CHAPTER 10 MERGERS AND ACQUISITIONS Presenters name Presenters

CHAPTER 10 MERGERS AND ACQUISITIONS Presenter’s name Presenter’s title dd Month yyyy

1. INTRODUCTION • Mergers and acquisitions (M&A) are complex, involving many parties. • Mergers and acquisitions involve many issues, including - Corporate governance. - Form of payment. - Legal issues. - Contractual issues. - Regulatory approval. • M&A analysis requires the application of valuation tools to evaluate the M&A decision. Copyright © 2013 CFA Institute 2

EXAMPLE OF A MERGER: AMR AND U. S. AIRWAYS November 2012 July 2012 • U. S. Airways proposes merger to bankrupt AMR. April 2012 • AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone. • AMR and U. S. Airways begin merger discussions. September 2012 • U. S. Airways proposes merger, with its shareholders owning 30% of the new company. • Details of the merger are worked out. • Merger filed with the FTC under Hart. Scott-Rodino Act. February 2013 Copyright © 2013 CFA Institute 3

2. MERGERS AND ACQUISITIONS DEFINITIONS Merger with Consolidation Company A Acquisition Company X Company C Company B Copyright © 2013 CFA Institute Company X Company Y 4

MERGERS AND ACQUISITIONS DEFINITIONS • Parties to the acquisitions: - The target company (or target) is the company being acquired. - The acquiring company (or acquirer) is the company acquiring the target. • Classified based on endorsement of parties’ management: - A hostile takeover is when the target company board of directors objects to a takeover offer. - A friendly transaction is when the target company board of directors endorses the merger or acquisition offer. Copyright © 2013 CFA Institute 5

MERGERS AND ACQUISITIONS DEFINITIONS Classified by the relatedness of business activities of the parties to the combination: Type Characteristic Example Horizontal merger Companies are in the same line of business, often competitors. Walt Disney Company buys Lucasfilm (October 2012). Vertical merger Companies are in the Google acquired Motorola same line of production Mobility Holdings (June (e. g. , supplier–customer). 2012). Conglomerate merger Companies are in unrelated lines of business. Copyright © 2013 CFA Institute Berkshire Hathaway acquires Lubrizol (2011). 6

3. MOTIVES FOR MERGER Creating Value • • • Synergy Growth Increasing market power Acquiring unique capabilities or resources Unlocking hidden value Cross-Border Mergers • • • Exploiting market imperfections Overcoming adverse government policy Technology transfer Product differentiation Following clients Dubious Motives • • Diversification Bootstrapping earnings Managers’ personal incentives Tax considerations Copyright © 2013 CFA Institute 7

EXAMPLE: BOOTSTRAPPING EARNINGS Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the market’s use of the pre-merger P/E to value post -merger EPS. Assumptions: • Exchange ratio: One share of Company One for two shares of Company Two • Market applies pre-merger P/E of Company One to post-merger earnings. Company Two Company One Post-Acquisition $100 million $50 million $150 million Number of shares 100 million 50 million 125 million Earnings per share $1 $1 $1. 20 P/E 20 10 20 $10 $24 $2, 000 million $500 million $3, 000 million Company One Earnings Price per share Market value of stock Copyright © 2013 CFA Institute 8

EXAMPLE: BOOTSTRAPPING EARNINGS Assumptions: • Exchange ratio: One share of Company One for two shares of Company Two • Market applies weighted average P/E to the post-merger company. Company Two Company One Post-Acquisition $100 million $50 million $150 million Number of shares 100 million 50 million 125 million Earnings per share $1 $1 $1. 20 P/E 20 10 16. 67 $20 $10 $2, 000 million $500 million $2, 500 million Company One Earnings Price per share Market value of stock Copyright © 2013 CFA Institute 9

