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578 Making Key Strategic Decisions Tax Savings Corporations in the U.S. pay billions each year in corporate in- come taxes. M&A activity may create tax savings that would not be possible ab- sent the transaction. While acquisitions made solely to reduce taxes would be disallowed, substantial value may result from tax savings in deals initiated for valid business purposes. We consider the following three ways that tax incen- tives may motivate acquisition activity: 1. Unused operating losses. 2. Excess debt capacity. 3. Disposition of excess cash. Operating losses can reduce taxes paid, provided that the firm has operating profits in the same period to offset. If this is not the case, the operating losses can be used to claim refunds for taxes paid in the three previous years or car- ried forward for 15 years. In all cases, the tax savings are worth less than if they were earned today due to the time value of money. Example 4 Consider two firms, A and B, and two possible states of the econ- omy, boom and bust with the following outcomes: Firm A Firm B Boom Bust Boom Bust Taxable income $1,000 $(500) $(500) $1,000 Taxes (at 40%) (400) 0 0 (400) Net income $ 600 $(500) $(500) $ 600 Notice that for each possible outcome, the firms together pay $400 of taxes. In this case, operating losses do not reduce taxes for the individual firms. Now consider the impact of an acquisition of firm B by firm A. Firm A/B Boom Bust Taxable income $500 $500 Taxes (at 40%) (200) (200) Net income $300 $300 The taxes paid have fallen by 50% to $200 under either scenario. This is incremental cash flow that must be considered when assessing the acquisition’s impact on value creation. This calculation must be done with two caveats. Firstly, only cash flows over and above what the independent firms would ulti- mately save in taxes should be included and secondly, the tax savings cannot be the main purpose of the acquisition. Interest payments on corporate debt are tax deductible and can generate significant tax savings. Basic capital structure theory predicts that firms will issue debt until its additional tax benefits are offset by the increased likelihood Profitable Growth by Acquisition 579 of financial distress. Because most acquisitions provide some degree of diversi- fication, that is, they reduce the variability of profits for the merged firms, they can also reduce the probability of financial distress. This diversification effect is illustrated in the previous example, where the postmerger net income is constant. The result is a higher debt-to-equity ratio, more interest payments, lower taxes, and value creation. Many firms are in the enviable position of generating substantial operat- ing cash flows and over time, large cash surpluses. At the end of 1999, for ex- ample, Microsoft and Intel held a combined $29 billion in cash and short-term investments. Firms can distribute these funds to shareholders via a dividend or through a stock repurchase. However, both of these options have tax conse- quences. Dividends create substantial tax liabilities for many shareholders and a stock repurchase, while generating lower taxes due to capital gains provisions cannot be executed solely to avoid tax payments. A third option is to use the ex- cess cash to acquire another company. This strategy would solve the surplus funds “problem” and carry tax benefits as no tax is paid on dividends paid from the acquired to the acquiring firms. Again, the acquisition must have a busi- ness rationale beyond just saving taxes. The following example summarizes the sources of value discussed in this section and illustrates how we might assess value creation in a potential acquisition. Example 5 MC Enterprises Inc. manufactures and markets value-priced digi- tal speakers and headphones. The firm has excellent engineering and design staffs and has won numerous awards from High Fidelity magazine for its most recent wireless bookshelf speakers. MC wants to enter the market for personal computer (PC) speakers, but does not want to develop its own line of new prod- ucts from scratch. MC has three million outstanding shares trading at $30/share. Digerati Inc. is a small manufacturer of high-end speakers for PCs, best known for the technical sophistication of its products. However, the firm has not been well managed financially and has had recent production problems, leading to a string of quarterly losses. The stock recently hit a three-year low of $6.25 per share with two million outstanding shares. MC’s executives feel that Digerati is an attractive acquisition candidate that would provide them with quick access to the PC market. They believe an acquisition would generate incremental after-tax cash flow from three sources. 1. Revenue enhancement: MC believes that Digerati’s technical expertise will allow it to expand their current product line to include high-end speakers for home theater equipment. They estimate these products could generate incremental annual cash flow of $1.25 million. Because this is a risky undertaking, the appropriate discount rate is 20%. 