amoco Shareholders when measured over different time periods similarly matched the premiums indicated by comparable transactions when measured over the same time period.

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Classification of Synergies

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Classification of Synergies Free Cash Flow Based

Attempt to classify synergies into categories to discuss measurement EBITDA Capital Expenditures Cost (Operating Expenses and Capital Expenditures)
 Economies of Scale  Best Practices  Capacity Utilization

Revenues
 Price Increases  Volume (Growth) Increases

Risk Reduction

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Classification of Synergies Economies of Scale

Definition of economies of scale reduced average cost per unit when the total production increases.  No matter how small a company, need billing systems, accounting, basic treasury etc. These are fixed costs that can be spread over larger output with a merger.  Often referred to as duplication or redundant costs  Include purchasing economies that come from ability to achieve lower input prices through greater bargaining power.

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Classification of Synergies Best Practices

Eliminating the inefficiency of target companies. Sometimes called X-efficiency or reduction of slack. Diffusion of capabilities across the two firms acquiring company may have patents, different historic experience or other things to manage more efficiently. Can come from both companies one company is good at making brakes and the second company is good at making gears.

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Classification of Synergies Capacity Optimization

Relocate production capacity across companies to allow more efficient capacity to be used first. Use of surplus capacity More efficient use of existing portfolio Reasons for cost differences Different cost curves Different levels of capacity relative to demand Use of unique production processes

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Classification of Synergies Volume Growth

Synergies can occur because the volume of unit sales is above the amount that could be received from the two companies on a standalone basis. Examples include:  Young R&D intensive company that does not have marketing know-how and/or does not have distribution capabilities.  Creation of new products from components of products developed by Target and Acquirer.  Cross-selling of products where increased sales occur because of selling products together.

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Classification of Synergies Price Increases

Could occur in horizontal mergers where companies operate in the same industry Must have pricing power not in commodity business such as oil, mining etc. Evidence is when stock price of competing companies increases when the merger occurs. Not much hard evidence of market power in horizontal mergers.

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Areas of Synergy Savings - KPMG

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Example of Synergies Exxon Mobil

Exxon Mobil  Near-term Operating Synergies. We believe we can run the combined company more efficiently than either company on its own. Specifically, we expect the combined company to achieve about $2.8 billion in annual pre-tax benefits from operating synergies. By operating synergies we mean increases in production, sales, and efficiency, decreases in unit costs and overhead expense, and other benefits made possible by combining complementary operations. We expect to realize the full $2.8 billion in annual pre-tax synergy benefits by the third year after the merger.  About two-thirds of these benefits should come from:
  Streamlining the combined organization, which we can run with less administrative and overhead cost than two separate organizations; Eliminating excess capacity, duplicate facilities, and redundant operations.

 Additional synergy benefits should come from:

   Exploring for oil and gas more efficiently in regions where the companies operate separately today; Applying each company's best business practices across the worldwide operations of the combined company; Coordinating purchases of raw materials across the two companies' extensive supply, refining and chemicals networks.

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Classification of Synergies Bank Mergers

1. 2. 3. 4. 5. 6.

Economies of Scale, Cost Cutting Increase Market Share Enhanced Product lines Entry into Attractive New Markets Improved Managerial Capabilities, and Increased Financial Leverage Financial and Operating Leverage

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Measurement of Synergies Macro Synergies

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Subjects in Synergy Measurement

Macro versus Micro Measurement Statistical versus Accounting Approach Use of Estimates from Other Mergers Computation of Realized Synergies Before Announcement versus After Announcement Economies of Scale versus Best Practice

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Macro Measurement of Synergies P/E Ratio

Recall were value comes from earning more than the cost of capital and growing and use this to measure potential value of the merger.  Example: Say the target and the acquiring company are in very similar industries with similar cost of capital and with the potential to realize similar growth and earn similar returns. The difference in P/E could be then argued to be due to management strategies and efficiencies. The synergies from a merger can then be measured with differential P/Es.  Formula:
 Target P/E Increment = Acquiring P/E - Existing Target P/E  P/E Increment x Target EPS = Value Creation After Tax  Value Creation After Tax = After Tax Synergy

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P/E Analysis Use of P/E Ratio in Valuation

J.P. Morgan performed an analysis comparing Exxon's price to earnings multiples with Mobil's price to earnings multiples for the past five years. The source for these price to earnings multiples was the one and two year prospective price to earnings multiple estimates by I/B/E/S International Inc. and First Call, organizations which compile brokers' earnings estimates on public companies. Such analysis indicated that Mobil has been trading in the recent past at an 8% to 15% discount to Exxon. J.P. Morgan's analysis indicated that if Mobil were to be valued at price to earnings multiples comparable to those of Exxon, there would be an enhancement of value to its shareholders of approximately $11 billion. Finally, this analysis suggested that the combined company might enjoy an overall increase in its price to earnings multiple due to the potential for improved capital productivity and the expected strategic benefits of the merger. According to J.P. Morgan's analysis, a price to earnings multiple increase of 1 for Exxon Mobil would result in an enhancement of value to shareholders of approximately $10 billion.

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P/E Analysis and Value Creation Example

J.P. Morgan performed an analysis comparing BP's and Amoco's price to earnings multiples ("P/E multiple") to those of Exxon and The Shell Transport & Trading Company plc ("Shell T&T") for the past five years. Such analysis indicated that BP and Amoco had been trading in the recent past at a 20% to 25% discount to both Exxon and Shell T&T. J.P. Morgan's analysis indicated that if BP and Amoco were to be valued at P/E multiples comparable to those of Exxon and Shell T&T there would be significant enhancement of value to shareholders of BP and Amoco. J.P. Morgan pointed out that there could be no assurance that this value would be realized.