MOTIVES AND THE INDUSTRY’S LIFE CYCLE • The motives for a merger are influenced, in part, by the industry’s stage in its life cycle. • Factors include - Need for capital. - Need for resources. - Degree of competition and the number of competitors. - Growth opportunities (organic vs. external). - Opportunities for synergy. Copyright © 2013 CFA Institute 10

MERGERS AND THE INDUSTRY LIFE CYCLE Industry Life Industry Cycle Stage Description Pioneering Industry exhibits development substantial development costs and has low, but slowly increasing, sales growth. Types of Motives for Mergers Younger, smaller companies may Conglomerate sell themselves to larger companies Horizontal in mature or declining industries and look for ways to enter into a new growth industry. Young companies may look to merge with companies that allow them to pool management and capital resources. Rapid Industry exhibits Explosive growth in sales may Conglomerate accelerating high profit margins require large capital requirements to Horizontal growth caused by few expand existing capacity. participants in the market. Copyright © 2013 CFA Institute 11

MERGERS AND THE INDUSTRY LIFE CYCLE Industry Life Industry Cycle Stage Description Mature Industry growth experiences a drop in the entry of new competitors, but growth potential remains. Stabilization Industry faces and market increasing maturity competition and capacity constraints. Copyright © 2013 CFA Institute Motives for Mergers may be undertaken to achieve economies of scale, savings, and operational efficiencies. Types of Mergers Horizontal Vertical Mergers may be undertaken to Horizontal achieve economies of scale in research, production, and marketing to match the low cost and price performance of other companies (domestic and foreign). Large companies may acquire smaller companies to improve management and provide a broader financial base. 12

MERGERS AND THE INDUSTRY LIFE CYCLE Industry Life Industry Types of Cycle Stage Description Motives for Mergers Deceleration Industry faces Horizontal mergers may be Horizontal of growth and overcapacity and undertaken to ensure survival. Vertical decline eroding profit Vertical mergers may be carried out Conglomerate margins. to increase efficiency and profit margins. Companies in related industries may merge to exploit synergy. Companies in this industry may acquire companies in young industries. Copyright © 2013 CFA Institute 13

4. TRANSACTION CHARACTERISTICS Form of the Transaction Method of Payment Attitude of Management Copyright © 2013 CFA Institute • Stock purchase • Asset purchase • Cash • Securities • Combination of cash and securities • Hostile • Friendly 14

FORM OF AN ACQUISITION • In a stock purchase, the acquirer provides cash, stock, or combination of cash and stock in exchange for the stock of the target firm. - A stock purchase needs shareholder approval. - Target shareholders are taxed on any gain. - Acquirer assumes target’s liabilities. • In an asset purchase, the acquirer buys the assets of the target firm, paying the target firm directly. - An asset purchase may not need shareholder approval. - Acquirer likely avoids assumption of liabilities. Copyright © 2013 CFA Institute 15

METHOD OF PAYMENT • Cash offering - Cash offering may be cash from existing acquirer balances or from a debt issue. • Securities offering - Target shareholders receive shares of common stock, preferred stock, or debt of the acquirer. - The exchange ratio determines the number of securities received in exchange for a share of target stock. • Factors influencing method of payment: - Sharing of risk among the acquirer and target shareholders. - Signaling by the acquiring firm. - Capital structure of the acquiring firm. Copyright © 2013 CFA Institute Merger Transactions, 2005 Cash only Stock only Cash and securities Other securities Based on data from Mergerstat Review, 2006. Fact. Set Mergerstat, LLC (www. mergerstat. com). 16

MINDSET OF MANAGERS Friendly merger: Offer made through the target’s board of directors Approach target management. Enter into merger discussions. Hostile merger: Offer made directly to the target shareholders Types • Bear hug • Tender offer • Proxy fight Perform due diligence. Enter into a definitive merger agreement. Shareholders and regulators approve. Copyright © 2013 CFA Institute 17