2. Operating efficiencies: MC is currently operating at full capacity with significant overtime. Digerati has unused production capacity and could easily adapt their equipment to produce MC’s products. The estimated 580 Making Key Strategic Decisions annual cash flow savings would be $1.5 million. MC’s financial analysts are reasonably certain these results can be achieved and suggest a 15% discount rate. 3. Tax savings: MC can use Digerati’s recent operating losses to reduce its tax liability. Their tax accountant estimates $750,000 per year in cash sav- ings for each of the next four years. Because these values are easy to esti- mate and relatively safe cash flows, they are discounted at 10%. The values of MC and Digerati premerger are computed as follows: Number of Company Shares Price/Share Market Value MC Enterprises 3,000,000 $30.00 $90 million Digerati Inc. 2,000,000 6.25 12.5 million Assume that MC pays a 50% premium to acquire Digerati and that the costs of the acquisition total $3 million. What is the expected impact of the transaction on MC’s share price? Solution: We first compute the total value created by each of the incremental cash flows: Annual Cash Discount Source Flow Rate Value Revenue enhancement $1.25 million 20% $ 6.25 million Operating efficiencies 1.5 million 15 10.0 million Tax savings $750,000 10 2.38 million Total Value = $18.63 million The total value created by the acquisition is $18.63 million. A 50% pre- mium would give $6.25 million of this incremental value to Digerati’s share- holders. After $3 million of acquisition costs, $9.38 million remains for MC’s three million shareholders. Thus, each share should increase by $3.13 ($9.38 million divided by the 3 million shares outstanding) to $33.13. Note that the solution to Example 5 assumes the market knows about and accepts the value creation estimates described. Investors will often discount management’s estimates of value creation, believing them to be overly opti- mistic or doubting the timetable for their realization. In practice, estimating the synergistic cash flows and the appropriate discount rates is the analyst’s most difficult task. Summary The sole motivation for initiating a merger or acquisition should be increased wealth for the acquirer’s shareholders. We know from the em- pirical evidence presented in section III that many transactions fail to meet this simple requirement. The main point of this section is that value can only come from one source—incremental future cash flows or reduced risk. If we can estimate these parameters in the future, we can measure the acquisition’s Profitable Growth by Acquisition 581 synergy, or potential for value creation. For the deal to benefit the acquirer’s shareholders, management must do two things. The first is to pay a premium that is less than the potential synergy. Many acquisitions that make strategic sense and generate positive synergies fail financially simply because the bid- der overpays for the target. The second task for the acquirer’s management is to implement the steps needed after the transaction is completed to realize the deal’s potential for value creation. This is a major challenge and is discussed further in section VII. In the next section we briefly present some of the key issues managers should consider when initiating and structuring acquisitions. SOME PRACTICAL CONSIDERATIONS In this section, we briefly discuss the following issues you may encounter in de- veloping and executing a successful M&A strategy: • Identifying candidates. • Cash versus stock deals. • Pooling versus purchase accounting. • Tax considerations. • Antitrust concerns. • Cross-border deals. This is not meant to be a comprehensive presentation of these topics. Rather, the important aspects of each are described with the focus on how they can in- fluence cash flows and synergy. The goal is to make sure that you are at least aware of how each item might affect your strategy and the potential for value creation. Identif ying and Screening Candidates Bidders must first identify an industry or market segment they will target. This process should be part of a larger strategic plan for the company. The next step is to develop a screening process to rank the potential acquisitions in the indus- try and to eliminate those that do not meet the requirements. This first screen is typically done based on size, geographic area, and product mix. Each of the target’s product lines should be assessed to see how they relate to (a) the bid- der’s existing target market, (b) markets that might be of interest to the bid- der, and (c) markets that are of no interest to the bidder. Keep in mind that undesirable product lines may be sold. It is also important to evaluate the current ownership and corporate gov- ernance structure of the target. If public, how dispersed is share ownership and who are the majority stockholders? What types of takeover defenses are in 582 Making Key Strategic Decisions place and have there been previous acquisition attempts? If so, how have they fared? For a private company, there should be some attempt to discern how likely the owners are to sell. Information about