Mergers and

Acquisitions
Simplified
A Snapshot

In this edition of Fin Discussion, Monetrix brings to

you the very basics of an M&A deal, which is going
to help all the budding investment bankers to get a
basic understanding of M&As.

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Basics of Merger and Acquisitions

When we use the term "merger", we are referring to the merging of two
companies where one new company will continue to exist. The term "acquisition"
refers to the acquisition of assets by one company from another company. In an
acquisition, both companies may continue to exist.
The acquiring company will remain in business and the acquired company
(which we will sometimes call the Target Company) will be integrated into the
acquiring company and thus, the acquired company ceases to exist after the
merger.

Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services.
Horizontal mergers are often used as a way for a company to increase its market
share by merging with a competing company. For example, the merger between
Exxon and Mobil will allow both companies a larger share of the oil and gas
market.
Vertical: Two firms are merged along the value-chain, such as a
manufacturer merging with a supplier. Vertical mergers are often used as a way to
gain a competitive advantage within the marketplace. For example, Merck, a large
manufacturer of pharmaceuticals, merged with Medco, a large distributor of
pharmaceuticals, in order to gain an advantage in distributing its products.
Conglomerate: Two firms in completely different industries merge, such as
a gas pipeline company merging with a high technology company. Conglomerates
are usually used as a way to smooth out wide fluctuations in earnings and provide
more consistency in long-term growth. Typically, companies in mature industries
with poor prospects for growth will seek to diversify their businesses through
mergers and acquisitions. For example, General Electric (GE) has diversified its

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businesses through mergers and acquisitions, allowing GE to get into new areas
like financial services and television broadcasting.

Reasons for M&A

Every merger has its own unique reasons why the combining of two
companies is a good business decision. The underlying principle behind mergers
and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of Company A is $ 2
billion and the value of Company B is $ 2 billion, but when we merge the two
companies together, we have a total value of $ 5 billion. The joining or merging of
the two companies creates additional value which we call "synergy" value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher
revenues then if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower
expenses then if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a
lower overall cost of capital.
For the most part, the biggest source of synergy value is lower expenses.
Many mergers are driven by the need to cut costs. Cost savings often come from
the elimination of redundant services, such as Human Resources, Accounting,
Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include:

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Positioning - Taking advantage of future opportunities that can be

exploited when the two companies are combined. For example, a
telecommunications company might improve its position for the future if it were to
own a broad band service company. Companies need to position themselves to
take advantage of emerging trends in the marketplace.
Gap Filling - One company may have a major weakness (such as poor
distribution) whereas the other company has some significant strength. By
combining the two companies, each company fills-in strategic gaps that are
essential for long-term survival.
Organizational Competencies - Acquiring human resources and
intellectual capital can help improve innovative thinking and development within
the company.
Broader Market Access - Acquiring a foreign company can give a
company quick access to emerging global markets.
Mergers can also be driven by basic business reasons, such as:
Bargain Purchase - It may be cheaper to acquire another company then to
invest internally. For example, suppose a company is considering expansion of
fabrication facilities. Another company has very similar facilities that are idle. It
may be cheaper to just acquire the company with the unused facilities then to go
out and build new facilities on your own.
Diversification - It may be necessary to smooth-out earnings and achieve
more consistent long-term growth and profitability. This is particularly true for
companies in very mature industries where future growth is unlikely. It should be
noted that traditional financial management does not always support
diversification through mergers and acquisitions. It is widely held that investors

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are in the best position to diversify, not the management of companies since
managing a steel company is not the same as running a software company.
Short Term Growth - Management may be under pressure to turnaround
sluggish growth and profitability. Consequently, a merger and acquisition is made
to boost poor performance.
Undervalued Target - The Target Company may be undervalued and
thus, it represents a good investment. Some mergers are executed for "financial"
reasons and not strategic reasons. For example, Kohlberg Kravis & Roberts acquires
poor performing companies and replaces the management team in hopes of
increasing depressed values.