HOSTILE VS. FRIENDLY MERGERS • The classification of a merger as friendly or hostile is from the perspective of the board of directors of the target company. • A friendly merger is one in which the board negotiates and accepts an offer. • A hostile merger is one in which the board of the target firm attempts to prevent the merger offer from being successful. Copyright © 2013 CFA Institute 18

5. TAKEOVERS Takeover defenses are intended to either prevent the transaction from taking place or to increase the offer. - Pre-offer mechanisms are triggered by changes in control, generally making the target less attractive. - Post-offer mechanisms tend to address ownership of shares and reduce the hostile acquirer’s power gained from its ownership interest in the target. Copyright © 2013 CFA Institute 19

TAKEOVER DEFENSES Pre-Offer Takeover Defense Mechanisms Post-Offer Takeover Defense Mechanisms • Poison pills (flip-in pill and flip-over pill) • “Just say no” defense • Poison puts • Greenmail • Incorporation in a state with restrictive takeover laws • Share repurchase • Staggered board of directors • Restricted voting rights • Supermajority voting provisions • Fair price amendments • Golden parachutes Copyright © 2013 CFA Institute • Litigation • Leveraged recapitalization • “Crown jewels” defenses • “Pac-Man” defense • White knight defense • White squire defense 20

6. REGULATION Antitrust Law Securities Law Regulation of Mergers and Acquisitions Copyright © 2013 CFA Institute 21

ANTITRUST LAW: UNITED STATES Sherman Antitrust Act (1890) • Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegal Clayton Antitrust Act (1914) • Outlawed specific business practices Celler–Kefauver Act (1950) • Closed loopholes in the Clayton Act Hart–Scott–Rodino Antitrust Improvements Act (1976) • Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance Copyright © 2013 CFA Institute 22

ANTITRUST • The European Commission reviews combinations for antitrust issues. • Regulatory bodies besides the FTC may review combinations (e. g. , U. S. Federal Communications Commission, Federal Reserve Bank, state insurance commissions). • If the combination involves companies in different countries, it may require approvals by all countries’ regulatory bodies. Copyright © 2013 CFA Institute 23

THE HHI • HHI Concentration Level and Possible Government Action Post-Merger HHI Concentration Change in HHI Government Action Less than 1, 000 Not concentrated Any amount No action Between 1, 000 and 1, 800 Moderately concentrated 100 or more Possible challenge More than 1, 800 Highly concentrated 50 or more Challenge Copyright © 2013 CFA Institute 24

EXAMPLE: HHI Consider an industry that has six companies. Their respective market shares are as follows: Company Market Share A 25% B 15% C 15% D 15% E 15% F 15% 100% What is the likely government action, if any, if Companies E and F combined? Copyright © 2013 CFA Institute 25

EXAMPLE: HHI Market HHI Company Share Before Market Company Share HHI After A 25% 625 B 15% 225 C 15% 225 D 15% 225 E+F 30% 900 F 15% 225 Total 100% 1125 Total 100% 1575 • The industry would be considered moderately concentrated before and after the combination of E and F, and • The change in the HHI is 450, which may result in a government challenge. Copyright © 2013 CFA Institute 26

SECURITIES LAWS: UNITED STATES • Williams Act (1968): - Requires public disclosure when a party acquires 5% or more of a target’s common stock. - Specifies rules and restrictions pertaining to a tender offer. Copyright © 2013 CFA Institute 27

7. MERGER ANALYSIS • The discounted cash flow (DCF) method is often used in the valuation of the target company. • The cash flow that is most appropriate is the free cash flow (FCF), which is the cash flow after capital expenditures necessary to maintain the company as an ongoing concern. • The goal is to estimate future FCF. - We can use pro forma financial statements to estimate FCF - We use a two-stage model when we can more accurately estimate growth in the near future and then assume a somewhat slower growth out into the future. Copyright © 2013 CFA Institute 28

