This paper is on synergy and synergy valuation. It touches upon various types of synergy and discusses how these synergies are achieved. Synergy as the most common rationale for any merger and acquisition deal plays a major role in determining how much is paid by the acquirer for the target. Synergy Valuation is the process of valuing the synergy that can be attained. The calculation of synergy depends on the type of the deal. The calculations of synergy valuation are not discussed as this paper mainly focuses on the rationales and assumptions for synergy. The main aim of the paper is to show that despite the optimistic view that managers put on the synergy that can be achieved, most of the M&A deals end up in failure. Can the exorbitant prices that are paid justifiable in achieving the objective of shareholders wealth maximization? The paper ends with a short case study on EBay-Skype deal and shows how the deal ended in failure.
WHAT IS SYNERGY?
Synergy is the additional value that is generated by combining two firms, creating opportunities for growth, increase in revenue and cost reductions that would not been available to these firms operating independently. It is the increase in value that is generated by combining two entities to create new and more valuable entity. Synergy is the magic ingredient that allows acquirers to pay billions of dollars in premiums in acquisitions. [1]
Synergy, the increase in value that is generated by combining two entities to create a new and more valuable entity, is the magic ingredient that allows acquirers to pay billions of dollars in premiums in acquisitions. [2] It is basically the increased competitiveness and resulting cash flows beyond what the two companies could have achieved independently in a standalone basis.
As quoted by Aswath Damodaran, Professor of Finance at Stern School of Business "Synergy is the most widely used and misused rationale in merger and acquisitions." [3] The biggest source of synergy is the reduction in costs. That is the reason why most of the mergers and acquisitions are driven by the objectives of lowering the overall costs of the company. In most of the mergers and acquisition it has been seen that expected synergy may not be realized and therefore leads to the failure of the alliance. Likewise, these benefits may accrue to the acquirer (including its subsidiaries and associated), the acquired business or a combination of both. [4] It is a one off cost but comes along with implementation risks during the execution of the deal.
TYPES OF SYNERGYC:\Documents and Settings\asus\Desktop\valuation term paper\synergy valuation figure.bmp
Figure Synergy and ValueThere are major two types of synergy, namely, operating and financial synergy. Operating synergies includes reduction in costs with higher utilization of facilities and personnel, spreading of overhead costs, achieving advantages of common learning curves amongst others. They affect the operations of the combined firm and include economies of scale, increasing pricing power and higher growth potential. They generally show up as higher expected cash flows and are created either through lower cost of capital or higher cash flows. Financial synergies are more focused and include tax benefits, diversification, a higher debt capacity and uses for excess cash. The total value assigned to the synergies gives management some idea of how much of a premium they should pay above the valuation of the target company.
The types of synergy and their sources are further explained in the following table:
OPERATING SYNERGIES
FINANCIAL SYNERGIES
Economies of scale mostly in horizontal mergers
Increase in debt capacity
greater pricing power with reduction in competition
tax benefits by acquiring loss making companies with better prospects
combination of different functional strengths
diversification
higher growth in new or existing market
WHAT IS SYNERGY VALUATION?
Figure M&A Tool: Synergy ValuationSynergy valuation is one of the most used and over used rationale for mergers and acquisitions worldwide. The merger or acquisition takes place when it is believed that it will create synergy between the concerned companies. Valuing synergy is the most crucial part in any merger and acquisition deal. It is derived from the expected value that the combined firm would make in future. The crux of the matter is to come up with a value that is rational, justifiable and attainable. C:\Documents and Settings\asus\Desktop\valuation term paper\tool_ask_2.gif
In the initial stage, the CEO's of the company play a crucial role in valuing the synergy. It is important to define the acquiring CEO's valuation of the target as it will be the maximum price he is willing to pay for the target; (at any higher price, acquiring the target would negatively affect his current utility).