the recent performance of the firm or the financial health of the owners may provide some insight. The original list of potential acquisitions can be shortened considerably by using these criteria. The companies on this shortened list should be first an- alyzed assuming they would remain as a stand-alone business after the acquisi- tion. This analysis should go beyond just financial performance and might include the following criteria: 14 Other popular tools for this analysis include SWOT (strengths, weak- nesses, opportunities, and threats) analysis, the Porter’s Five Forces model, and gap analysis. Once this process is completed, the potential synergies of the deal should be assessed using the approach presented in the previous sec- tion. The result will be a list of potential acquisitions ranked by both their po- tential as stand-alone companies and the synergies that would result from a combination. Cash versus Stock Deals The choice of using cash or shares of stock to finance an acquisition is an im- portant one. In making it, the following factors should be considered: 1. Risk-sharing: In a cash deal, the target firm shareholders take the money and have no continued interest in the firm. If the acquirer is able to create significant value after the merger, these gains will go only to its sharehold- ers. In a stock deal, the target shareholders retain ownership in the new firm and therefore share in the risk of the transaction. Stock deals with Microsoft or Cisco in the 1990s made many target-firm shareholders wealthy as the share prices of these two firms soared. Chrysler Corpora tion Future Performance Forecast Growth prospects Future margin Future cash flows Potential risk areas Key Strengths/Weaknesses Products and brands Technology Assets Management Distribution Industry Position Cost structure versus competition Position in supply chain Financial Performance Profit growth Profit margins Cash flow Leverage Asset turnover Return on equity Business Performance Market share Product development Geographic coverage Research and assets Employees Profitable Growth by Acquisition 583 stockholders on the other hand, have seen the postmerger value of the Daimler-Benz shares they received fall by 60%. 2. Overvaluation: An increase in the acquirer’s stock price, especially for technology firms, may leave its shares overvalued historically and even in the opinion of management. In this case, the acquirer can get more value using shares for the acquisition rather than cash. However, investors may anticipate this and view the stock acquisition as a signal that the ac- quirer’s shares are overpriced. 3. Taxes: In a cash deal, the target firm’s shareholders will owe capital gains taxes on the proceeds. By exchanging shares, the transaction is tax-free (at least until the target firm stockholders choose to sell their newly acquired shares of the bidder). Taxes may be an important consideration in deals where the target is private or has a few large shareholders, as Example 6 makes clear. Often firms will make offers using a combination of stock and cash. In a study of large mergers between 1992 and 1998, only 22% of the deals were cash-only. Stock only (60%) and combination cash and stock (18%) accounted for the vast majority of the deals. 15 This contrasts with the 1980s when many deals were cash offers financed by the issuance of junk bonds. The acquirer’s financial ad- visor or investment banker can help sort through these factors to maximize the gains to shareholders. Example 6 Sarni Inc. began operations 10 years ago as an excavating com- pany. Jack Sarni, the principal and sole shareholder, purchased equipment (a truck and bulldozer) at that time for $40,000. The equipment had a six-year useful life and has been depreciated to a book value of zero. However, the ma- chinery has been well maintained and because of inflation, has a current mar- ket value of $90,000. The business has no other assets and no debt. Pave-Rite Inc. makes an offer to acquire Sarni for $90,000. If the deal is a cash deal, Jack Sarni will immediately owe tax on $50,000, the difference be- tween the $90,000 he receives and his initial investment of $40,000. If he in- stead accepts shares of Pave-Rite Inc. worth $90,000 in a tax-free acquisition, there is no immediate tax liability. He will only owe tax if and when he sells the Pave-Rite shares. Of course in this latter case, Sarni assumes the risk that Pave-Rite’s shares may fall in value. Purchase versus Pooling Accounting The purchase method requires the acquiring corporation to allocate the pur- chase price to the assets and liabilities it acquires. All identifiable assets and liabilities are assigned a value equal to their fair market value at the date of ac- quisition. The difference between the sum of these fair market values and the purchase price paid is called goodwill. Goodwill appears on the acquirer’s books as an intangible asset and is amortized, or written off as a noncash 584 Making Key Strategic Decisions ex pense for book purposes over a period of not more than 40 years. The amor- tization of purchased goodwill is deductible for tax purposes and is taken over 15 years. Under the pooling of interests method, the assets of the two firms are combined, or pooled, at their historic book values. There is no revaluation of assets to reflect market value and there is no creation of goodwill. Because of this, there is no reduction in net income due to goodwill amortization. This method requires that the acquired firm’s shareholders maintain an equity stake in the surviving company and is therefore used primarily in acquisitions for stock. Weston and Johnson report that 52% of the 364 acquisitions they analyzed used pooling and 48% used purchase accounting. 