A Reality Check
As mentioned earlier, mergers and acquisitions are extremely difficult.
Expected synergy values may not be realized and therefore, the merger is
considered a failure. Some of the reasons behind failed mergers are:
Poor strategic fit - The two companies have strategies and objectives that
are too different and they conflict with one another.
Cultural and Social Differences - It has been said that most problems
can be traced to "people problems." If the two companies have wide differences in
cultures, then synergy values can be very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the
"watchdog" within the M & A Process. If you fail to let the watchdog do his job,
you are in for some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires
a very high level of quality management. In the words of one CEO, "give me some

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people who know the drill." Integration is often poorly managed with little
planning and design. As a result, implementation fails.
Paying too Much - In today's merger frenzy world, it is not unusual for the
acquiring company to pay a premium for the Target Company. Premiums are paid
based on expectations of synergies. However, if synergies are not realized, then the
premium paid to acquire the target is never recouped.
Overly Optimistic - If the acquiring company is too optimistic in its
projections about the Target Company, then bad decisions will be made within the
M & A Process. An overly optimistic forecast or conclusion about a critical issue
can lead to a failed merger. The above list is by no means complete. As we learn
more about the M & A Process, we will discover that the M & A Process can be
riddled with all kinds of problems, ranging from organizational resistance to loss of
customers and key personnel.

VARIOUS METHODS FOR TARGET COMPANY

VALUATION

DISCOUNTED CASH FLOW ANALYSIS

Free cash flow (FCF) is the relevant measure in the context of a target
company valuation because it represents the actual cash that would be available to
the companys investors after making all investments necessary to maintain the
company as an ongoing enterprise. There are two stages over which to evaluate a
company. In the first stage companys FCF is calculated over an appropriate time
horizon for each year. In the second stage a terminal value is calculated as the end
value of first stage. The FCF and terminal value are discounted using an
appropriate discount rate to incorporate the business risk and operating
environment of the target firm. When evaluating the target from a non-control

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perspective, we would use the targets WACC or else the acquirers WACC. The
FCF are adjusted based on proposed synergies between the firms.

The terminal value can be calculated using any of the below methods:
1.

g is the long-term equilibrium growth rate that the company can expect to
achieve in perpetuity, accounting for both inflation and real growth.
2.

Multiply the terminal year FCF with a multiple reflecting the expected

risk, growth, and economic conditions in the terminal year. The multiple depends
on the type of industry as well.

ADVANTAGE OF USING DISCOUNTED CASH FLOW ANALYSIS

Expected changes in the target companys cash flows from operating

synergies and cost structure changes) can be easily incorporated.

DISADVANTAGES OF USING DISCOUNTED CASH FLOW ANALYSIS

1.

A rapidly expanding company may be profitable but have negative

free cash flows because of heavy capital expenditures to the horizon that can be
forecast with confidence.
2.

There is a great deal of uncertainty in Estimating cash flows and

earnings far into the future.

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3.

Estimates of discount rates can change over time because of capital

market developments or changes that specifically affect the companies in question.

4.

The estimate of terminal value can differ depending on the specific

technique used.

COMPARABLE COMPANY ANALYSIS

In this method a set of companies that are similar to the target company are
identified. This set can include companies within the targets primary industry as
well as companies in similar industries having similar size and capital structure.
After this various relative value measures based on the current market prices of the
comparable companies in the sample are calculated. The multiples can include
enterprise value to free cash flow, enterprise value to EBITDA, enterprise value to
EBIT, enterprise value to sales, price to cash flow per share (P/CF), price to sales
per share (P/S), price to earnings per share (P/E), and price to book value per
share (P/BV). Each metric (P/E, P/CF, etc.) is likely to produce a different estimate
for the targets value.
In order to calculate an acquisition value, a takeover premium is also
estimated. The takeover premium is the amount by which the takeover price for
each share of stock must exceed the current stock price in order to entice
shareholders to relinquish control of the company to an acquirer.

ADVANTAGES OF USING COMPARABLE COMPANY ANALYSIS

1.

It provides a reasonable approximation of a target companys value

relative to similar companies in the market.

2.

The estimates of value are derived directly from the market. Hence it is

not based on many assumptions and estimates.