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Macro Synergy Analysis ROIC Comparison

If two companies operate in the same industry and have similar assets, they should be able to achieve similar returns. If the acquiring company is earning higher returns than the target, one could argue that the target could apply its management techniques to the target and realize savings. ROICacquirer x Investmenttarget = NOPLATAfter Acquistion ROICtarget x Investmenttarget = NOPLATBefore Acquistion Synergy = NOPLATAfter Acquistion -NOPLATBefore Acquistion

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Return on Invested Capital Difference to Measure Synergies

The argument has been made that the best measure to evaluate management performance that is not distorted by leverage (as in the case of ROE) or has the problems of ROA is the return on invested capital. An example of use of this ratio is in the Exxon Mobile Merger:  J.P. Morgan reviewed and analyzed the return on capital employed ("ROCE") of both Exxon and Mobil since 1993. J.P. Morgan observed that Exxon's ROCE has consistently been 2-3% above that of Mobil.  J.P. Morgan's analysis indicated that if Mobil were to be merged with Exxon, the combined entity's capital productivity would eventually be higher than the pro forma capital productivity of Exxon and Mobil.  J.P. Morgan indicated that it would be reasonable to assume that the benefits of this capital productivity increase would occur within three years of the closing of the merger.

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Macro Synergy Analysis Tobins Q Ratio

Recall, the Q ratio which is defined as: Q = Enterprise Value/Replacement Cost The Q ratio measures how much management is adding to the replacement cost of assets. If management is adding nothing, the company should be liquidated and the company can be purchased for replacement cost. If management is adding a lot, the Q ratio exceeds 1.0. If the acquiring company has a Q ratio of 2.0 and the target has a Q ratio of 1.5 and the companies are in the same industry, one could argue that the target company should achieve an increase from 1.5 to 2.0 from a merger: Merger Value = (QAcquirer QTarget) x Replacement CostTarget

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Detailed Synergy Analysis - Economies of Scale

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Synergy Analysis Economies of Scale

To measure synergies from economies of scale, three methods can be used:  Function by function analysis of the staffing levels before and after the merger  Comparative ratios with other companies  Statistical Analysis of expense ratios relative to the level of sales

Example of function by function analysis

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Economies of Scale Example - Bank Mergers

Traditionally, bank mergers were based on a dominant partner purchasing a weaker entity and realizing huge cost savings from the integration of overlapping operations. The benefits for shareholders in mergers of equals are long-term and tend to hinge on whether the banks have enough overlapping operations to allow cost-slashing.  Consolidation of data processing and backroom operations  Consolidation, diversification, and streamlining of investment departments and the securities portfolio  Consolidation of the credit department, including loan documentation and preparation  Consolidation of loan review and audit operations  Consolidation of branch delivery systems, including use of the Internet

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Mergers and cost efficiencies

Even though the rapid consolidation has improved efficiency ratios in the U.S. banking industry, these benefits have yet to be realized by the largest banks as compared with other smaller banks. The evidence, however, suggests that average unit costs are flat across different size banks. Size essentially represents prestige and financial power.

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Summary performance measures by bank size, 1992 and 2001

Bank Size Year < $100M 2001 1992

$100M to $300M 2001 1992

$300M to $500M 2001 1992

$500M to $1B 2001 1992

$1B to $10B 2001 1992

> $10B 2001 1992

All Comm Banks 2001 1992

Number of institutions Total assets (in billions) Total deposits (in billions) Net income (in millions) % of unprofitable institutions % of institutions with earn gains Performance ratios (%) Return on equity Return on assets Equity capital ratio Net interest margin Yield on earning assets Cost of funding earn assets Earning assets to total assets Efficiency ratio Noninterest inc to earn assets Noninterest exp to earn assets LN&LS loss provision to assets Asset Quality (%) Net charge-offs to LN&LS Loss allow to Noncurr LN&LS Loss allowance to LN&LS Net LN&LS to deposits Capital Ratios (%) Core capital (leverage) ratio Tier 1 risk-based capital ratio Total risk-based capital ratio

4,486 221.6 187.7 1,912 11.19 49.53 8.07 0.91 10.90 4.23 7.83 3.61 91.39 69.59 1.11 3.74 0.30 0.34 128.1 1.41 71.11 10.63 15.87 16.96

8,292 346.0 306.5 3,487 6.83 78.69 11.10 1.04 9.38 4.74 8.55 3.81 91.16 66.85 1.05 3.90 0.35 0.57 114.2 1.79 57.22 9.37 16.33 17.51

2,350 396.8 331.2 4,364 3.40 63.28 11.62 1.16 9.83 4.35 7.93 3.58 91.26 63.70 1.42 3.71 0.34 0.38 142.3 1.39 75.93 9.40 13.52 14.66

2,141 350.9 308.3 3,611 5.93 81.83 12.60 1.06 8.48 4.71 8.41 3.71 91.21 64.98 1.28 3.92 0.45 0.64 104.4 1.80 61.35 8.43 13.98 15.19

509 195.0 158.7 2,351 1.77 71.91 13.41 1.28 9.45 4.37 7.87 3.50 90.88 62.14 1.94 3.98 0.35 0.40 161.0 1.40 78.91 8.93 12.50 13.69

397 151.9 130.3 1,445 8.06 75.82 12.26 0.98 8.06 4.72 8.32 3.60 90.84 63.82 1.27 3.87 0.57 0.75 105.9 1.85 67.21 7.94 12.32 13.61

335 227.6 178.5 2,607 2.09 71.04 12.38 1.20 9.63 4.39 7.90 3.52 91.17 62.07 2.04 4.07 0.46 0.48 161.1 1.55 82.95 8.98 12.15 13.38

252 177.4 148.6 1,611 7.54 80.56 12.33 0.93 7.75 4.83 8.32 3.49 89.69 64.36 1.49 4.13 0.69 0.96 102.0 2.12 69.51 7.57 11.48 12.91

320 915.4 625.0 11,518 3.12 69.06 13.77 1.31 9.76 4.31 7.76 3.45 89.49 55.75 2.62 4.02 0.66 1.03 167.7 1.79 88.72 8.74 11.83 13.77

329 1,034.2 787.9 10,322 11.25 79.33 13.74 1.02 7.68 4.71 8.19 3.47 88.41 62.53 2.47 4.59 0.91 1.38 108.7 2.77 76.10 7.38 10.41 12.37