ESTIMATING FREE CASH FLOW (FCF) Calculate Net Interest after Tax (Interest expense – Interest income) × (1 – Tax rate) Calculate Unlevered Net Income Net income + Net interest after tax Calculate NOPLAT Unlevered net income + Change in deferred taxes Calculate FCF NOPLAT + Noncash charges – Change in working capital – Capital expenditures Copyright © 2013 CFA Institute 29

EXAMPLE: FCF FOR THE ABC COMPANY Suppose analysts have constructed pro forma financial statements for the ABC Company and report the following: From the pro forma income statement Net income $40 From the pro forma income statement Change in deferred taxes Interest expense $5 Depreciation Interest income $2 Change in working capital Capital expenditures Assumed Tax rate = $3 $10 $6 $20 45% What is ABC’s free cash flow? Copyright © 2013 CFA Institute 30

EXAMPLE: FCF Net income Plus Net interest after tax Equals Unlevered net income Plus Change in deferred taxes Equals Net operating profit minus adjusted taxes Plus Depreciation Minus Change in working capital Minus Capital expenditures Equals Free cash flow Copyright © 2013 CFA Institute $40. 00 1. 65 $41. 65 3. 00 $44. 65 10. 00 6. 00 20. 00 $28. 65 31

DISCOUNTED CASH FLOW (DCF) AND THE TERMINAL VALUE We can estimate the terminal value: - Assuming a constant growth after the initial few years or - Assuming a multiple (based on comparables) of pro forma FCF for the last estimated year. Copyright © 2013 CFA Institute 32

THE DCF METHOD • Advantages of using the DCF method: - The model allows for changes in cash flows in the future. - The cash flows and estimated value are based on forecasted fundamentals. - The model can be adapted for different situations. • Disadvantages of using the DCF method: - For a rapidly growing company, the FCF and net income may be misaligned (e. g. , higher-than-normal capital expenditure). - Estimating future cash flows is difficult because of the uncertainty. - Estimating discount rates is difficult, and these rates may change over time. - The terminal value estimate is sensitive to the assumptions and model used. Copyright © 2013 CFA Institute 33

COMPARABLE COMPANY ANALYSIS Select Comparable Companies • Publicly traded companies that are similar to the subject company • Same or similar industry Calculate Relative Value Measures • Enterprise value multiples • Price multiples Apply Metrics to Target • Judgment needed to select appropriate metric Estimate Takeover Price • Takeover premium added Copyright © 2013 CFA Institute 34

EXAMPLE: COMPARABLE COMPANY ANALYSIS Suppose an analyst has gathered the following information on the target company, the XYZ Company: XYZ Company Average of Comparables Earnings $10 million P/E of comparables 30 times Cash flow $12 million P/CF of comparables 25 times Book value of equity $50 million P/BV of comparables 2 times Sales $100 million P/S of comparables 2. 5 times If the typical takeover premium is 20%, what is the XYZ Company’s value in a merger using the comparable company approach? Copyright © 2013 CFA Institute 35

EXAMPLE: COMPARABLE COMPANY ANALYSIS Assuming that the average of the values from the different multiples is most appropriate: Comparables’ Multiples Estimated Stock Value Earnings $10 million × 30 $300 million Cash flow $12 million × 25 $300 million Book value of equity $50 million × 2 $100 million × 2. 5 $250 million Sales Average = $237. 5 million Estimated takeover price of the XYZ Company = $237. 5 million × 1. 2 = $285 million Copyright © 2013 CFA Institute 36

COMPARABLE COMPANY ANALYSIS • Advantages - Provides reasonable estimate of the target company’s value - Readily available inputs - Estimates based on market’s value of company attributes • Disadvantages - Sensitive to market mispricing - Sensitive to estimate of the takeover premium, and historical premiums may not be accurate to apply to subsequent mergers - Does not consider specific changes that may be made in the target postmerger Copyright © 2013 CFA Institute 37