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DISADVANTAGES OF USING COMPARABLE COMPANY ANALYSIS

1.

The method is sensitive to market mispricing.

2.

In order to estimate a fair takeover price, analysts must additionally

estimate a fair takeover premium and use that information to adjust the estimated
stock price.
3.

The data available for past premiums may not be timely or accurate

for the particular target company under consideration.

COMPARABLE TRANSACTION ANALYSIS

This approach uses details from recent takeover transactions for comparable
companies to make direct estimates of the target companys takeover value. In this
approach we compare the multiples like P/E, P/CF, other industry-specific
multiples actually paid for similar companies in other M&A deals.

ADVANTAGES OF COMPARABLE TRANSACTION APPROACH

1.

It is not necessary to separately estimate a takeover premium. The

takeover premium is derived directly from the comparable transactions.

2.

The use of prices established through other recent transactions reduces

litigation risk for both companies board of directors and managers regarding the
merger transactions pricing.

DISADVANTAGES OF COMPARABLE TRANSACTION APPROACH

1.

There is a risk that the real takeover values in past transactions were

not accurate. If true, these inaccurate takeover values are imputed in the estimates
based on them.

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2.

There may not an adequate number of, comparable transactions to use

for calculating the takeover value.

3.

It is difficult to incorporate any specific plans for the target (e.g.,

changing capital structure or eliminating duplicate resources) in the valuation.

BID VALUATION

The post-merger value of the combined company is a function of the premerger values of the two companies, the synergies created by the merger, and any
cash paid to the target shareholders as part of the transaction.
Confidence in synergy estimates will have implications not only for the bid
price but also for the method of payment. The different methods of payment for the
merger cash offer, stock offer, or mixed offerinherently provide varying degrees
of risk shifting with respect to misestimating the value of merger synergies.

Due Diligence
There is a common thread that runs throughout much of the M & A Process. It
is called Due Diligence. Due diligence is a very detail and extensive evaluation of
the proposed merger. An over-riding question is - Will this merger work? In order
to answer this question, we must determine what kind of "fit" exists between the
two companies. This includes:
Investment Fit - What financial resources will be required, what level of
risk fits with the new organization, etc.?
Strategic Fit - What management strengths are brought together through
this M & A? Both sides must bring something unique to the table to create
synergies.

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 Marketing Fit - How will products and services complement one another
between the two companies? How well do various components of marketing fit
together - promotion programs, brand names, distribution channels, customer mix,
etc.?
Operating Fit - How well do the different business units and production
facilities fit together? How do operating elements fit together - labour force,
technologies, production capacities, etc.?
Management Fit - What expertise and talents do both companies bring to
the merger? How well do these elements fit together - leadership styles, strategic
thinking, ability to change, etc.?
Financial Fit - How well do financial elements fit together - sales,
profitability, return on capital, cash flow, etc.?
Due diligence is also very broad and deep, extending well beyond the
functional areas (finance, production, human resources, etc.). This is extremely
important since due diligence must expose all of the major risk associated with the
proposed merger. Some of the risk areas that need to be investigated are:
Market - How large is the target's market? Is it growing? What are the
major threats? Can we improve it through a merger?
Customer - Who are the customers? Does our business compliment the
target's customers? Can we furnish these customers new services or products?
Competition - Who competes with the target company? What are the
barriers to competition? How will a merger change the competitive environment?
Legal - What legal issues can we expect due to an M & A? What liabilities,
lawsuits, and other claims are outstanding against the Target Company?

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Another reason why due diligence must be broad and deep is because
management is relying on the creation of synergy values. Much of Phase I Due
Diligence is focused on trying to identify and confirm the existence of synergies
between the two companies. Management must know if their expectation over
synergies is real or false and about how much synergy can we expect? 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. In some
cases, the merger may be called off because due diligence has uncovered
substantially less synergies then what management expected.