80 4,612.8 2,910.5 51,559 1.25 62.50 13.43 1.13 8.77 3.71 7.06 3.35 83.03 56.83 3.19 4.07 0.74 1.06 123.5 1.97 89.68 7.23 8.86 12.16

51 1,445.3 1,017.1 11,510 7.84 86.27 13.33 0.81 6.62 3.94 8.62 4.68 85.87 65.96 2.64 4.42 0.85 1.57 73.3 3.16 80.87 6.17 7.39 10.75

8,080 6,569.2 4,391.6 74,310 7.54 56.73 13.10 1.16 9.09 3.90 7.29 3.40 85.23 57.72 2.85 4.03 0.67 0.94 131.0 1.85 87.06 7.79 9.90 12.72

11,462 3,505.7 2,698.7 31,987 6.85 79.27 12.98 0.93 7.51 4.41 8.43 4.02 88.08 64.68 2.17 4.33 0.76 1.27 87.6 2.68 73.28 7.21 9.84 12.30

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Source: FDIC Statistics on Depository Institutions (SDI), www.fdic.gov (http://www3.fdic.gov/sdi/index.asp).

Lessons Range of Cost Savings

Years of capture 1 1 1 1 1 2 2-3 2

Executive and general administration Treasury Marketing Legal HR Audit and accounting Facilities IT Credit/mortgage operations Payments operations Deposits operations Others operations Branch network
Source: McKinsey & Company

80 90 60 50 40 30 20 20 30 25 10 10 20 30 20 20 30 30 30 40 50 70 60 90

100 100

2 2 2 2 3

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Estimated Synergies
EUROPEAN BANK MERGERS AND ACQUISITIONS Acquirer Country Target Country Year TSB UK UBS Switzerland Creditanstalt Austria Hypobank Germany Argentaria Spain Paribas France Postbanken Norway BCH Spain RealDanmark Denmark Swedbank Sweden Credit Lyonnais France Gjensidige Norway MERITA Finland Unidanmark Denmark Christiania Norway Winterthur Switzerland Trygg Hansa Sweden 1995 1997 1997 1998 1999 1999 1999 1999 2000 2001 2003 2003 1997 2000 2000 1997 1997

Type In-market

%Target cost 31% 45% 41% 30% 46% 17% 16% 44% 37% 18-22% 15-19% 37% 7% 11% 11% 4% 25%

Lloyds UK SBC Switzerland Bank Austria Austria Vereinsbank Germany BBV Spain BNP France DnB Norway Santander Spain Danske Bank Denmark SEB Sweden Credit Agricole France DnB Norway Nordbanken Sweden Cross-border MeritaNordbanken Nordic MeritaNordbanken Nordic Credit Suisse Switzerland Bancassurer SEB Sweden
Source: Company data and Smith Barney analysis

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Lessons Range of Synergies

In-market vs out-of market cost savings

40% 35%

35% 15% Administrative Consolidation 15% Administrative Consolidation

Percentage 30% Cost 25% Reduction 20% 15%

10% 5% 0%

20%

Operational Consolidation (including Branches)

In-Market Transaction

Out-of-Market Transaction
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Source: Corporate Advisory Board, First Manhattan Consulting Group M&A Analysis

Bank Merger Example Chemical and Manufacturers Hanover

Chemical and Manufacturers Hanover were rivals with overlapping operations;  as a result, major cost savings were anticipated from the merger. Over 80 branches were closed and over 6,000 employees displaced following the merger.  Cost savings in excess of $750 million were anticipated by the end of 1994. The merged entity appeared to be on track to meet this goal (Cline, 1992);  Chemical and Manufacturers Hanover were very similar organizations with an abundance of common interests. Both were commercial banks headquartered in New York City and were competitors in one of the America's most competitive banking markets.  They shared the same markets and banking philosophies. Both were big city banks specializing in corporate banking and competed for the business of the biggest and strongest companies in the markets they shared; and

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Chemical Merger Continued

The Chemical/Manufacturers merger was viewed favorably by the market, as reflected in the stock return of 88.06% for the first year following the merger. For the 3-year period of 1991-1994, the stock of Chemical Bank outperformed other super-regional banks and the KBW 50 index easily with a handsome annual return of 33.9%. The average annual increase for the large national banks in the study for the period was a comparable 36%.

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Best Practices Synergies

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Best Practices Synergies

Best practices synergies come about from using more efficient cost structures in the new company. The synergies can be computed by:  Incremental costs of running company  Statistical analysis of cost per customer, cost per transaction etc.  Comparative ratios

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Theory of synergies

Optimization of asset management (best practices) Alternative types of synergies Receipt of synergy valuation by target or acquiring company The synergy trap Negative synergies Real world synergy measurement

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Example of Incremental Approach SDG&E Merger

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Distribution of Savings Using Incremental Approach

Incremental Staffing Analysis
Executives Regulatory Law and Claims Planning and Research Communications Audits Tax Accounting Corporate Accounting Property Accounting Human Resources Nuclear Engineering Gas Operations Corporate Secretary Treasury Administration of Real Estate Transportation Services Fuel and Material Management Information Services

60% 45% 48% 73% 69% 88% 82% 46% 79% 46% 120% 0% 0% 66% 30% 30% 60% 64% 20% 40% 60% 80% 100% 120% 140%

0%

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Example of Real World Synergy Analysis

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Ability to Implement with Attrition

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ROIC and PE Comparison Problems

Indeed, some businesses thrive on certain inherent (history, name association, appeal, etceteras) qualities that yield premium returns. Imagine trying to synergise on brand value by combining Versace and Marks & Spencer. In this case, the grapes grew on Gaul soil will it be the same in Rome. Would this conquest destroy value for both rather than to create?