COMPARABLE TRANSACTION ANALYSIS Collect Information on Recent Takeover Transactions of Comparable Companies Copyright © 2013 CFA Institute Calculate Multiples for Comparable Companies Estimate Takeover Value Based on Multiples 38

EXAMPLE: COMPARABLE TRANSACTION ANALYSIS Suppose an analyst has gathered the following information on the target company, the MNO Company: MNO Company Average of Multiples of Comparable Transactions Earnings $10 million P/E of comparables 15 times Cash flow $12 million P/CF of comparables 20 times Book value of equity $50 million P/BV of comparables 5 times P/S of comparables 3 times Sales $100 million Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. Copyright © 2013 CFA Institute 39

EXAMPLE: COMPARABLE TRANSACTION ANALYSIS Comparables’ Transaction Multiples Estimated Stock Value Earnings $10 million × 15 $150 million Cash flow $12 million × 20 $240 million Book value of equity $50 million × 5 $250 million $100 million × 3 $300 million Sales Copyright © 2013 CFA Institute 40

COMPARABLE TRANSACTION ANALYSIS • Advantages - Does not require specific estimation of a takeover premium - Based on recent market transactions, so information is current and observed - Reduces litigation risk • Disadvantages - Depends on takeover transactions being correct valuations - There may not be sufficient transactions to observe the valuations - Does not include value of changes to be made in target Copyright © 2013 CFA Institute 41

EVALUATING BIDS The acquiring firm shareholders want to minimize the amount paid to target shareholders, not paying more than the pre-merger value of the target plus the value of the synergies. The target shareholders want to maximize the gain, accepting nothing below the pre-merger market value. Copyright © 2013 CFA Institute 42

EVALUATING BIDS: FORMULAS Target shareholders’ gain = Premium = PT – VT (10 -7) where PT = price paid for the target company VT = pre-merger value of the target company Acquirer’s gain = Synergies – Premium = S – (PT – VT) (10 -8) where S = synergies created by the business combination VA* = VA + VT + S – C (10 -9) where VA* = post-merger value of the combined companies VA = pre-merger value of the acquirer C = cash paid to target shareholders Copyright © 2013 CFA Institute 43

EXAMPLE: EVALUATING BIDS Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. 1. What are the synergistic gains from this merger? 2. What parties, if any, share in these gains? 3. What is the estimated value of the Big Company post-merger? Copyright © 2013 CFA Institute 44

EXAMPLE: EVALUATING BIDS 1. Synergistic gains = $2 million 0. 10 = $20 million 2. Division of gains: First calculate the gains for each party and then evaluate the division. Target shareholders gain = $18 million – $15 million = $3 million Acquirer’s gain = $20 million – 3 million = $17 million Little shareholders get $3 million $20 million = 15% of the gain Big shareholders get $17 million $20 million = 85% of the gain 3. Value of Big Company post-merger = $400 million + $15 million + $20 million – $18 million = $417 million Copyright © 2013 CFA Institute 45

EFFECTS OF PRICE AND PAYMENT METHOD • The more confidence in the realization of synergies, - the greater the chance that the acquiring firm will pay cash and - the more the target company shareholders will prefer stock. • The greater the use of stock in a deal, - the greater the burden of the risks borne by the target shareholders and - the greater the potential benefits accrue to the target shareholders. • The greater the confidence of the acquiring firm managers in estimating the value of the target, the more likely the acquiring firm is to offer cash. Copyright © 2013 CFA Institute 46

8. WHO BENEFITS FROM MERGERS? • Mergers create value for the target company shareholders in the short run. • Acquirers tend to overpay in merger bids. - The transfer of wealth is from acquirer to target company shareholders. - Roll: Overpayment results from “hubris. ” • Acquirers tend to underperform in the long run. - They are unable to fully capture any synergies or other benefit from the merger. Copyright © 2013 CFA Institute 47