Reverse Mergers
Reverse mergers are a very popular way for small start-up companies to "go
public" without all the trouble and expense of an Initial Public Offering (IPO).
Reverse mergers, as the name implies, work in reverse whereby a small private
company acquires a publicly listed company (commonly called the Shell) in order
to quickly gain access to equity markets for raising capital. This approach to
capitalization (reverse merger) is common practice with internet companies like
stamps.com, photoloft.com, etc. For example, ichargeit, an e-commerce company
did a reverse merger with Para-Link, a publicly listed distributor of diet products.
According to Jesse Cohen, CEO of ichargeit, an IPO would have cost us $ 3 - 5
million and taken over one year. Instead, we acquired a public company for $
300,000 and issued stock to raise capital. The problem with reverse mergers is that
the Shell Company sells at a serious discount for a reason; it is riddled with
liabilities, lawsuits, and other problems. Consequently, very intense due diligence
is required to "clean the shell" before the reverse merger can take place. This may
take six months. Another problem with the Shell Company is ownership. Cheap
penny stocks are sometimes pushed by promoters who hold the stock in "street
name" which mask's the true identity of owners. Once the reverse merger takes
place, the promoters dump the stock sending the price into a nose-dive. Therefore,
it is absolutely critical to confirm the true owners (shareholders) of shell companies
involved in reverse mergers.
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ROYAL DUTCH SHELL AND BRITISH GAS

A mammoth synergy between the Anglo Dutch Royal Dutch Shell and the
British giant British Gas underwent in early April this year. It was seen as an out of
time deal due to the reeling oil prices which were down more than 50% from the
highs during the time of the deal. The financials of the deal skew it heavily towards
the British Gas, but RDS PLC is eyeing at the increase in Free Cash Flows and
greater market share it would receive in the Natural Gas industry and more so at a
premium of over 50%. Experts also believe that Shell is targeting greater access to
the Brazilian oil reserves, which has made it desparate to make such an offer to BG.
The changing dynamics in the oil industry is expected to create a few other
big names merge together for better access to the reserves all across the world. In
recent news, Shell has received approvals from all the major anti-trust agencies and
the merger is set to sail through.
Under the terms of the Combination, BG Shareholders will be entitled to
receive:
For each BG Share:
383 pence in cash and0.4454 Shell B Shares
Based on the 90 trading day volume weighted average price of 2,170.3 pence
per Shell B
Share on 7 April 2015 (being the last Business Day before the date of this
Announcement),
The terms of the Combination represent:
a value of approximately 1,350 pence per BG Share; and
a premium of approximately 52% to the 90 trading day volume weighted
average price of 890.4 pence per BG Share on 7 April 2015.

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Based on the Closing Price of 2,208.5 pence per Shell B Share on 7 April 2015
(being the last Business Day before the date of this Announcement), the terms of
the Combination represent:
a value of approximately 1,367 pence per BG Share
a premium of approximately 50% to the Closing Price of 910.4 pence per BG
Share on 7 April 2015
a value of approximately 47.0 billion for BGs entire issued and to be issued
share
capital

SABMILLER AND ABINBEV

A $104.2 billion combination of the worlds two biggest brewers, AnheuserBusch InBev NV and SABMiller PLC, would redraw the map of the global beer
industry and is likely to trigger higher beer prices for CONSUMERS around the
world. SABMiller's African brands are actually one of the main reasons AB InBev is
so thirsty for this merger. SABMiller, of course, has its roots in Africa - South
African Breweries was founded around the time of gold rush in Johannesburg in
the late 19th Century. As it stands, and if this deal goes through, it would mean
that the merged entity would control 31% of global beer sales.
The global beer industry is poised for a new generation all together. After 4
failed attempts, a final successful bid by AB InBev has left the competition thinking
about the strategy in Africa and India especially. The emerging markets have
always known to be the biggest markets of SABMIller, AbinBev is in all the modd
to encash this opportunity. The global giant is willing to pay a premium of more
than 50%.

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For each SABMiller Share: 44.00 in cash (the Cash Consideration)

The Cash Consideration represents:
a premium of approximately 50% to SABMillers closing share price of
29.34 on 14 September 2015 (being the last Business Day prior to renewed
speculation of an approach from AB InBev)
a premium of approximately 36% to SABMillers three month volume
weighted average share price of 32.31 to 14 September 2015

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