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Capacity Mix and Capacity Amount

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Exercise

Optimize Mix and Capacity Amount Optimize in Standalone and Combined Case Compute Savings from Optimizing Use Excel Solver

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Volume Synergies

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Example of New Product Synergies

Two firms, each of which is a significant producer of word processing software, produce rather different products. Firm A produces a fast but stripped-down text processor, ASCII Alphabet, with very limited features and font supports. Firm B produces a powerful but hard-to-use desktop publishing package, Beauteous Bitmap. When the products are introduced, the firms perceive themselves as being in unrelated markets. Two years later, the firms become aware that a growing number of end-users use Alphabet to draft documents and then import the files into Beauteous. This process is sometimes fraught with problems, however, because of the very different file formats, and customers increasingly complain. Engineers from the two firms meet to work on improving compatibility. These technical meetings, however, are increasingly canceled or postponed at managements urging, as each firms marketing department starts to report that users perceive the products as being competitors. The firms then propose to merge, and claim that improved interoperability will be an efficiency of the merger. Clearly, improved interoperability would be an efficiency, and (if each firm keeps its file format proprietary and subject to change) one that neither firm could achieve unilaterally: in other words, a synergy.

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Examples of Volume Synergy

Bank Synergy  The merger was to create a powerhouse by funneling Societys wealth of products, such as trusts and investment management, through the new KeyCorps 1300 branches, which stretched from Maine to Alaska. Eli Lilly  Acquired Hybritech, a small boutique, to channel pathbreaking products through efficient marking force. Computation  Increased revenues incremental costs

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Hypothetical Example of Volume Synergy

Toyota developed a new and superior approach to manufacturing cars, but (initially) lacked a ubiquitous distribution network in North America. General Motors had a well established distribution network, but its manufacturing was less efficient than Toyotas. Had Toyota and General Motors proposed to merge, the bringing together of these assets would have been a synergy.

How should this be quantified

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Volume Synergies from Increased Growth

Alex Mandl, Chairman and CEO of Teligent: The plain fact is that acquiring is much faster than building. And speed speed to market, speed to positioning, speed to becoming a viable company is absolutely essential in the new economy.

Mackey McDonald, Chairman of VF Corporation: An acquisition becomes attractive if it offers us a new consumer segment or geographic market to sell our products to or if it adds new products to one of our core categories.

Other comments by CEOs in the article focus on the creation of synergies in research and development that can be reinvested in new drugs, or cutting costs in the chemical business.

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Example of Volume Growth - Cisco

Cisco Systems has successfully employed a growth strategy that involves acquisitions. Since going public in 1990, Cisco has seen its revenues grow by more than 40 per cent every year except 1998, when they grew a meagre 31 per cent. Since acquiring its first company in 1993, it has acquired over 70 companies (Fortune Magazine, 2001). Its success rate in acquiring these companies is well documented. In fact, Goldbatt (1999) said that, to find a business that has handled acquisitions as well as Cisco, one would have to go back to the turn of the century when AT&T assembled hundreds of tiny phone companies into MA Bell. Even in the current economic downturn, Cisco has faired much better than its competitors.

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Example of Synergies Marketing of Patent Products

Brilliant Biotech patents its only product, Cognizance, an IQraising treatment that enables the user to understand the economics of merger efficiencies. Brilliant has no manufacturing or distribution capabilities. Megadrug Pharmaceutical has excellent manufacturing, strong distribution, and a powerful brand name. Megadrug proposes to acquire Brilliant Biotech.

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Example of Synergies Network Configuration

Two railroads each have a single track running between A and B. Customers shipping products in one direction sometimes experience delays when a train runs in the other direction on the same track, necessitating complex siding work. The railroads propose to merge, and offer as an efficiency that they will use one track exclusively for A-to-B traffic, and the other for B-to-A. It is plausible that this side-by-side complementary specialization is an efficiency. Moreover, neither firm alone can offer both an A-to-Bonly product and a B-to-A-only product, so if customers demand the ability to get shipments in both directions from a single firm, then the efficiency is a synergy. It is less clear whether it is a synergy if customers would be willing to buy these products separately, because then either firm could unilaterally specialize and thus offer a superior product in its chosen direction.

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Aggregate Synergies Retail Example

The combination of the two companies is conservatively estimated to generate $500 million of annualized cost and revenue synergies to be fully realized by the end of the third year after closing. The transaction, after giving effect to estimated synergies, is expected to be significantly accretive to earnings per share in the first year before one-time restructuring costs. The companies expect to realize approximately $200 million in incremental gross margin from revenue synergies by capitalizing on crossselling opportunities between Kmart and Sears proprietary brands and by converting a substantial number of off-mall Kmart stores to the Sears nameplate in addition to the 50 Kmart stores Sears acquired earlier this year. The company expects to achieve annual cost savings of over $300 million principally through improved merchandising and nonmerchandising purchasing scale as well as improved supply chain, administrative and other operational efficiencies. In addition, the combined company will complete a full store asset review as part of a plan to monetize non-strategic real estate assets as appropriate.

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Synergies Relative to Size

M&A Analysis

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Lessons Range of Revenue Synergies

2) WIDE RANGE OF MERGER SYNERGIES (cont) c) revenue synergies: small and elusive barriers to cross selling single digit projections - rarely more than 5% example of bancassurance in KBC

M&A Analysis

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Risk Reduction and Other Synergies

M&A Analysis

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Example of Merger Savings from Risk Reduction Retail

While operating on a national scale presents more complex issues than those faced by regional operators, Morton believes the issue cuts both ways. For example, during the third quarter of 2003, Gart was up against difficult sales comparisons from the prior year when the World Series between the Anaheim Angles and San Francisco Giants benefited its West Coast stores. As a standalone company, Gart's sales would have suffered last fall because the World Series was played between the New York Yankees and Florida Marlins, and Gart had no East Coast stores to benefit from the matchup. "It is nearly impossible for us to have exposure to licensed apparel events that go away from one of our markets today," Morton said. The same is true of the winter sports categories. Gart was heavily exposed to winter apparel and ski equipment because of its stores in the mountainous Western states. A dry winter and unseasonable warm weather in the West guaranteed weak same-store sales and missed earnings estimates. With a national footprint, the weather-related risk is spread over a larger store base so the volatility of same-store sales growth and profits should be reduced.

