Session 27: Closure on Acquisitons + Value Enhancement

Key Concepts

Value Enhancement vs. Price Enhancement: The distinction between fundamentally increasing a company's worth (value) and artificially inflating its stock price (price).
Drivers of Value: Cash flows, growth, and risk.
Synergy Valuation: A three-step process to quantify the value created by combining two companies.
NOL (Net Operating Loss): A tax asset that can reduce future tax liabilities.
Accretive vs. Dilutive Deals: Transactions that increase or decrease earnings per share, respectively.
CEO Ego and Defensive Mergers: Psychological and strategic factors that can drive M&A decisions, often leading to overpayment.
Value Enhancement Pathways: Increasing cash flows from existing assets, increasing value from growth, building competitive advantages, and reducing the cost of capital.
Competitive Advantages (Moats): Sustainable advantages that allow a company to earn returns above its cost of capital.
Continuing Value, Abandonment Value, Divestiture Value: Three metrics to assess the value of an asset or division.
Growth Strategies: New product development, expanding existing markets, maintaining share in growing markets, competing for share in stable markets, and inorganic growth (acquisitions).

Project and Exam Deadlines

Project Numbers: Due Sunday at midnight, submitted to the master spreadsheet. These include ECF value, pricing, price per share, and recommendation. A fifth number for real options is optional.
Final Project: Due Monday by 5:00 PM, submitted as a PDF with group members listed alphabetically on the front page.
Final Exam: Scheduled for the 12th, from 4:00 PM to 5:50 PM. It will be in-person for those in New York (unless otherwise permitted) and online for others. The format is not multiple-choice and is similar to previous final exams.

Changing Company Value: Beyond Estimation

The focus shifts from estimating company value to actively changing it. This is crucial for new CEOs, business owners seeking to increase their company's worth, and consultants advising troubled companies. The core question is: "What can I do to make my business more valuable?"

Actions and Their Impact on Value Drivers

The lecture explores various actions and their potential impact on cash flows, growth, and risk.

Stock Split:
- Impact: Primarily changes the number of shares outstanding (denominator), not the underlying value.
- Potential Price Impact: Can indirectly affect price by increasing float, liquidity, or signaling future growth to traders. However, it does not fundamentally change value.
Goodwill Impairment:
- Impact: A non-cash accounting charge resulting from an acquisition where the acquired company's value falls below its purchase price.
- Value Impact: Generally does not affect cash flows, growth, or risk unless the amortization of goodwill is tax-deductible (e.g., in Spain).
- Price Impact: Can affect stock price in the short term due to negative earnings announcements.
Changing Depreciation Methods (Reporting Books Only):
- Impact: Shifting from accelerated to straight-line depreciation in reporting books can increase reported earnings by reducing depreciation expense.
- Value Impact: No impact on value as it does not affect tax books or cash flows. This is a cosmetic change.

The pattern observed is that many actions that affect reported price or earnings do not alter the fundamental value drivers (cash flows, growth, risk). Companies often engage in these actions to influence market perception.

Strategic Decisions for a Multi-Business Company CEO

As CEO of a company with four divisions, the objective is value enhancement. The decision of which division to divest is critical.

Divestiture Decision:
- Key Consideration: The value of a divestiture is not simply about getting rid of a "bad" business. It depends on the difference between the business's continuing value to the current owner and what an outsider will pay for it.
- Irony: The best businesses (e.g., a great software division) are often the ones for which a company can receive more than fair value, as buyers may overpay for them. Conversely, selling a "bad" business for less than its continuing value can destroy value.
- Framework: The decision should be based on comparing the continuing value, abandonment value, and divestiture value of each division. The highest of these three should guide the decision.

Synergy Valuation: A Three-Step Process

Synergy arises when two companies can achieve more together than they could as standalone entities. Valuing synergy requires a structured approach:

Value Standalone Companies: Value the acquiring company and the target company independently.
Sum Standalone Values: Add the values of the two companies to get the value of the combined entity without synergy.
Value Combined Company with Synergies: Value the combined company incorporating all anticipated synergies (cost savings, growth, lower cost of capital).

