Presenters name Presenters 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 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. July 2012 AMR and U.S. Airways begin merger discussions. September 2012 U.S. Airways proposes merger, with its shareholders owning 30% of the new company. November 2012 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 Company A Company B Company C Company X Company Y Company X Copyright 2013 CFA Institute 4 Merger with Consolidation Acquisition 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:
Copyright 2013 CFA Institute 6 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 same line of production (e.g., suppliercustomer). Google acquired Motorola Mobility Holdings (June 2012). Conglomerate merger Companies are in unrelated lines of business. Berkshire Hathaway acquires Lubrizol (2011). 3. MOTIVES FOR MERGER Copyright 2013 CFA Institute 7 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 EXAMPLE: BOOTSTRAPPING EARNINGS Company One Company Two Company One Post-Acquisition Earnings $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 Price per share $20 $10 $24 Market value of stock $2,000 million $500 million $3,000 million Copyright 2013 CFA Institute 8 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. Bootstrapping earnings is the increase in earnings per share as a result of a merger, combined with the markets use of the pre-merger P/E to value post-merger EPS. EXAMPLE: BOOTSTRAPPING EARNINGS Company One Company Two Company One Post-Acquisition Earnings $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 Price per share $20 $10 $20 Market value of stock $2,000 million $500 million $2,500 million Copyright 2013 CFA Institute 9 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. WeightedP E = $100 $150 20 + $50 $150 10 = 16.67 MOTIVES AND THE INDUSTRYS LIFE CYCLE The motives for a merger are influenced, in part, by the industrys 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 Cycle Stage Industry Description Motives for Merger Types of Mergers Pioneering development Industry exhibits substantial development costs and has low, but slowly increasing, sales growth. Younger, smaller companies may sell themselves to larger companies 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. Conglomerate Horizontal Rapid accelerating growth Industry exhibits high profit margins caused by few participants in the market. Explosive growth in sales may require large capital requirements to expand existing capacity. Conglomerate Horizontal Copyright 2013 CFA Institute 11 MERGERS AND THE INDUSTRY LIFE CYCLE Industry Life Cycle Stage Industry Description Motives for Merger Types of Mergers Mature growth Industry experiences a drop in the entry of new competitors, but growth potential remains. Mergers may be undertaken to achieve economies of scale, savings, and operational efficiencies. Horizontal Vertical Stabilization and market maturity Industry faces increasing competition and capacity constraints. Mergers may be undertaken to 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. Horizontal Copyright 2013 CFA Institute 12 MERGERS AND THE INDUSTRY LIFE CYCLE Industry Life Cycle Stage Industry Description Motives for Merger Types of Mergers Deceleration of growth and decline Industry faces overcapacity and eroding profit margins. Horizontal mergers may be undertaken to ensure survival. Vertical mergers may be carried out 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. Horizontal Vertical Conglomerate Copyright 2013 CFA Institute 13 4. TRANSACTION CHARACTERISTICS Form of the Transaction Stock purchase Asset purchase Method of Payment Cash Securities Combination of cash and securities Attitude of Management Hostile Friendly Copyright 2013 CFA Institute 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 targets 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 16 Merger Transactions, 2005 Cash only Stock only Cash and securities Other securities Based on data from Mergerstat Review, 2006. FactSet Mergerstat, LLC (www.mergerstat.com). MINDSET OF MANAGERS Friendly merger: Offer made through the targets board of directors Copyright 2013 CFA Institute 17 Shareholders and regulators approve. Enter into a definitive merger agreement. Perform due diligence. Enter into merger discussions. Approach target management. Hostile merger: Offer made directly to the target shareholders Types Bear hug Tender offer Proxy fight 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 acquirers power gained from its ownership interest in the target.