16 To illustrate the difference between the two methods of accounting for an acquisition, we offer a simple example. Example 7 Consider the following predeal balance sheets for B.B. Lean Inc. and Dead End Inc., both clothing retailers: B.B. Lean Inc. ($ millions) Dead End Inc. ($ millions) Cash $ 6 Equity $28 Cash $ 3 Equity $12 Land 22 Land 0 Building 0 Building 9 Total $28 $28 Total $12 $12 Now assume that B.B. Lean offers to purchase Dead End for $18 million worth of its stock and elects to use the purchase method of accounting. As- sume further that Dead End’s building has appreciated and has a current mar- ket value of $12 million. B.B. Lean’s balance sheet after the deal appears as follows: B.B. Lean Inc. ($ millions) Purchase Method Cash $ 9 Equity $46 Land 22 Building 12 Goodwill 3 Total $46 $46 Note that the acquired building has been written up to reflect its market value of $12 million and that the difference between the acquisition price ($18 million) and the market value of the assets acquired ($15 million) is booked as goodwill. Lean’s equity has increased by the $18 million of new shares it issued to pay for the deal. Now assume that the same transaction occurs, this time using the pooling method. Profitable Growth by Acquisition 585 B.B. Lean Inc. ($ millions) Pooling Method Cash $ 9 Equity $40 Land 22 Building 9 Goodwill 0 Total $40 $40 Under the pooling method, there is no goodwill and the acquired assets are put on B.B. Lean’s balance sheet at their book value. Entire volumes have been written on the accounting treatment of acqui- sitions and this is a very complex and dynamic issue. In fact, as this chapter is being written, accounting-rule makers in the United States were proposing to eliminate the pooling of interests method of accounting for acquisitions. Be- cause of this, it is important to get timely, expert advice on these issues from competent professionals. Tax Issues Taxes were discussed briefly in the paragraph comparing cash and stock deals. In a tax-free transaction, the acquired assets are maintained at their historical levels and target firm shareholders don’t pay taxes until they sell the shares re- ceived in the transaction. To qualify as a tax-free deal, there must be a valid business purpose for the acquisition and the bidder must continue to operate the acquired business. In a taxable transaction, the assets and liabilities ac- quired are marked up to reflect current market values and target firm share- holders are liable for capital gains taxes on the shares they sell. In most cases, selling shareholders would prefer a tax-free deal. In the study by Weston and Johnson (1999), 65% of the transactions were nontaxable. However, there are situations where a taxable transaction may be preferred. If the target has few shareholders with other tax losses, their gain on the deal can be used to offset these losses. A taxable deal might also be optimal if the tax savings from the additional depreciation and amortization outweigh the capital gains taxes. In this case, the savings could be split between the target and bid- der shareholders (at the expense of the government). Again, it is important to get current, expert advice from knowledgeable tax accountants when structur- ing any transaction. Antitrust Concerns Regulators around the world routinely review M&A transactions and have the power to disallow deals if they feel they are anti-competitive or will give the merged firm too much market power. More likely than an outright rejection are provisions that require the deal’s participants to modify their strategic 586 Making Key Strategic Decisions plan or to divest certain assets. These concessions can have important implica- tions for margins and ultimately cash flow and shareholder value. For example, in approving the recent megamerger between AOL and Time Warner, the U.S. Federal Trade Commission (FTC) imposed strict provisions on the new com- pany with respect to network access by competing internet service providers. The goal of this is to increase competition, which will ultimately reduce AOL/Time Warner’s margins and future cash flows. The basis for antitrust laws in the U.S. is found in the Sherman Act of 1890, the Clayton Act of 1914, and the Hart-Scott-Rodino Act of 1976. Regu- lators assess market share concentration within the context of the economics of the industry. Factors such as ease of entry for competitors and the potential for collusion on pricing and production levels are also considered. In the end, an- titrust enforcement is an inexact science that can have a major impact on M&A activity. When assessing potential acquisition candidates, the potential for reg- ulatory challenges—and an estimate of the valuation impact of likely reme- dies—must be considered in the screening and ranking process. Cross-Border Deals In 1999, for the first time in history, there were more acquisitions of foreign companies (10,413) than U.S. companies (7,243). The U.S. deals were larger on average, totaling $1.2 trillion versus $980 billion for the foreign transac- tions. 