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Financial Synergies
Pecking order financing  Matching of cash-rich firms with firms that have investment opportunities  Internal capital markets may have less frictions (no informational costs, issuance costs, regulatory approval) Increased debt capacity Implicit too big to fail guarantee A merger may reduce the required investment in working capital and fixed assets relative to the two firms operating separately Firms may be able to manage existing assets more effectively under one umbrella Some assets may be sold if they are redundant in the combined firm (this includes human capital as well)

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72

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Risk in Growth and M&A

"The nice thing about acquiring is that there is a certain degree of certainty of what you're going to get," said Conor Bill, managing director at Mt. Auburn Capital, in Toronto. "Building involves a great deal of risk and patience and these days most of the CEOs are reacting to a market that doesn't have patience. It makes it much easier to buy than to build."

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Financial Sources of Value

Target is undervalued  Markets are inefficient  Unused gains from the use or sale of accumulated tax losses from net operating losses  Unused debt capacity

Lower cost of internal funds  cash cow combining with growth firm can use internal funds for investment

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74

January 12

Pure Diversification
Diversification by merger may create value  Decrease cash flow variability  Lower cost of capital  Managers can take riskier projects and invest in human capital  Obtain the control benefits in other companies Usual counter-argument is that shareholders can diversify better using capital markets  Benefits of taking controlling positions are not available to small shareholders

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75

January 12

Taxes

Take advantages of net operating losses Carry-backs and carry-forwards Merger may be prevented if the IRS believes the sole purpose is to avoid taxes

Unused debt capacity Surplus funds Pay dividends Repurchase shares Buy another firm

Asset write-ups

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Examples of Success and Failures

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Reasons for Acquisitions

Increased market power Overcome entry barriers Cost of new product development Increased speed to market
Lower risk compared to developing new products

Problems in Achieving Success

Integration difficulties Inadequate evaluation of target Large or extraordinary debt Inability to achieve synergy Too much diversification Managers overly focused on acquisitions Too large
78 January 12

Increased diversification Avoid excessive competition

M&A Analysis

M&A Failures
Acquirers were over optimistic in their assumptions Acquirers over estimated expected synergies Acquirers overbid in the heat of the bidding process Poor post acquisition integration Inability to achieve synergy: poor fit between products, geographic markets, technical skills, and/or managerial values. Too much diversification: inability to manage in newly acquired product and/or geographic markets. Managers overly focused on acquisition/merger: excessive energy spent on acquisition. Too large (bureaucratic): managing new operation becomes infeasible in existing management structure

M&A Analysis

79

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Why Do Acquirers Fare Poorly?

Overbidding  Winners curse

Poor fit between buyer and seller  Clash of corporate cultures

Ignorance of targets industry Failure to integrate operations carefully and quickly

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80

January 12

Examples of Merger Disasters

Novell bought Wordperfect for $1.4 billion and sold it two years later for $200 million AT&T purchased NCR for a $4.2 billion (125%) premium and did not change management suggesting that it did not expect synergies. NCR lost money Northwest Airlines purchased Republic Airlines for $884 million. Integration of unions was disasterous and the company was taken over. Unisys/Burroughs-Sperry. Burroughs paid a 50% premium. The systems could not run parallel and late orders caused problems. 90% of shareholder value was destroyed.

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81

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Examples of Merger Disasters

Sony paid $3.4 billion for Columbia. Synergies never materialized and Sony took a loss of $3.2 billion. Unisys/Burroughs-Sperry. Burroughs paid a 50% premium. The systems could not run parallel and late orders caused problems. 90% of shareholder value was destroyed. Tyco  Tyco grew from a sleepy industrial company into one of the worlds most most aggressive deal machines.  The company deployed teams of lightning fast negotiators who could swoop in, buy companies and start cutting costs in a matter of days.  Tyco acquired 700 companies in three years.  The stock has fallen dramatically and there executives have been indicted.

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82

January 12

Examples of Merger Disasters Worldcom and AOL

Worldcom built the company with 70 acquisitions. Bought MCI for $37 billion and then tried to buy Sprint. The stock has fallen by 95% since 2000 and the company is bankrupt. AOL took the largest write-off in corporate history -- $54 BILLION -- from the value of goodwill associated with the merger with Time Warner. Quaker Oats bought in 1994 Snapple for $ 1,7 bn.     $ 500 mil. lost on announcement, $ 100 mil. a year later Snapple was spun off 2 years later at 20% of price

Anheuser-Busch bought in 1982 Campbell-Taggart at $ 560 mil closed down after 13y of struggling for survival

IBM bought Lotus for $ 3,2 bn. (more than 100% premium) probably never to be recouped

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83

January 12

HP and Apollo Integration Problems

Hewlett-Packards acquisition of Apollo Computer in mid-1989 documented by consultants Philip Mirvis and Mitchell Marks. It is a fascinating tale of a successful and respected corporation with a respected culture trying to bond with a maverick, with little to no success. It started with the number three company in market share for work stations buying the number one company Apollo, and ended with number two Sun Microsystems running right by the combined organisation. The story includes such fascinating titbits as the CEO of Apollo riding his Harley right into the second-storey conference room for a significant meeting with HP, emphasising the difference between us and them (Mirvis and Marks, 1992).

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84

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Examples of Synergies

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Example of Synergies BP Amoco

The Amoco Board and the BP Board believe that the merged enterprise would be able to achieve an annual rate of $2 billion in (pre-tax) cost savings by the end of 2000, significantly enhancing the earnings potential of the merged enterprise over the earnings potential of Amoco and BP as separate companies. The estimated cost savings, which are in addition to cost savings previously targeted by the two companies separately, are expected to come from:  staff reductions in areas of overlap,  more focused exploration efforts,  standardization and simplification of business processes (E.G., information technology),  improved procurement and the elimination of duplicative facilities (E.G., distribution depots). The Amoco Board and the BP Board expect that the cost savings will begin to be realized in the first two years but that these are likely to be offset by special restructuring charges (currently estimated at $2 billion) which will be incurred over the first two years to cover the cost of achieving these savings.

