How supply chain effects an M&A Deal

By Dinesh S Gaur Last few years have witnessed a number of mergers and acquisitions globally. But most of the M&A deals end up in a failure. Fantastic financial valuation before the deal does not necessarily translate into creation of shareholders wealth after the merger. The researchers have identified negligence towards supply chain during due diligence stage of deal as one of the biggest factor for such failures. This article examines such thoughts and suggests some critical success factors, which directly influence supply chain, to consider before making a deal. Looking at the trend in past few years Merger and Acquisitions are on rise both in terms of volume and value. Increased confidence of top management in the economy combined with the strong cash reserve, opening up of new markets through the increased connectivity of global trade and continued search for non-organic growth and the hope to capture synergy opportunities are few of the market forces that are responsible for this trend1. M&A transaction are inherently risky and have very high failure rate. Consider the following figures2: seventy percent of mergers and acquisition failed to accomplish goals set-up by top management (KPMG survey 2003), Deal costs recovered within 10 years in only 23% of all transaction (The economist survey), In almost 60% of all cross border transaction, the acquiring company did not earn back its cost of capital, 50% of transactions result in same or lower profits and of 150 deals between 2000 and 2003 about half destroyed the shareholders’ wealth (Business week research) Historically, M&A deals have resulted in shareholders’ value erosion due to inefficient planning and integration and inattention to the supply chain. When organizations focus on supply chain, it creates a significant source of value because of the role it plays in managing cost and fulfilling customer needs. In an independent study4 it has been observed that there is a correlation between supply chain performance and financial performance (see the Graph4). In all the successful mergers, be it BenQ’s acquisition of Siemens, HP’s merger with Compaq or Cadbury Schweppes’ acquisition of Adams, supply chain accounted for around 30-50% of the synergy savings2.

1 How Supply Chains Drive M&A Success-Harvard Business Review (2005) 2 IBM Internal Researches 3 Supply Chain Integration Keys to Merger Success- Supply Chain Management Review (2003) 4 Supply Chain Management Review

How to make right deal: Pre merger due diligence dive
Five most critical success factors1 for a successful M&A deal, that need to be evaluated at due diligence stage are: 1. Supply chain fit to the organization strategy.

2. 3. 4. 5.

Realistic valuation Opportunity cost of process and IT integration Change in trading relationship. Human Resource Management

1. Supply chain fit to the organization strategy
This is perhaps the most critical success factor of all. Firms have not historically made decisions about mergers on the basis of the supply chain’s ability to integrate new operations. Dissimilar processes, supply bases and distribution networks are combined when there is no synergy. In order to find if there is any fit of targeted Company’s supply chain to the organization strategy following factors can be considered. • Supply Chain Network Fit: Parameters to judge this include cost per shipment for both inbound and out bound logistics, quality which can be measured in terms of returns from customers, delivery in terms of fill rate and perfect order performance from the supplier and to the retailers, flexibility and response. If synergies between two merging supply chains exist then that must reflect on some or all of these parameters. Therefore from due diligence perspective the value of these parameters for both the organization should be captured and then expected value after merger should be estimated and compared with pre merger values and may be with industry benchmark/average (if possible).

Product/Service Line Fit: Product/service line of the target company fits to organization strategy in various ways. The product/service line of potential target can help in reducing costs relative to competitors; it can help in acquiring necessary capability or may be in building new business all together. In case of fragmented industry, acquisition of companies which are in same business in terms of product and services results in huge saving in cost base. For example pharmaceutical industry in US until early 1990s remained relatively fragmented with no company responsible for more than 5 percent of sales. Then this industry witnessed a decade of aggressive mergers and acquisition. Acquirers have been able to cut their combined cost in administration, sales and R&D by 8% on average and up to 18% in individual cases. Pfizer being the most popular for such strategies generate an average annual shareholder’s return of 19.5% outperforming the S&P 500 by more than 9 percentage point. With the acquisition of Warner-Lambert in 2000 and Pharmacia in 2003, Pfizer transformed into a nearly $40 billion company, the largest in the industry2.

Similar to Pfizer, Cisco has also gone through series of acquisitions since mid 1980s till early 2000s. But unlike Pfizer the objective of Cisco was not cost reduction. Cisco went for the companies which were in same service line i.e. data networking business to fill the gaps in capability rather than waiting to develop those. Due to its 82 acquisition in that period Cisco kept its dominant position in data networking business2. 1 IBM internal researches and Supply Chain Management Review 2”Growing Through Acquisition” The BCG Report -2004 But it is not true that synergies can only exist when the target company has similar product/service line. Consider the case of Newell, a small curtain rod manufacturer in US since 1902. It was a small company till early 1970s with less than $100 million in revenues when it realized the growing dominance of large retailers like Kmart and Wal-Mart. The company executive identified that these big retailers are selling

merchandise supplied by thousands of small manufacturer and managing logistics for these many suppliers was big headache for such retailers. So Newell set out to become one-stop shop for mega-retailers. Over the next 25 years, Newell made some 100 acquisitions of supplier of various products like hardware and household product. This led the company to dramatically improve the operations by exploiting the economies of scale in logistics and sales force, increasing the product development and introducing the common system and infrastructure. The result was an integrated low cost vendor that grew to $ 2 billion revenue in mid 1990s1. In all of the above cases the critical thing was to identify the product or service of the target company that will fit to acquiring organization’s long term strategy.

