The ABCs of M&As

Recent deals in the business world have created joint ventures and product cross-overs that consumers would have never expected. Darth Vader and hordes of Stormtroopers roam the streets of the happiest place on earth and Amazon’s Alexa is ready to order your Whole Foods grocery haul in an instant. Why are companies driven to merge with and acquire one another, what work happens behind the scenes to allow these deals to take place, and what are the early indicators of success?

What is a Merger or Acquisition?

Simply put, companies have two paths to growth. They can do so organically, by doing things like diversifying their products and improving their production capacity over time. Or alternatively, companies can jump-start their growth by merging with or acquiring another company.

The mechanics behind these two terms, mergers and acquisitions, are fundamentally very similar and are often times used interchangeably in the media. To differentiate between the two, a merger is when two companies come together to form an entirely new entity under a new name while in an acquisition, one company purchases and absorbs another into their operations. For example, in 1998 Exxon and Mobil merged to form the company Exxon Mobil while just recently in 2018 Cisco acquired DUO Security for 2.3 billion dollars to gain access to their technology.

Sometimes in an acquisition, the targeted company will retain its name so it can continue to appear to operate smoothly and not be disrupted by the uncertainty that comes with a change in ownership. This can be seen when Facebook acquired Instagram in 2012 or when Disney purchased Pixar back in 2006.

What are the Drivers for M&A?

The underlying rationale behind the practice of mergers and acquisitions is that a company will buy another company if it believes that it will earn an acceptable internal rate of return after factoring in the cost of the acquisition. This leads to the question of what makes a company believe its business endeavor will result in a positive return on investment? In determining this, companies will look at two points of reasoning: financial reasons and fuzzy reasons.

With financial reasons, a business will look at how acquiring another company will improve their profitability. Examples of financial reasons could include the following…

Consolidation: Companies can merge with other companies of a similar industry to better compete with larger firms.

Geography: Businesses can enter new markets by acquiring companies that have already successfully established themselves within a target region.

Potential Customers: A firm might be purchased because it has a unique customer pool that an acquirer wants access to.

Company is undervalued: The targeted companies stock price does not reflect the asset and potential earning value that the acquiring company attributes to it.

A key part of the financial reasoning is the ability to assess the monetary value associated with merging with or acquiring a company. This is done through assessing a seller’s (a company looking to be bought) EPS or earnings per share. EPS is calculated by dividing a company’s net income by their shares outstanding (or the amount of stock on the open market). Companies will do their best to predict how purchasing their target will affect the EPS as compared to the value prior to purchase. If the deal is calculated to show EPS accretion than the value of the EPS has gone up as opposed to if the deal is determined to show EPS dilution, when the value of EPS goes down.

While with financial reasons, the motivations for a company to acquire or merge with another are quite clear and distinct, with fuzzy reasons, the rationale is much more… well, fuzzy. Fuzzy reasons tend to consider more intangible benefits. For instance, some examples of fuzzy reasons could include…

Defensive Acquisition: A company could buy a firm that might pose a threat to them in the future

Ego: A company might be driven by a desire to be the biggest and best in the industry

Tech: A business could be bought because it possess some technology, intellectual property, or patent that is of value

Employees: A company might be bought because it has a number of stellar employees that a buyer thinks could serve as a catalyst for growth within their own firm

Horizontal and Vertical Integration

Regardless of the motivations or trends evaluated, we can categorize a merger or acquisition as either being horizontal or vertical. In a horizontal merger or acquisition, the two entities involved will generally serve the same customers and sell similar products. By contrast, a vertical merger or acquisition involves entities at different levels in the production cycle. A horizontal merger offers the opportunity to take advantage of economies of scale and technological innovations to better compete with companies in the industry. Vertical mergers and acquisitions allow companies to increase their operational efficiencies and reduce costs of production.

Financing the Decision

The purchase of a company is no cheap matter, so the decision of how a company will finance their acquisition is an important one. Different values of cash, stock, and debt are all evaluated in assessing the best purchase method. Cash offers the benefit of being an immediate resource to distribute, but has the drawback of giving up potential interest when spent. The quantity of cash that could have been earned if not used is known as a foregone interest on cash. Taking out debt allows companies to amass cash that they may not presently have, but creates the liability of paying that principal back over time alongside accumulated interest. Lastly, companies can utilize stock as a means of financing their purchase. They would be using the value an asset (their company) to purchase something else (the target company). The downside in this is that by using their own stock they would be increasing their quantity of shares outstanding hence lowering their company’s earnings per share; a value of which we know is calculated by dividing net income by shares outstanding.

Realistically, companies will typically use a combination of the methods described above. To determine the quantities that best fit the situation at hand, sensitivity reports are made. Sensitivity reports allow you to analyze how changes in purchase price, transaction structure, and payment method impact a target company’s EPS.

How Do We Measure Success?

After a storm of paperwork, the combining of financial statements, and a number of accounting adjustments have been made (a process by which an entirely different article could be written), how do we measure if an M&A is working out as expected? A key early indicator is how the combined company creates synergies in both revenue and expenses. Revenue synergy is critical but hard to quantify. The concept centers around how consumers react to the new products and services offered by a merger or acquisition. Expense synergy is much clearer and shows how operation costs can be streamlined as a result of the combining of firms. Reduction in workforce is an expense synergy where a combined firm can reduce costs by eliminating redundant positions through layoffs. Another example would be through building consolidation, where a combined firm can move into into one space consequently reducing property costs. Alongside these benefits, one has to constantly monitor and counter immediate dangers and threats posed by merging with or acquiring a firm such as failures in synergy, difficulties in integration, and mismatches in culture.

While Mergers and Acquisitions are and have been key buzzwords in business, 70–90% end up in failure. To be successful, it is critical to not only understand the mechanics behind an M&A, but to fully evaluate both the financial and intangible attributes of the combined company.