For a risk averse CEO, the target valuation represents his certainty-equivalent. The CEO's valuation is the initial stage of the acquisition process. At this stage, potential competition is exogenous. The CEO has some perception of the potential behavior of competitors, once the acquisition attempt becomes public.
There are various methods that can be applied for valuation of companies in the M&A deals. Few are as discussed below:
Comparing ratios: Mostly P/E ratios and Enterprise value to sales ratios are considered. The acquiring company usually makes an offer that is the multiple of the earnings of the target company. Considering the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. Likewise, with enterprise value to sales ratio, the acquiring company makes an offer as a multiple of the revenues, while being aware of the price-to-sales ratio of other companies in the industry.
Replacement costs: In this method, the cost of replacing the target company is analyzed and in this basis the valuation is done. This method is not widely used as all resources cannot be easily valued.
Discounted Cash flow (DCF): This is the most widely used method for valuation. It determines the company's current value according to its estimated future cash flows. This method is a bit complicated but the right use of this method can help come up with the right value of for the company and the synergy that can be created through the M&A deal.
Both the buyers and sellers involved in the M&A deal will be interested in the synergy value that can be achieved from the deal. The buyers should be willing to pay a certain premium unless the target company has been declared bankrupt or is almost in that state. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy: [5]
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For instance: InBev paid USD 70 per share for acquiring Anheuser Busch in November 2008. Anheuser Busch was valued at USD 52 billion for the deal. They had expected synergy of USD 1.5 Billion to be achieved in 3 years. By 2009, their synergy was valued at USD 1.1 billion and in 2010 till date the value of the synergy is USD 450 million. This shows that the synergy that InBev had targeted for is almost achieved before the target year.
The synergy in the deal exists when the target firm has some specialized resource that becomes more valuable if combined with the bidding firm's resources. The type of the resource will vary depending upon the merger scenario:
• Horizontal mergers: economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales.
• Vertical integration: The major source of synergy in this scenario is achieved from the control of value chain of production.
• Functional integration: If the merger is between two equally competent firms then the synergy arises by exploiting the core competency of each firm.
STEPS IN SYNERGY VALUATION
WHY IS SYNERGY VALUATION IMPORTANT?
Synergy valuation provides the basic rationale for any merger and acquisition deal. It is the crucial area of focus for the investment bankers these days. There are various models that are used to come up with the value of synergy. In these models, both quantitative as well as qualitative data are taken into consideration. In an open market transaction where both the companies operate, expected post-acquisition synergies that are quantified combined with perceived strategic value are often important factors affecting the merger and acquisition deals.
Empirical data accumulated in 1998 by Toronto-based Campbell Valuation Partners Limited found that over 80% of corporate acquirers typically consider post-acquisition synergies in assessing the value of an acquisition target. Of those 80%-plus acquirers who consider synergies, more than one-half indicated that they normally incorporate 50% or less of the value of anticipated synergies in their acquisition pricing analysis. [6]
WHY MERGER AND ACQUISITIONS FAIL?
-Role of synergy creation in success or failure of M&A
Research has shown that more than 70% of the merger and acquisition deals that takes place all over the world have resulted as failures. There are various issues that can lead to the failure including, non- alignment of objectives, poor strategic fit, lack of cultural integration, HR issues, incomplete and inadequate due diligence amongst others. Included in this list is the wrong valuation. C:\Documents and Settings\asus\Desktop\valuation term paper\1.bmp
Winner's Curse
When companies merge or a target company is acquired by the acquirer, most of the shareholder value created is likely to go not to the buyer but to the seller. This is basically explained by winner's curse which states that the acquirer materially overstates the premium expected from the deal.