The value of synergy is the difference between the value calculated in Step 3 and Step 2.

Example: Procter & Gamble (P&G) acquiring Gillette:
- Standalone P&G Value: $221 billion
- Standalone Gillette Value: $59.9 billion
- Combined Value (No Synergy): $281.2 billion
- Best-Case Synergy Assumptions: $250 million cost savings, 1% growth increase.
- Combined Value (with Synergies): $298 billion
- Best-Case Synergy Value: $17.2 billion
- Premium Paid: $25 billion
- Analysis: Despite a positive synergy valuation, the $25 billion premium paid meant the deal was likely not value-enhancing for P&G shareholders.
Base-Case Scenario Adjustments:
- Realistic Cost Cuts: Assume 80% of promised cost savings (e.g., $200 million instead of $250 million).
- Time Delay: Discount synergy value back for the time it takes to realize them (e.g., two years).
- Discount Rate: Use the combined company's cost of capital for discounting synergy values.
Example: Zenith and its NOL:
- Asset: $2 billion Net Operating Loss (NOL).
- Value: Tax savings of $720 million (assuming a 36% tax rate and sufficient taxable income).
- Discounting: If taxable income is spread over four years ($180 million annually), the discount rate used should be Best Buy's cost of capital, as the risk lies in Best Buy's future taxable income.

Lessons on Synergy:

Avoid Buzzwords: Do not treat synergy as a vague concept or a placeholder.
Be Specific: Clearly define the source and magnitude of synergies. Specificity aids valuation and implementation.
Control vs. Synergy: Synergy requires both companies to gain; control can be exercised by one company improving the target. They are negotiated differently.

The Dangers of Pricing in M&A

Pricing, while common in trading, is a dangerous approach in acquisitions.

Banker's Pitch: Using comparable company multiples (e.g., 5x EBIT) or exit multiples to justify higher acquisition prices.
The Problem:
- Biased Sample: Using multiples from other acquired companies creates a biased sample, as acquisitions often involve overpayment.
- Focus on Price, Not Value: Acquisitions should be about building a business for cash flows, not about buying low and selling high.
- Accretive Deals: The term "accretive" (increasing EPS) is often misused. A deal can be accretive but still be a bad deal if it doesn't create value. It's a mathematical outcome based on PE ratios and financing.
Recommendation: If pricing is used, it should be based on all comparable companies, not just those that have been acquired. The focus should be on cash flows and building a business.

Factors That Drive Bad Deals

Several factors contribute to M&A deals going wrong:

CEO Egos: The desire to "get the deal done" can override rational decision-making. Winning the deal becomes the primary objective, regardless of value creation.
Defensive Mergers: Acquiring companies not because the deal creates value, but to avoid being left behind in an consolidating industry. This often signals a fundamentally weak business.
Lack of Accountability: When deals fail, individuals often avoid responsibility, leading to a perpetuation of poor practices.
HP and Autonomy Acquisition:
- Details: HP paid $11.1 billion for Autonomy, which was trading at $5.9 billion, a premium of over 80%.
- Justification: Synergies and strategic reasons were cited.
- Outcome: HP later wrote down $8.8 billion of the acquisition's value.
- Blame Allocation: The lecture humorously attempts to allocate blame among the CEO, bankers, and accountants, highlighting the lack of actual accountability.
- Critique of M&A Classes: The speaker suggests M&A classes often provide "escape hatches" that reduce accountability, unlike capital budgeting.

Glimmers of Hope: Making Better Acquisition Choices

To improve the odds of successful acquisitions, consider these choices:

Bidding Wars:
- Evidence: Companies that lose bidding wars tend to perform better long-term than those that win.
- Recommendation: As an acquirer's shareholder, hope your company loses a bidding war.
Target Type:
- Public vs. Private: Acquiring private companies generally offers better value creation potential than public companies.
- Reason: Public companies have market prices embedded, which can be a starting point for overpayment. Private companies allow for negotiated values.
- Subsidiaries: Acquiring subsidiaries being divested by larger companies can be particularly advantageous, as they may be sold at a steep discount.
Payment Method:
- Cash vs. Stock:
  - If your stock is overpriced: Paying with stock can be advantageous, but it signals this to the target, potentially increasing the premium.
  - For large deals: Paying with cash is generally safer to avoid excessive premiums.
Target Size:
- Small vs. Large Deals: Smaller deals (target < 6% of acquirer's value) are more likely to create value. Larger deals are more complex and prone to failure.
- Mergers of Equals vs. Unequals: Mergers of unequals (acquiring a smaller company) are generally easier to integrate and manage than mergers of equals, which often suffer from cultural clashes.
Synergy Type:
- Cost Synergies: More explicit, easier to quantify, and more likely to be delivered (median delivery around 80-90%).
- Growth Synergies: More fuzzy, harder to quantify, and less likely to be delivered (median delivery around 40-50%).
- Recommendation: Focus on cost synergies due to their higher predictability.

The Importance of Discipline in Acquisitions

Successful M&A strategies require discipline.

Discipline: Sticking to a defined strategy (e.g., acquiring small private businesses) and knowing when to stop.
The Temptation: As a company grows, there's a temptation to make larger acquisitions, which can lead to a loss of discipline.
Cisco Example: Cisco's success with its "SWAT team" for integrating acquired products eventually faltered as the company grew too large for its strategy to remain effective.
Accountability: Holding individuals responsible for forecasts and deal outcomes is crucial. If someone advocates for a deal, make them responsible for delivering its projected synergies.
Ecosystem Reform: The author suggests mechanisms like clawbacks on advisory fees for failed deals to improve accountability within the M&A ecosystem.

Four Pathways to Value Enhancement

The core of changing company value lies in these four pathways:

Increase Cash Flows from Existing Assets:
- Cost Cutting: Reducing operating expenses (e.g., closing branches, improving efficiency).
- Tax Minimization: Legally paying as little tax as possible (reducing the 't' in EBIT(1-t)).
- Reduce Maintenance Capex: Optimizing capital expenditures needed to maintain operations.
- Reduce Working Capital: Efficiently managing inventory and receivables.
- Caution: Cost cutting can destroy value if it harms future growth (e.g., cutting R&D) or operational capacity.
Increase Value from Growth:
- Reinvesting More (in good businesses): Companies earning above their cost of capital should reinvest to grow.
- Reinvesting Less (in bad businesses): Companies earning below their cost of capital should reduce or stop reinvestment to avoid deepening losses.
- Growth Strategies Ranked (by value created per $1M invested):
  - New Product Development: High payoff, but low success rate (e.g., Apple's reinvention).
  - Expanding Existing Market: Geographic or product line expansion (e.g., Uber Eats).
  - Maintaining Growing Share in Growing Market: Benefiting from market expansion (e.g., Nvidia in AI chips).
  - Competing for Share in Stable Market: Difficult due to price competition and margin erosion (e.g., Chipotle).
  - Inorganic Growth (Acquisitions): Historically the worst strategy due to upfront costs and integration challenges. Building from scratch is often better.
Build Competitive Advantages (Moats):
- Definition: Sustainable advantages that allow a company to earn returns above its cost of capital for an extended period.
- Types of Moats:
  - Brand Name: Pricing power and customer recognition (e.g., Converse).
  - Switching Costs: Making it difficult for customers to leave (e.g., mobile carrier contracts). Good businesses make switching in easy and switching out hard.
  - Network Benefits: Value increases as more users join (e.g., Facebook, Google).
  - Cost Advantage: Lower production costs than competitors (e.g., Aramco's oil extraction). Can be permanent or temporary.
  - Legal Protection: Patents and monopolies (though regulated monopolies can lose pricing power).
Reduce Cost of Capital:
- This is a crucial element that will be discussed further in the next session.

Conclusion on Value Enhancement

Value enhancement is achieved by fundamentally improving a company's cash flows, growth prospects, competitive advantages, or cost of capital. Actions that only affect stock price without altering these underlying drivers are not true value enhancement. Discipline, accountability, and a focus on first principles are essential for successful M&A and overall value creation.

Office Hours

Office hours will be held on Friday for project-related questions (regressions, pricing, DCFs). Details for the Zoom session will be provided.