Service Requirement: last two decades have seen remarkable improvement in service levels across all industries and across all geography. Once post sell service used to be a differentiating factor. But as Philip Kotler 2 said once an augmented product becomes expected product next time. This is perfectly true for customer service. Therefore it is customary to evaluate the service requirement of targeted company, access existing post sell service capability of both the companies and to look at industry benchmark. Take the earlier example of Newell, Newell success model depends on acquiring companies reasonably well managed, in good standing with big discount retailers and not so large that Newell couldn’t easily intervene to get desired performance. But in 1999 Newell purchased Rubbermaid, Newell’s largest acquisition ever. But Rubbermaid was slow to recognize the power shift towards large discount retailers and had alienated them by not being responsive to their needs and lacking in the service standard. Newel’s revenue and share price suffered as result. Newell’s shareholder returns lagged the S&P 500 by 2.9%1.

2. Realistic Valuation
Valuation is integral part of any M&A deal. But in most of the cases valuation are only based on financial ratios and future earning and cash flows. Globally, finance experts and M&A architects put stress on top down approach of valuation but in practice it is seldomly followed. Macro level indicator like maturity profile, industry benchmark etc are sometimes ignored because of excellent projection of future cash flow. Point to be noted here is that future cash flow or earnings are based on past performance and an assumed and agreed upon growth rate. Won’t it be more robust projection if organizations focus more on specific projects and opportunities rather than a cumulative growth rate of target organization as a whole?

1”Growing Through Acquisition” The BCG Report -2004 2 Marketing Management (12th edition) by Philip Kotler (author), Prentice Hall publication Moreover, organizations emphasize to achieve synergies in terms of financial terms, like synergies in working capital or operating expenses etc. But looking closely one can easily discover that these synergies are not possible to achieve without achieving synergies in more fundamental supply chain parameters. For example Inventory turns, Inventory days of supply, days of sales outstanding, lead time, average payment period etc has direct impact on working

capital. If organizations are looking to achieve synergies after merger they should look to improve these parameters and resulting financial parameters automatically will improve. Another thing that needs to be taken care during valuation is cost of inaction1. Cost of inaction means where and how is a competing bidder likely to attack if it acquires the target company? What market would the combined footprint of the two companies put at risk? What product launches might this new competitor preempt with strengthened R&D? How would new cost position pressure price? Answering such questions can help a company to anticipate and minimize future damage. It also reveals the true value of acquiring the target.

3. Opportunity Cost of Process and IT integration
An acquirer needs to take an all-encompassing view of the value that might be created or lost in a prospective transaction. For example resource diversion; in theory, any project with a positive net present value justifies incremental investment. In practice, however, time and resource are constrained, and acquisitions rob other initiatives. For this reason, it is important to review not only the number of projects that will be eliminated, delayed or discounted but also the time frame in which processes will be stabilized. Thinking on the same line the total opportunity cost can be breakdown further into three parts; (1) opportunity cost of organizational and functional stabilization, (2) opportunity cost of supply side stabilization and (3) opportunity cost of distribution side stabilization. One of the best metrics to capture opportunity cost of organizational and functional stabilization is percent of day one (after merger) requirement successfully met on time. Similarly, opportunity cost of supply side stabilizations can be measured in terms of expected loss of days to achieve projected/expected purchase order cycle time. Whereas opportunity cost of distribution side stabilization can be measured in terms of expected loss of days to achieve projected/expected on time delivery rate and projected/expected fill rate.

4. Change in Trading Relationships
Change in trading relationships is inevitable in any M&A process. Some of the expected synergies may not be realized if this change is not handled well. An organization should be ready beforehand for the nature and magnitude of these changes. It should have a clear picture of its new sourcing strategy, vendor life cycle management, distribution strategy, 3PL provider management after the merger. It is recommended that an organization should make a list of contracts that has to amended, re-priced, re-negotiated or to be terminated. This will give the clear indication about the impact on inbound and outbound logistics cost, procurement cost etc after the merger.

1”Growing Through Acquisition” The BCG Report -2004

5. Human Resource Management
Last but certainly not the least, it is very important to analyze the organization structure, approval hierarchy and procurement control of both the merging organization. But from due diligence perspective this analysis will provide an insight about other parameters like how the trading relationships will change and opportunity cost of integration. Some industry experts 1

also advocate establishing an M&A leadership team to guide and supervise this transition from two entities into one. The logical question that follows this discussion is that if SCM plays such a big role in an M&A deal than why traditionally it has not been a part of due diligence exercise? This may be due to the fact that due diligence for M&A is always done only or primarily by financial experts. Another reason for ignoring SCM in due diligence could be unavailability of relevant data for this kind of analysis. In many organizations there is no system in place to capture the day to day operations/transaction data, without which this assessment can not be completed. Finally, to conclude this article lets reinstate the conventional belief that due diligence is critical to screen potential M&A target. But it should not be looked as mere financial assessment but a detailed investigation that tests the viability of proposed merger or acquisition. The critical factors that should be considered in this include Supply chain fit to the organization strategy, Realistic valuation, Opportunity cost of process and IT integration, Change in trading relationship and Human Resource Management. All these aspects have been identified as important in previous researches also.

1 How Supply Chains Drive M&A Success-Harvard Business Review (2005)