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Example of Synergy Analysis Chevron Texaco

Significant cost savings: We believe that the combined company can operate more efficiently than can either individual company. Specifically, we expect that the merger will reduce our combined costs by at least $1.2 billion per year within six to nine months of the merger's completion. These cost savings are dependent, in part, on the timely and cost-effective integration of the two companies. We expect that the historic associations and strategic compatibility of Chevron and Texaco will enable rapid integration of the two companies. The most significant savings, approximately $700 million, will come from more efficient exploration and production activities, Other areas will contribute as well, including some $300 million from the consolidation of corporate functions and $200 million from other operations. We anticipate that the combined workforce of about 57,000 will be reduced by approximately seven percent worldwide.

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Example of Synergies Phillips Conoco

We expect the combined company to achieve annual recurring cost savings of at least $750 million within the first full year after the completion of the merger. These savings exclude one-time cost savings and expenses associated with the merger, which have not been fully identified or quantified. These savings are expected to result from  more efficient exploration, production and downstream activities, and  the elimination of duplicate corporate and administrative positions, programs and operating offices.

M&A Analysis

88

January 12

Lattice Semiconductor acquired Vantis

June 99 stock went from $20 to $53 in 6 months CFO credited success to: y They were related businesses y Lattice had a clear idea of what it intended to do with the enlarged business y They quickly integrated the two companies y They reduced costs without laying off

M&A Analysis

89

January 12

Bank Merger Example

The KeyCorp and Society merger combined two companies that at the time had records of high performance, no significant asset quality problems, strong management teams with experience in successful merger transactions, and maintained compatible dataprocessing and other operating systems. Both KeyCorp and Society believed that the merger would provide the opportunity for the combined entity to reach expanded markets by combining the strengths of the two. Although management provided no assurances, the merger was initially projected to achieve a cost savings of $80 to $105 million, or 5% of combined total expenses, by the end of the first quarter of 1995. In contrast, many bank mergers of companies in similar markets assume cost savings of as much as 25% to 30% (Lipin, 1993).

M&A Analysis

90

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Bank Merger Synergies

NCNB and C&S/Sovran were rivals competing in overlapping markets including Georgia, Florida, and South Carolina; the merger was also expected to provide major cost savings. Annual cost savings of $350 million were believed to be very conservative by bank analysts (Cline, 1991).
 Approximately 60% of the savings was expected to come from the consolidation of operations and data processing and the closing of branches in overlapping markets.  both NCNB and C&S/Sovran were known to have some credit quality problems.

M&A Analysis

91

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General Electric
GE is the world's most valuable company, with a market capitalization of $402 billion, about a 5,000 percent increase in value for the stock, including dividends, during 1981-2001. [GE CAPITALIZATION WAS $384 BN ON 1/18/02] The Jack Welch era (1981-2001) included 993 acquisitions for GE at an estimated cost of approx. $165 billion  Divestitures included over 400 businesses valued at an estimated $28 billion  The company's revenue has grown to $130 billion in 2000 from $21 billion when Welch became Chairman in 1981  GE EXPERIENCED 9.9% ANNUAL COMPOUNDED GROWTH DURING 1985-2000, OF WHICH 4 PERCENTAGE POINTS CAME FROM ACQUISITIONS [WSJ, SOME WONDER HOW LONG GE CAN RELY ON DEALS FOR GROWTH, JULY 31, 2001]  The market cap is more than $100 billion greater than the next two largest companies, which include Microsoft Corp. and Exxon Mobil Corp. [GE=$384 BN, MSFT=$355 BN, XOM=$262BN ON 1/18/02]  Notable buys are RCA in 1986, a deal that included NBC; investment bank Kidder, Peabody in 1990; aircraft firms Greenwich Air Services and UNC in 1997.  GE Capital, the huge financial services arm of General Electric Co., has agreed to buy Heller Financial Inc. for $5.3 billion in cash (July 30, 2001)  GE Capital grew to one of the powerhouses of the financial services industry during Welchs tenure, and now accounts for nearly half of the company's revenue.

M&A Analysis

92

January 12

The Ford-Volvo Merger

Bought Volvos Car Business for $6 billion Worldwide sales now 7.2 million units Ford will achieve three goals; boost market share, fill a hole in the lineup, gain momentum in battle with G.M. Volvo forecasts 200,000 units sold in U.S. by 2001 Ford will now compete in the $30,000-$40,000 range Analysts see only six major players by 2010

M&A Analysis

93

January 12

First Union- CoreStates

Takeover was a $19.7 Billion deal CoreStates 1997 net income - $830 million First Union forecast $258 Million savings in after tax expenses from synergy In 1998 FUC missed goal by $50 Million Payback period is about 18 years- Does this make sense? Why else spend that much money? Expand into the Northeast Capture CoreStates investment banking business Position itself to merge with another large bank (Chase Manhattan)

M&A Analysis

94

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Studies of Merger Benefits and Costs

M&A Analysis

95

January 12

Studies of Mergers and Economic Efficiency

Productivity Studies Event Studies Leveraged Buyouts

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96

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Evidence on Acquisitions
Shareholders of target companies tend to earn excess returns in a merger  Shareholders of target companies gain more in a tender offer than in a straight merger  Target firm managers have a tendency to oppose mergers, thus driving up the tender price Shareholders of bidding firms earn a small excess return in a tender offer, but none in a straight merger  Anticipated gains from mergers may not be achieved  Bidding firms are generally larger, so it takes a larger dollar gain to get the same percentage gain  Management may not be acting in stockholders best interest  Takeover market may be competitive  Announcement may not contain new information about the bidding firm

M&A Analysis

97

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Post Merger Performance

1992 study: (of mergers in 1980s)  Firms show better operating performance post-merger  Improved asset efficiency
 Cash flows / assets: improved  Sales / assets: improved

1996 study: (of mergers in 1985-94)  80% of firms earn their cost of capital  A previous study of firms in the 1970s showed only 33% of firms earned their cost of capital

M&A Analysis

98

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M&A Studies

KPMG Study: Over destroy shareholder value Another 1/3 added no value Only 1/6 of mergers add value to firms Booz Allen Hamilton Study: 51.3 % of M&A lost value vs. peers 48.7 % gained value

M&A Analysis

99

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M&A Studies

Empirical evidence on M&A over last decades: The majority of the studies report that there has been a significant proportion of M&A failures over last five decades since the waves of mergers (MAE grounds) started Actual success rate varies but ballpark figure could be ca. 50% However, some studies are very alarming:
 1) Millman and Grey show that 83% of mergers produce no benefit whatsoever to shareholders  2) Sirower finds 60-70% of acquisitions failing to produce positive returns.