Copyright 2013 CFA Institute 19 TAKEOVER DEFENSES Pre-Offer Takeover Defense Mechanisms Poison pills (flip-in pill and flip-over pill) Poison puts Incorporation in a state with restrictive takeover laws Staggered board of directors Restricted voting rights Supermajority voting provisions Fair price amendments Golden parachutes Post-Offer Takeover Defense Mechanisms Just say no defense Litigation Greenmail Share repurchase Leveraged recapitalization Crown jewels defenses Pac-Man defense White knight defense White squire defense
Copyright 2013 CFA Institute 20 6. REGULATION Regulation of Mergers and Acquisitions Antitrust Law Securities Law Copyright 2013 CFA Institute 21 ANTITRUST LAW: UNITED STATES Copyright 2013 CFA Institute 22 Made combinations, contracts, and conspiracies in restraint of trade or attempts to monopolize illegal Sherman Antitrust Act (1890) Outlawed specific business practices Clayton Antitrust Act (1914) Closed loopholes in the Clayton Act CellerKefauver Act (1950) Gave the FTC and the Justice Department an opportunity to review and challenge mergers in advance HartScottRodino Antitrust Improvements Act (1976) 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 The HerfindalhlHirschman Index (HHI) is a measure of concentration within an industry and is often used by regulators to evaluate the effects of a merger. The HHI is constructed as the sum of the squared market shares of the firms in the industry: HHI = Output of firm i Total sales or output of the market 100 2 n i
Copyright 2013 CFA Institute 24 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 EXAMPLE: HHI Consider an industry that has six companies. Their respective market shares are as follows:
What is the likely government action, if any, if Companies E and F combined? Copyright 2013 CFA Institute 25 Company Market Share A 25% B 15% C 15% D 15% E 15% F 15% 100% EXAMPLE: HHI Company Market Share HHI Before Company Market Share HHI After A 25% 625 A 25% 625 B 15% 225 B 15% 225 C 15% 225 C 15% 225 D 15% 225 D 15% 225 E 15% 225 E+F 30% 900 F 15% 225 Total 100% 1125 Total 100% 1575 Copyright 2013 CFA Institute 26 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. SECURITIES LAWS: UNITED STATES Williams Act (1968): - Requires public disclosure when a party acquires 5% or more of a targets 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) Copyright 2013 CFA Institute 29 Calculate FCF NOPLAT + Noncash charges Change in working capital Capital expenditures Calculate NOPLAT Unlevered net income + Change in deferred taxes Calculate Unlevered Net Income Net income + Net interest after tax Calculate Net Interest after Tax (Interest expense Interest income) (1 Tax rate) EXAMPLE: FCF FOR THE ABC COMPANY Net income $40 Interest expense $5 Interest income $2 Copyright 2013 CFA Institute 30 Change in deferred taxes $3 Depreciation $10 Change in working capital $6 Capital expenditures $20 From the pro forma income statement From the pro forma income statement Assumed Tax rate = 45% What is ABCs free cash flow? Suppose analysts have constructed pro forma financial statements for the ABC Company and report the following: EXAMPLE: FCF Net income $40.00 Plus Net interest after tax 1.65 Equals Unlevered net income $41.65 Plus Change in deferred taxes 3.00 Equals Net operating profit minus adjusted taxes $44.65 Plus Depreciation 10.00 Minus Change in working capital 6.00 Minus Capital expenditures 20.00 Equals Free cash flow $28.65 Copyright 2013 CFA Institute 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 Copyright 2013 CFA Institute 34 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 EXAMPLE: COMPARABLE COMPANY ANALYSIS Suppose an analyst has gathered the following information on the target company, the XYZ Company:
If the typical takeover premium is 20%, what is the XYZ Companys value in a merger using the comparable company approach?
Copyright 2013 CFA Institute 35 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 EXAMPLE: COMPARABLE COMPANY ANALYSIS Assuming that the average of the values from the different multiples is most appropriate:
Copyright 2013 CFA Institute 36 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 Sales $100 million 2.5 $250 million Average = $237.5 million Estimated takeover price of the XYZ Company = $237.5 million 1.2 = $285 million COMPARABLE COMPANY ANALYSIS Advantages - Provides reasonable estimate of the target companys value - Readily available inputs - Estimates based on markets 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 post- merger
Copyright 2013 CFA Institute 37 COMPARABLE TRANSACTION ANALYSIS Collect Information on Recent Takeover Transactions of Comparable Companies Calculate Multiples for Comparable Companies Estimate Takeover Value Based on Multiples Copyright 2013 CFA Institute 38 EXAMPLE: COMPARABLE TRANSACTION ANALYSIS 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 Sales $100 million P/S of comparables 3 times Copyright 2013 CFA Institute 39 Suppose an analyst has gathered the following information on the target company, the MNO Company: Estimate the value of the MNO Company using the comparable transaction analysis, giving the cash flow multiple 70% and the other methods 10% each. 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 Sales $100 million 3 $300 million Copyright 2013 CFA Institute 40 Value of MNO = 0.7 $240 + 0.1 $150 + 0.1 $250 + 0.1 $300
Value = $238 million 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 = P T V T (10-7) where P T = price paid for the target company V T = pre-merger value of the target company
Acquirers gain = Synergies Premium = S (P T V T ) (10-8) where S = synergies created by the business combination
V A* = V A + V T + S C (10-9) where V A* = post-merger value of the combined companies V A = 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 Acquirers 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.
Copyright 2013 CFA Institute 49 Parent compan y Equity Carve-Out Spin-Off Split-Off Divestiture Liquidation 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 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 companys managers. There are 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 HerfindahlHirschman 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