ASSESSING THE IMPACT OF SYNERGY ON VALUE
Many recent studies have examined the success rates of acquisitions. Surprisingly, their conclusions consistently show that nearly two- thirds of all acquisitions are deemed failures when measured by a return less than the cost of capital used in the acquisition. In other words, in most cases, acquisitions destroy, rather than create, value. One reason a company returns less than its cost of capital is that the acquirer may misvalue the potential synergy of a transaction.
Synergy is a perceived benefit that relates to the potential or enhanced strategic position, operational performance, or managerial decision making that can arise from the combination of two or more companies.2 The analyst often uses the perceived value of synergy to justify a higher acquisition price, but frequently does not consider all relevant factors when performing a valuation analysis of potential synergies to determine an appropriate acquisition price. Consequently, the analyst may conclude the benefits are greater than they are.
Nevertheless, synergies do exist. Often the motive for an acquisition is the value creation that can result in several ways from the transaction's synergy. Value can be created, for example, through revenue enhancement, cost reductions, increased operating cash flow, improved managerial decision making, or the sale of redundant assets. However, value created from proposed synergies also may have an incremental investment cost as well.
One primary motive for an acquisition is to increase revenues. Through acquisitions, companies can increase their market shares, which should provide greater cash flow in the future. Additionally, companies may make acquisitions to use available technology or intellectual property more effectively in the marketplace at a cost lower than developing the technology internally.
Revenue enhancement as a growth strategy is found in high-growth industries. In the technology industry, for example, market share is paramount, and intellectual property and technology can be acquired quickly through an acquisition. This strategy was demonstrated in Sun Microsystems' recent acquisition of Star Division Corp., which developed a suite of office system software similar to Microsoft Office. Sun, through its own distribution experience, plans to make this software available through the Internet. The acquisition allowed Sun to not only acquire a functioning system without the opportunity costs associated with development but also offer existing customers a product that complements Sun products. Sun's strategy is to create value through increased revenue and market share.3
Another common strategy that creates value from the synergy of an acquisition is cost reduction through enhanced manufacturing efficiencies, consolidation of overhead, or increased economies of scale. Consider, for example, the value creation through cost reduction achieved by the acquisition strategy of Service Corp. International (SCI), a Houston-based corporation that owns more than 4,500 funeral homes, cemeteries, and crematories worldwide. SCI's successful strategy has been to acquire high-volume funeral homes, maintaining their original names and local reputations, yet clustering the homes with cemeteries, marketing services, and embalming to reduce costs.4
Synergy also can create value through the improvement of managerial decision-making. Often an acquiring company has greater managerial and financial resources than the acquired company. The depth of these resources can result in better working capital management, shorter production cycle times, and less need for future capital expenditures, each of which may create value. Better management decisions also can result in the sale of noncore businesses, technology, and intellectual property, which can create value not only from the cash received from the sale but also through shifting greater managerial resources to value creation in the company's core competencies.
For example, Telefon ABL.M Ericsson, the Swedish telecommunications company, pro- posed a sale of real estate holdings as part of its strategy to concentrate on its core business and to use its capital more efficiently. The market value of the real estate divestiture is believed to be between $1.1 billion and $1.2 billion. In addition to selling certain real estate, Ericsson's capital program also includes better management of accounts receivables and inventory.5 Ericsson plans to create value through synergies derived from better asset management. While this strategy is not directly related to a recent acquisition, it does illustrate that value can be created from better managerial decision making about assets acquired in previous transactions.
Valuation professionals often focus on only the benefits of synergies when performing a pricing analysis for an acquisition. However, acquirers often must make incremental investments before realizing the return on capital generated by synergies. Many analysts, however, do not consider these incremental investments or "hidden" costs when performing a pricing analysis or valuation of a potential target. Failure to consider the hidden costs often causes the overvaluation of a potential target, which may lead to destroying, rather than creating, value.
One potential 'cost' many analysts often ignore in estimating the value of potential synergies is competitors reactions to an acquisition. An acquisition does not take place in a vacuum. Market reactions may affect the assumptions behind the valuation of the potential synergies of the valuation model in an acquisition and can change the fundamentals that drive an acquisition price. Competitors may react by making acquisitions of their own, which often changes the market's dynamics. Competitors may also lower prices or lure away key employees of the target company.
Consider, for example, the pricing of long distance phone service before and after the recent MCI-WorldCom merger. One reaction to the MCI-WorldCom merger was lower prices. Before the merger, the industry standard seemed to be 'ten cents a minute' of long-distance use. Recently, the price has been advertised as "seven cents a minute.' In pricing the transaction, the merger analysts would have to consider the competition's reactions to changing market dynamics.
ELIMINATING REDUNDANT OVERHEAD
Valuation analysts also must consider other types of incremental investments in pricing a transaction that may be necessary to realize the value of synergies. One potential benefit of an acquisition is the elimination of redundant overhead. This strategy of value creation, however, may not be as simple as it first sounds. Eliminating redundant overhead is frequently subject to company policy and legal restraints. For example, part of a transaction's value creation may be the elimination of corporate managerial overhead. In order to achieve that cost reduction, the acquirer may have to invest in severance packages, relocation, training, and other costs.
The acquired entity also may have stranded fixed costs such as leases and other expenses that cannot be eliminated immediately. In addition to those costs, the acquirer often invests in process changes such as integrating new equipment into the merged entity and training for employees. When pricing an acquisition, valuation analysts must consider the cash outflows associated with such investments as well as the potential benefits of a transaction's synergy.
The valuation analyst also must consider other factors that can affect the realization of potential synergies. The postmerger integration process of the acquired company is vital to achieving value creation through synergies. The identified synergies must be the drivers for the postmerger integration, or else value may not be created. The integration creates another level of risk for both entities, which the valuation analyst needs to consider in determining the target's cost of capital or the required rate of return.
Postmerger integration issues, as well as competitors' reactions, can contribute to the hidden costs of an acquisition. Valuation analysts need to consider them along with the usually positive impact of revenue enhancements, cost reductions, and generation of other efficiencies when asked to assist in a pricing analysis of a potential acquisition that includes the synergy of a transaction.
1Copeland, Valuation: Measuring and Managing the Value of Companies, 2nd Edition, (New York; John Wiley, Inc. 1995), p. 416
2Coopers & Lybrand (PricewaterhouseCoopers), Corporate Finance Power Learning Series
3The Wall Street Journal, August 31, 1999