M&A Analysis

100

January 12

Studies of Merger Success

LaJoux cites 15 major studies of the success or failure of acquisitions. For the studies reporting failure rates, the rate ranged from 40 per cent to 80 per cent, with the exception of one study done in 1965, which reported a 16 per cent failure rate (LaJoux, 1998). More than three-quarters of corporate combinations fail to attain projected business results. In fact most produce higher-than-expected costs and lower-than-acceptable returns. Meanwhile, executive time and operating capital are diverted from internal growth; morale, productivity, and quality often plummet; talented crew members jump ship; and customers go elsewhere. In a great majority of combinations, one plus one yields less than two. Joining Forces, Marks and Mirvis (1998)

M&A Analysis

101

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Empirical Evidence
Target firms in a takeover receive an average premium of 30%. Evidence on buying firms is mixed. It is not clear that acquiring firm shareholders gain. Some mergers do have synergistic benefits. CUMULATIVE AVERAGE ABNORMAL RETURN (%) Selling companies +

Buying companies

0 Announcement date

M&A Analysis

TIME AROUND ANNOUNCEMENT (days)

102

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Value Created by LBOs

M&A Analysis

103

January 12

Productivity Study and LBOs

M&A Analysis

104

January 12

Productivity Study of LBOs

M&A Analysis

105

January 12

Merger Studies in Airlines

M&A Analysis

106

January 12

Synergies and Strategic Analysis

M&A Analysis

107

January 12

Business Strategy Models and Economic Profit

Business strategy models boil down to various components of economic profit:  Porter Model is assessment of barriers to entry in various aspects of the business.  Ansoffs Model assesses in what markets can competitive advantage be obtained resulting in more economic rents.  The SWOT concept should consider each term in the context of barriers to entry and sustainable competitive advantage.

M&A Analysis

108

January 12

Barriers to Entry
The types of business activities that lead to barriers can be complex: In classic economic theory, capital intensive industries such as steel firms and automobile firms were thought to have market power from barriers to entry. However, excess capacity can exist in the capital intensive businesses and size alone has not turned out to be an effective barrier.

More interesting barriers to entry are from a strong name in the advertising and financial services business, a highly skilled work force in financial services and software, standardization of computer platforms and even barrier to entry from high stock prices.

M&A Analysis

109

January 12

Business Strategy Models

Review models of business strategy for a few reasons:  The models provide insight as to how economic profit can be realized from strategic planning  The models give insight for later subjects in the course related to M&A and project finance  The models summarize strategy that is measured with financial models

M&A Analysis

110

January 12

Corporate Strategies for Market Entry

Level of competition in the host market Start-up risk in green-field investments Availability of organizational resources for organic growth Advantage of speed of entry  Example: Difficulty of Sansbury foods in establishing stores in Scotland because of license problems

M&A Analysis

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Strategic Choice Analysis

Strengths Weaknesses Opportunities Threats

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112

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Ansoffs Model of Strategic Choice and Internal versus External Growth

Market penetration: Increase market share in its existing markets through adding sales force or acquiring competitor in the current market. Market extension: Move to new geographic markets through adding new regional offices or acquiring firm in the new geographic area. Product extension: Develop new products internally or purchase a firm that already has the new products. Diversification: Develop products and hire new sales force or purchase a company that already has the capabilities.

M&A Analysis

113

January 12

Ansoffs Model and Economic Profit

Product Extension: Can the competitive advantage that generates economic profit in one product be transferred to other products. For example, could Microsoft enter the internet server market and extend profit from its other products. Diversification: Can the firm use its ability to make economic profit and extend it into other markets with other products. For example, can the name recognition of a consulting firm be extended to new services in new markets.

M&A Analysis

114

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Ansoffs Model and Economic Profit

Market Penetration: Does the company currently have a competitive advantage that generates economic profit and can the profit be extended through more marketing. For example, can an investment bank with good name recognition increase its client base. Market Extension: Does the firms current product have a competitive advantage or a low cost structure that can be extended to other markets. For example, can Southwest Airlines move to new geographic markets.

M&A Analysis

115

January 12

Porters Model
Framework for analyzing rivalry within an industry: Barriers to entry ;threat of new entrants Bargaining position Generic Strategies Class leadership Differentiation Focus Questions to address Which product are most distinctive Which products are most profitable Which customers are most satisfied

M&A Analysis

116

January 12

Porters Five Forces Model and How Can Competitive Position be Enhanced

Develop strategies (M&A, investments etc) to further limit competitors ability to contest their current input prices, processes or output markets Open new markets and/or encroach on their competitors markets where these competitors cannot respond

M&A Analysis

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Porters Model

M&A Analysis

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Porters marketing strategies

Competitive advantage
Low cost Differentiation

Broad

Cost-leadership

Differentiation

Assortment

Narrow

Cost focus

Differentiationfocus

M&A Analysis

119

January 12

Ansoffs Model of Strategic Choice

Synergy analysis is related to general management strategy. For each choice, there is a way to accomplish the objective with M&A. Market penetration: The firm increasing market share in its existing markets Market extension: The firm selling its existing products in new geographic markets Product extension: The firm sells new products related to existing ones in present markets Diversification: The firm sells new products in new markets

M&A Analysis

120

January 12

Ansoffs Model of Strategic Choice and Internal versus External Growth

Market penetration: Increase market share in its existing markets through adding sales force or acquiring competitor in the current market. Market extension: Move to new geographic markets through adding new regional offices or acquiring firm in the new geographic area. Product extension: Develop new products internally or purchase a firm that already has the new products. Diversification: Develop products and hire new sales force or purchase a company that already has the capabilities.