17 By any measure, the level of international M&A activity is increasing as the globalization of product and financial markets continues. All of the is- sues discussed in this chapter apply to cross-border deals, in some cases with significant added complexities, which are discussed briefly next. Each country has its own legal, accounting, and economic systems. This means that tax and antitrust rules may vary greatly from U.S. standards. While there is a move to standardized financial reporting via generally accepted ac- counting principles (GAAP) or international accounting standards (IAS), there is still great variability in the frequency and reliability of accounting data around the world. The problem is that developing nations, which offer some of the best acquisition opportunities, have the most problems. Doing M&A transactions across borders brings additional risks that have not been previously discussed. These include currency exchange risk, political risk, and the additional risk of national cultural differences. If a company is going to execute an effective international M&A strategy, all of these must be identified and quantified, because they can have a significant impact on syner- gies and the implementation timetable. It is critical for a bidder to get capable financial and legal advisors in each country it is considering acquisitions. SUCCESSFUL POSTMERGER IMPLEMENTATION The section on mergers and acquisitions makes it clear that most acquisitions fail to meet the expectations of corporate managers and shareholders. This Profitable Growth by Acquisition 587 dismal record is attributable to var ious causes, including ill-conceived acquisi- tion strategies, poor target selection, overpayment, and failed implementation. In a study of 45 Forbes 500 firms, Smolowitz and Hillyer ask senior executives to rate a list of reasons for the poor performance record of acquisitions. 18 The following were the five most frequently ranked factors: 1. Cultural incompatibility. 2. Clashing management styles and egos. 3. Inability to implement change. 4. Poor forecasting. 5. Excessive optimism with regard to synergy. The last two are premerger problems, but the first three occur in the post- merger transition process. Deloitte & Touche Consulting estimates that 60% of mergers fail largely because of integration approach. Managers must under- stand that the acquisition closing dinner marks the end of one stage of the transaction and the beginning of the process that will determine the deal’s ul- timate success or failure. In this section, we briefly discuss the following key components of a successful implementation plan: • Expect chaos and a loss of productivity. • Create a detailed plan before the deal closes. • First, keep your executives happy. • Speed and communication are essential. • Focus managerial resources on the sources of synergy. • Culture, culture, culture. The process of merging two firms creates havoc at every level of the or- ganization. The moment the first rumors of a possible acquisition begin, an air of uncertainty and anxiety permeates the company. The first casualty in this environment is productivity, which grinds to a halt as the gossip network takes over. While the executives debate grand, strategic issues, the employees are concerned with more basic issues and need to know several key things about their new employers, their compensation and their careers before productivity will resume. Managers must understand that this “me first” attitude is human nature and must be addressed—especially in transactions where the most im- portant assets are people. The first step in any postmerger implementation must be a detailed plan. We saw how Cisco “maps” the future of every employee in a soon-to-be- acquired firm. For those continuing on, their new position and duties within Cisco are clearly defined from the beginning. The employees that will be re- located or terminated are also identified and a separate plan for handling them is created. Relocation and severance packages must be generous to sig- nal retained workers that their new employer is ethical and fair. The second reason for a detailed plan is that it allows transition costs to be accurately es- timated. The costs to reconfigure, relocate, retrain, and sever employees . $(500) $(500) $1,000 Taxes (at 40%) (400) 0 0 (400) Net income $ 600 $(500) $(500) $ 600 Notice that for each possible outcome, the firms together pay. identify an industry or market segment they will target. This process should be part of a larger strategic plan for the company. The next step is to develop