To Merge or Not to Merge? Key Questions a Founder Must Ask
Mergers or acquisitions only make sense when the combined entities create greater value together than they can separately.
To help understand the key questions a founder must ask when assessing a merger or acquisition opportunity, let’s use the recent merger of T-Mobile and Sprint Corp.
Specifically, by describing how the combined entities were expected to create greater value together than separately (e.g. how they were going to increase revenue, lower costs, and/or better manage risks), we can thoroughly define the potential synergies of the merger.
Furthermore, by applying a CFO mindset, we can provide a more accurate assessment (and supporting rationale) about whether this merger makes sense from three key perspectives:
- Does the merger make sense from a strategic fit perspective?
- Does the valuation of the deal seem reasonable?
- Identify the biggest risk(s) the acquirer will confront in extracting the synergies post-transaction.
Quick Highlights
Acquirer: T-Mobile
Acquiree: Sprint
Valuation: $26B — based on the current enterprise value (i.e. market value).
Acquisition Strategy: synergy — reduce costs by $6B annually & increase profitability.
Terms: stock-for-stock exchange (i.e. all-stock deal).
- 9.75 Sprint shares for each T-Mobile share.
New ownership breakdown:
- 42% — T-Mobile parent company Deutsche Telekom AG.
- 27% — Sprint parent company SoftBank Group.
- 31% — public shares.
1) ASK: How are the combined companies expected to create greater value together than separately?
The primary way in which T-Mobile and Sprint expect to generate additional value is via the reduction of costs thanks to a combining of assets (i.e. a synergy strategy).
For example, each company, T-Mobile and Sprint, operate thousands of retail stores across the U.S. Obviously, there is no need to continue operating a Sprint retail store if there is also a T-Mobile store in the same shopping plaza.
Therefore, senior management could effectively close a large percentage of overlapping retail locations, thus liquidating real estate assets, cutting overhead and reducing the required number of staff.
Furthermore, the combining of assets will generate additional value in the form of a bolt-on acquisition, whereby T-Mobile can immediately incorporate Sprint’s network infrastructure/assets directly into its existing operations (since both companies utilize similar infrastructure technology).
Lastly, this merger will broaden T-Mobile’s geographic reach by strengthening its network availability in areas where Sprint has a greater brand presence and/or better infrastructure.
2) ASK: Does the merger make sense from a strategic fit perspective?
From a strategic fit perspective, this merger makes sense as it will increase revenue AND profits for T-Mobile. However, it’s important to understand that growing solely for the sake of increasing revenue does not necessarily produce greater value.
For example, the acquiree organization might produce strong revenues, however, if its operations are cash inefficient and capital intensive, the result could be a very unprofitable business with a negative bottom line. As such, the acquirer may get stuck with a cash-sucking lemon, thus destroying shareholder value.
Instead, the acquirer must assess whether it can successfully generate additional profits from the proposed acquisition.
While T-Mobile will benefit from higher reported revenue, the true value of the Sprint acquisition stems from the $6B in annual cost savings to be achieved by combining assets. As a result of these cost savings, T-Mobile will be able to increase its net profit margin.
For instance, if we take T-Mobile’s 2019 net income of $2.8B and divide it by their sales of $43.2B, we get a net margin ratio of 6.68%. If we pull the same data from Sprint’s old income statements (i.e. net income of -$1.9B and sales of $33.6B), we get a net margin ratio of -5.78%.
Next, we can calculate the anticipated combined top-line sales for the new company (i.e. $43.2B + $33.6B = $76.8B), and the combined net income (i.e. $2.8B + (-$1.9B) = $900MM).
If we add the anticipated $6B in annual cost savings to the bottom line as a result of the merger, we get a new net income of $6.9B.
Lastly, by dividing the new net income of $6.9B by the new total sales of $76.8B, we get a new net margin ratio of 8.98%.
As we can see, based on these high-level calculations, the merger will help T-Mobile increase its current net margin profitability ratio from 6.68% to 8.98%, which is certainly an attractive proposition for stakeholders.
3) ASK: Does the valuation of the deal seem reasonable?
As highlighted above, T-Mobile used the enterprise value method to establish Sprint’s $26B valuation.
At the time of the acquisition announcement in April 2018, this valuation seemed reasonable since it was based on the market value of Sprint’s closing share price on Friday, April 27, 2018. Moreover, the $26B did not include any type of control premium, therefore producing a lower and more favourable valuation for T-Mobile.
Unfortunately, due to regulatory issues, the acquisition was delayed more than 20-months, and the subsequent enterprise value for Sprint had dropped to $19.8B. Moreover, Sprint continued to lose customers each quarter as the company paused its marketing initiatives while it awaited regulatory approval.
As a result, since the acquisition was announced in April 2018, Sprint’s price-to-user multiple had undoubtedly changed, making the acquisition less attractive for T-Mobile.
Therefore, while the initial valuation of $26B seemed reasonable, this new price no longer represented an attractive deal for T-Mobile and should have been reduced to more accurately reflect Sprint’s enterprise value at the time.
4) ASK: What is the biggest risk(s) you think the acquirer will confront in extracting the synergies post-transaction?
As highlighted above, the biggest synergy from this acquisition is the anticipated $6B reduction in costs, helping T-Mobile improve profit margins.
However, given the sheer size of each organization, a merger wouldn’t exactly be easy. For instance, while both companies share similar strategic visions, operating strategies and IT systems, the biggest risk to the success of this acquisition was going to be the post-transaction integration of power and culture.
For example, this was not Sprint and T-Mobile’s first time at the negotiating table, with previous talks in 2017 falling-through due to a failure to agree on who would control the new company.
In this new deal, it had been agreed that T-Mobile would control the new company. However, with a combined full-time employee base of 80,000 people, there would undoubtedly be staffing cuts due to overlapping responsibilities.
As such, T-Mobile was at risk of Sprint employees reacting poorly to the deal for fear of getting laid-off; resulting in frustration, confusion, and subsequent reductions in operating results.
Moreover, if T-Mobile were unable to quickly blend the cultures of the two companies and make the necessary staff adjustments based on the new talent pool within 90-days, the new company would face the financial risk of having duplicate systems and people, thus costing the company valuable time and negatively impacting profit margins.
SUMMARY
As we’ve discovered, in any potential M&A scenario, it is critical we leverage a CFO mindset to provide a more accurate assessment (and supporting rationale) about whether the merger makes sense.
Specifically, by assessing the M&A from three key perspectives, including 1) strategic fit, 2) valuation, and 3) major risks, we can ensure the resulting combined entities create greater value together than they ever could separately.
Remember: 1+1 should always (at minimum) equal 3.
About the Author
Matthew is the Founder & Managing Director of Allied Venture Partners, a new AngelList syndicate dedicated to the growth and diversity of Western Canada’s technology ecosystem. To learn more please visit Allied.VC
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