Despite all the hype and excitement that is created in the market by the M&A deals, one thing that is often neglected in the long run impact on shareholder's value. Such was the case of Vodafone-Mannesmann merger which was proclaimed to be one of the biggest deals in the M&A history. Vodafone paid $190 billion to acquire Mannesmann to create a single entity worth $365 billion. This deal made the CEO's multi millionaires at the cost of shareholder's value. Eight years since the deal, the value of Vodafone in terms of market capitalization stands at $161.4 billion, down by a huge $203.6 Billion, a fall of 53%. Vodafone suffered a loss of $86 Billion in last eight years. Similar was the case of eBay shareholder's when eBay acquired Skype which resulted in the drop of share prices of eBay from $40 to $25. [7] C:\Documents and Settings\asus\Desktop\valuation term paper\2.bmp
Likewise, Tata Motors acquired Jaguar and Land Rover for a staggering $ 2.3 Billion, the market was skeptic whether Tata could fit in the luxury brand category. The revenue synergy that they were expecting was just limited to 2-3 years. The share price after merger dropped to INR 655.20 from INR 679.50.
Failure in achieving synergy in the M&A deals:
In the book, "The Complete Guide to Mergers and Acquisitions", authors Timothy J. Galpin and Mark Herndon have pointed out the following:
Synergies projected for M & A's are not achieved in 70% of cases.
Just 23% of all M & A's will earn their cost of capital.
In the first six months of a merger, productivity may fall by as much as 50%.
The average financial performance of a newly merged company is graded as C - by the respective managers.
In acquired companies, 47% of the executives will leave the first year and 75% will leave within the first three years of the merger.
EXAMPLES OF FEW OVER VALUED M&A DEALS
Merger/Acquisition
Date
Deal Value
Remarks
EBay- Skype
2005
$ 2.6 Billion
Sold of Skype for $ 2.75 Billion in 2009
Vodafone-Mannesmann
2000
£112 Billion
Vodafone suffered a loss of $86 Billion in last eight years
Daimler- Chrysler
1998
$ 36 Billion
Sold off Chrysler for $ 7.4 Billion in 2007
Tata- Jaguar and Land Rover
2008
$ 2.3 Billion
Share prices dropped significantly after the acquisition
Quaker Oats- Snapple Beverage
1994
$ 1.7 billion
Three years later, Quaker Oats sold Snapple for a paltry $300 million
Table Few Over- Valued M&A Deals
Various things could go unnoticed during the valuation of synergy. Major two are as highlighted below:
Costs of realizing synergies
In the competitive bidding situation, often the acquirer firm ends up paying excessive premium for the target company. It is important to understand that corporate acquirers frequently concentrate on the anticipated benefits from an acquisition and often do not give an adequate pre-acquisition consideration to the costs of integration, the timing of the anticipated proceeds, and the probability factors related to the actual realization of the perceived benefits. This usually occurs because synergy assessments are overly optimistic as a result of incomplete due diligence, extremely optimistic to rationalize the price that is deemed necessary to secure the deal, or do not adequately consider post-acquisition competitor strategies and activities. In many cases, financial due diligence is not carried out properly, impractical assumptions are made and the firm is unable to capture the changes in the unexpected changes in the external environment.
Quantifying synergies
While valuing the companies for merger and acquisition, the quantification of post-acquisition synergies is an important step. The intrinsic value of the company should be estimated as the base value and the value of synergies added to that base. This segregation will help in evaluating the reasonableness of the components, but in an open market transaction, the acquirer's pricing and negotiating strategy should consider the portion of expected synergies it wants to pay for. Where a purchaser does not pay for it, expected synergies serve to compensate for unanticipated shortfalls from expected post-acquisition discretionary cash flows. For the purpose of quantification, post-acquisition synergies are generally divided into tangible operating synergies, intangible operating synergies and financial synergies. A proper quantification of post-acquisition synergies requires a balanced, realistic perspective of the perceived benefits that will arise following the deal, as well as an assessment of the likely timing and the incremental costs to be incurred in their realization.