M&A Analysis

121

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Ansoffs Model and Economic Profit

Market Penetration:  Does the company currently have a competitive advantage that generates economic profit and can the profit be extended through more marketing. For example, can an investment bank with good name recognition increase its client base.

Market Extension:  Does the firms current product have a competitive advantage or a low cost structure that can be extended to other markets. For example, can Southwest Airlines move to new geographic markets.

M&A Analysis

122

January 12

Ansoffs Model and Economic Profit

Product Extension:  Can the competitive advantage that generates economic profit in one product be transferred to other products. For example, could Microsoft enter the internet server market and extend profit from its other products.

Diversification:  Can the firm use its ability to make economic profit and extend it into other markets with other products. For example, can the name recognition of a consulting firm be extended to new services in new markets.

M&A Analysis

123

January 12

Corporate Strategies for Market Entry

Level of competition in the host market Start-up risk in green-field investments Availability of organizational resources for organic growth Advantage of speed of entry  Example: Difficulty of Sansbury foods in establishing stores in Scotland because of license problems

M&A Analysis

124

January 12

 British Petroleum and ARCO have jointly operated the Prudhoe Bay oil field on Alaskas North Slope for over twenty years. Before merging, they experienced persistent difficulties associated with joint management of this resource which arguably raised the cost of extracting oil from the field. While institutions and contracts had developed over twenty years that tried to address these problems, the parties argued that nevertheless some of the rules or institutions put in place were plainly inefficient.

M&A Analysis

125

January 12

Retail Risk Reduction

While operating on a national scale presents more complex issues than those faced by regional operators, Morton believes the issue cuts both ways. For example, during the third quarter of 2003, Gart was up against difficult sales comparisons from the prior year when the World Series between the Anaheim Angles and San Francisco Giants benefited its West Coast stores. As a standalone company, Gart's sales would have suffered last fall because the World Series was played between the New York Yankees and Florida Marlins, and Gart had no East Coast stores to benefit from the matchup. "It is nearly impossible for us to have exposure to licensed apparel events that go away from one of our markets today," Morton said. The same is true of the winter sports categories. Gart was heavily exposed to winter apparel and ski equipment because of its stores in the mountainous Western states. A dry winter and unseasonable warm weather in the West guaranteed weak same-store sales and missed earnings estimates. With a national footprint, the weather-related risk is spread over a larger store base so the volatility of same-store sales growth and profits should be reduced.

M&A Analysis

126

January 12

Retail Mergers Sporting Goods

The same is true of the winter sports categories. Gart was heavily exposed to winter apparel and ski equipment because of its stores in the mountainous Western states. A dry winter and unseasonable warm weather in the West guaranteed weak samestore sales and missed earnings estimates. With a national footprint, the weather-related risk is spread over a larger store base so the volatility of same-store sales growth and profits should be reduced. The potential for sales growth is also viewed as a great opportunity. Prior to the merger, The Sports Authority stores avoided winter sports categories even though it had 85 stores in cold weather states and a strong presence in the Northeast. Ski apparel and equipment will be added to those stores.

M&A Analysis

127

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How to Make a Merger Work

Consider the following. Dont rush the wedding - do your homework carefully to prevent morning-after surprises. Know what youre buying - not just the financials, but the corporate culture. Adopt each partners best practices - dont assume the bigger company or the acquirer has all the answers. Be honest with employees about how a merger will affect them start early and communicate honestly with them. Take the time to do internal recruiting - make sure the managers you want to keep dont go wandering off to a competitor.
Adapted from How to Make a Merger Work, Fortune magazine, January 24, 1994.

M&A Analysis

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Example of Synergies in Retail - Sears

Economies of Scale The combined cost of goods sold of the 2 companies is roughly $40 billion. We purchase roughly $40 billion of merchandise from around the world. And I think that the ability to sort of work together to really get best practices from both organizations and work with our supplier base to really help drive their business and help them save money, so that we can save money for our customers, is a big opportunity. In terms of SG&A of the 2 companies, the combined SG&A is roughly $12 billion. And as you will see when we discuss the synergy opportunity, the opportunity both on the purchase of merchandise as well as the SG&A is fairly significant when you think of those numbers.

M&A Analysis

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January 12

Retail Synergy Example - Continued

Productivity and Best Practices Sears stores in general are roughly $80 per square foot more productive than Kmart stores. And if you talk about roughly 100 million square feet of real estate that Kmart has, if we could ever achieve that level of productivity in the Kmart stores, either as Sears or as Kmart, youre talking about an $8 billion opportunity. So I think that the financial dimensions are very, very significant and they blend very well with the strategic dimensions.

M&A Analysis

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Retail Synergy Example

Capacity Utilization Finally, I think that as a board and a management team, were going to have an ability and a willingness to monetize non-core and non-productive assets. We want to make sure that the businesses that we run are going to be able to produce real economic value for the shareholders over time, and at the same time I think we want to make sure that we stay focused on the biggest opportunities. And I think both at Kmart and Sears, there were certain other opportunities that we spent time on because we didnt have the significant opportunity that I think we have here today. I think while that may have been true at Kmart at one point in time, weve worked very, very hard to improve the profitability of each of our stores and to make those stores worth a lot more as an operating business than as real estate. The more money the store makes, the more valuable they are as operating businesses, and thats something that I think the combined company can do very, very well.

M&A Analysis

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Retail Example Relative Ratios

To the extent that we have stores that can produce the type of profit that were looking for, we would have to consider other alternatives. I think well-run retailers over time should be able to earn a 10 percent EBITDA to sales ratio. I think when you look at Home Depot, you look at Target, you look at The Gap, they all achieve that metric. And again, thats not something we think that were going to be able to do anytime soon, but thats something that were going to work towards. Were going to work towards best-inclass financial metrics and best-in-class customer metrics.

M&A Analysis

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Areas of Synergy Savings

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