MERGERS THAT CREATE VALUE • Buyer is strong. • Transaction premiums are relatively low. • Number of bidders is low. • Initial market reaction to the news is favorable. Copyright © 2013 CFA Institute 48

9. CORPORATE RESTRUCTURING A divestiture is the sale, liquidation, or spin-off of a division or subsidiary. Equity Carve-Out Liquidation Spin-Off Parent compan y Divestiture Copyright © 2013 CFA Institute Split-Off 49

REASONS FOR RESTRUCTURING • Companies generally increase in size with a merger or acquisition. • Restructuring, which includes divestitures, generally follows periods of merger and acquisitions. • Reasons for restructuring: - Change in strategic focus - Poor fit - Reverse synergy - Financial or cash flow needs Copyright © 2013 CFA Institute 50

FORMS OF DIVESTITURE 1. Sale to another company: - Direct sale of assets - Creation of a separate entity and the sale of interests in that entity (i. e. , an equity carve-out) 2. Spin-off: Parent company’s shareholders receive shares of stock - Split-offs are similar to a spin-off, but only some shareholders receive shares in the new entity in exchange for shares in the parent company’s stock. 3. Liquidation: Breaking up the entity and selling off its assets piecemeal Copyright © 2013 CFA Institute 51

10. SUMMARY • An acquisition is the purchase of some portion of one company by another, whereas a merger represents the absorption of one company by another. • Mergers may be a statutory merger, a subsidiary merger, or a consolidation. • Horizontal mergers occur among peer companies engaged in the same kind of business, vertical mergers occur among companies along a given value chain, and conglomerates are formed by companies in unrelated businesses. • Merger activity has historically occurred in waves. - Waves have typically coincided with a strong economy and buoyant stock market activity. - Merger activity tends to be concentrated in a few industries, usually those undergoing changes. • There are number of motives for a merger or acquisition; some are justified, some are dubious. Copyright © 2013 CFA Institute 52

SUMMARY (CONTINUED) • A merger transaction may take the form of a stock purchase or an asset purchase. - The decision of which approach to take will affect other aspects of the transaction. • The method of payment for a merger may be cash, securities, or a mixed offering with some of both. • Hostile transactions are those opposed by target managers, whereas friendly transactions are endorsed by the target company’s managers. • There a variety of both pre- and post-offer defenses a target can use to ward off an unwanted takeover bid. Copyright © 2013 CFA Institute 53

SUMMARY (CONTINUED) • Pre-offer defense mechanisms include poison pills and puts, incorporation in a jurisdiction with restrictive takeover laws, staggered boards of directors, restricted voting rights, supermajority voting provisions, fair price amendments, and golden parachutes. • Post-offer defenses include “just say no” defense, litigation, greenmail, share repurchases, leveraged recapitalization, “crown jewel” defense, “Pac-Man” defense, or finding a white knight or a white squire. • Antitrust legislation prohibits mergers and acquisitions that impede competition. • The Federal Trade Commission and Department of Justice review mergers for antitrust concerns in the United States. The European Commission reviews transactions in the European Union. • The Herfindahl–Hirschman Index (HHI) is a measure of market power based on the sum of the squared market shares for each company in an industry. • The Williams Act is the cornerstone of securities legislation for M&A activities in the United States. Copyright © 2013 CFA Institute 54

SUMMARY (CONTINUED) • Three major tools for valuing a target company are discounted cash flow analysis, comparable company analysis, and comparable transaction analysis. • In a merger bid, the gain to target shareholders is the takeover premium. The acquirer gain is the value of any synergies created by the merger, minus the premium paid to target shareholders. • The empirical evidence suggests that merger transactions create value for target company shareholders, yet acquirers tend to accrue value in the years following a merger. • A divestiture is a transaction in which a company sells, liquidates, or spins off a division or a subsidiary. • A company may divest assets using a sale to another company, a spin-off to shareholders, or a liquidation. Copyright © 2013 CFA Institute 55