For instance, in the year 1994, Quaker Oats purchased Snapple Beverage Co. for a total cost of $1.7 billion but the Snapple business was sold off after a period of three years for a loss of $1.4 billion. The main reason of this failure was the conflict between the corporate cultures of the two organizations. Quaker had an extremely focused, mass-market working approach and on the other hand Snapple's style was eccentric, commercial and tilted towards its distributors. This shows that despite the high prices paid, negligence in other factors leads to failure at achieving the target synergies.
According to the article on McKinsey Quarterly "Where Mergers Go Wrong" 2004, the lessons learnt from their survey of 160 mergers so far, the six practical measures that the executives can take to improve the chance of achieving synergies from acquisition are explained below:
Reduce top- line synergy estimates: Most of the companies which target for revenue synergies end up in failure. Revenue synergy as a rationale for the deal may not be the best rationale.
Acknowledge revenue dis-synergies
Increase estimates of onetime costs
Compare projections with realities
Apply outside- in benchmarks to cost synergies
Be realistic about timing
SHORT CASE STUDY: EBAY ACQUIRES SKYPE
Synergy valuation is the major rationale for any M&A deal. Such was the case of EBay- Skype deal which took place in 2006. EBay paid $ 2.6 Billion to acquire Skype. The main objective of EBay to acquire Skype was to integrate it with its EBay and PayPal services. It was expected that the revenue will reach $200 million by the end of 2006 and profitable by the end of 2006. Operating margins were expected to be at the range of 20-25%. But in 2007, EBay posted a loss of $936 million for the third quarter in 2007, a direct result of a previously disclosed $1.39 billion write down of its investment in Skype. Later it was accepted that it was just the hype of Skype that the management of EBay and the market had created to bring synergistic advantage to EBay's core business. In 2008, EBay CEO mentioned in an interview that it will be the year of testing synergies between the online voice and video communications service and other eBay operations such as auctions and PayPal payments. He also mentioned that in the synergies are strong, then EBay will hold on to Skype or else they will reassess their strategy. [8] Skype itself had grown, with 26 million more users, which brought it to a total of 246 million users. However, its sales were quite modest: only $98 million. With the acquisition of Skype various problems starting coming out. One major hurdle was that EBay bought Skype but not the peer to peer technology behind it, which was still owned by software's original developers. To put this situation into some sort of context, it's the equivalent of EBay having one wish and spending it on a lifetime's supply of tuna, but failing to persuade the genie to hand over a can opener. Ultimately in 2009, EBay agreed to sell the majority of Skype for $ 2.75 Billion to a group of private investors.
This is just a brief outline of the synergy value that EBay had anticipated from the deal. The original idea behind this ill-fated acquisition was that adding a leader in PC-based voice calls to online auctions would boost communication between curious buyers and nervous sellers, ultimately adding value to the company's core operations. But the objective that they held could not be achieved. Without the synergy in the objectives and the strategies, it is not really possible to accomplish the financial or operating synergy. Many analyst in the industry mentioned that the deal was over inflated and the synergies that were expected were not practical. The due diligence process was not up to the mark which led to various controversies that followed after. It was definitely not the best strategic decisions that EBay took when acquiring Skype. It was seen more like a hubris infected acquisition, just because EBay had lots of excess cash that they wanted to spend.
We can see that despite the objectives that EBay had put forward before the deal, it did not lead to maximization of shareholder's benefit. Despite the excessive premium and various attempts to save the deal, EBay ended up accepting the fact that this is definitely not the best acquisition that they had done.
CONCLUSION
The focus of synergy valuation should be on achievability, cost to implementation and timing of delivery of synergy. All aspects of synergy delivery including key risks, interdependencies and the probability of the successful achievement of synergy after the deal are implemented. The sharing of the benefits of synergy among the two players will depend on whether the bidding firm's contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the target firm whereas if it is unique, the sharing of benefits will be much more equitable.
In this paper I have tried to highlight the various types of synergies that a firm can achieve in the merger and acquisition deal. Also, the various cases of failures of M&A have been shown to stress the point that the synergy valuation is overly optimistic and does not always take into consideration the external factors and future prospects.
