The Urge To Merge
There are myriad reasons why companies acquire other companies. After over 20 years of doing M&A deals, I think I’ve heard them all. Despite significant research that suggests the average acquisition fails to deliver the expected returns, decision makers large and small aren’t letting up on the M&A throttle.
While the underlying motive of deals usually is generalized as “growth”, oftentimes, the strategy behind an acquisition is complex and multifaceted. The motivations may be different for public corporations versus privately-held or private-equity funded companies. Many deals are rationalized in several ways. Let’s examine some of the primary reasons companies succumb to “merger mania”:
- Synergy: If you’re an M&A junkie like me, you will have heard this motivation more than any other. Simply put, synergy is described by the nonsensical mathematical equation: 1 + 1 > 2. Synergies may be found by “cross-selling” (e.g., leveraging a marketing team to sell related or complimentary products or services) or via “economies of scale” (e.g., fully utilizing an asset, such as finding additional customers/sales to run factories more hours in a day, or combing two companies in the same industry and reducing redundant overhead costs). Disciplined acquirers know that projected synergies should always be quantified and captured in their valuation models. Decision makers should be concerned when the main cheerleader for an acquisition describes the synergies in qualitative, nebulous terms. If you can’t put numbers to them, don’t use them to justify a deal!
- “U-PICK-IT”: While synergies may be the most referenced reason deals are justified in press releases and earnings calls, the true motivation behind the plurality of deals by publicly-traded companies is the next quarter. The prices of publicly-traded shares, and the careers of the CEOs of the companies that issued such stock, are highly dependent upon their next quarter’s “numbers” – did they deliver the same percentage increase in earnings as they did for the previous quarter? When companies are small, it’s easy to deliver remarkable growth. Taking a HD repairer from $2 Million in Sales to $3 Million is much easier than growing a paint company such as Axalta from $4 Billion to $6 Billion – yet both would be 50% increases. As companies grow, it gets harder for them to deliver consistent earnings trends. Yet, Wall Street rewards certainty and consistency. As a result, public-company CEOs will use acquisitions to find the earnings growth they need to keep their stock prices moving in the desired northeasterly direction. These CEOs will mention all sorts of motivations to justify these deals and mask their true intentions; so, you get to pick the strategy the next time you read of a public company pursuing an acquisition that doesn’t seem rational.
- Diversification: The objective of diversification is to lower risk. Portfolio theory teaches us that a basket (a.k.a. portfolio) of multiple equities usually is less risky than holding just one company’s stock. [Note to Self: Ensure my 401(k) has a balanced, diversified selection of assets.] Similarly, companies large and small are less risky when they are diversified. This could come through having multiple locations or multiple service/product offerings or minimal customer concentration. Acquisitions are used to diversify regularly.
- D-Fence!: While often not cited publicly for fear of anti-trust laws, many deals are defensive. Defensive deals usually are meant to keep a competitor out of a market or away from a new opportunity. Occasionally, CEOs that get into bidding wars to keep competitors from winning deals find that they may win the battle but lose the war. If you find yourself considering a defensive deal, be sure you stay honest to your targeted returns and maintain deal discipline. It’s easy to overpay when fear influences strategy.
- D-Fence v2.0: Another form of defensive deals is when a company buys a competitor. While it’s challenging to think of many reasons to not acquire a competitor, it is easy to see how the buyer could overpay by believing that if a competitor is taken out, that buyer will have better pricing power. The Hart-Scott-Rodino Antitrust Improvements Act of 1976 is one arrow in the government’s quiver to ensure companies don’t get too much pricing power.
- Speed to Market: Deals occasionally are the result of a corporate initiative to pursue a new product, service or process, and management determines that it’s faster to acquire it versus taking the time to develop it internally. Multiple shop operators face this choice regularly when they want to expand their operations to a new zip code. Greenfielding/brownfielding may result a lower overall investment because they’re not having to pay for goodwill (a.k.a. blue sky – a topic we’ll visit in detail in a future article), but the time it takes to get to profitability can wipe out the savings.
- Taxes: This shouldn’t be surprising. Business of all sizes make decisions daily in part due to their tax consequences. The deal world is no different. It may be to capture some tax credits or to relocate a business to a different, more tax-efficient jurisdiction. Having been involved in numerous cross-border deals during my career, I can attest to the impact taxes have on the decision-making process when a US-based company buys another in a foreign country.
- Excess Cash: As corporations evolve from start-up to cash cows, they tend to reach the stage of generating more cash than is necessary to maintain the status quo. Obviously, shareholders like this stage because they hope to receive dividends; CFOs may advocate using the extra cash to buy their own company’s shares, or to invest in new equipment. While the question of how to deploy excess cash can lead to big battles in the boardroom and premature retirements, all stakeholders agree that the excess cash shouldn’t be simply sitting in a bank account earning next to nothing. Having excess cash on the balance sheet has led to many deals that strategically may have been underdeveloped. A parallel to this reasoning is the low interest rate environment. When corporations can buy a company that cash flows 15%, using money that only costs 3%, it’s easy to see how a lot over the past decade have been justified.
- Black Friday Prices: This of course is a reference to the day after Thanksgiving, which traditionally was the cheapest day of the year to shop – everything was on sale! The internet has disrupted this, but the principle still applies. The collective “we”, whether we’re individuals or corporations, tend to buy things when we perceive a good bargain. Put simply, some deals happen simply because the buyer believes the target company is undervalued. Buy low. Sell high.
- New Markets: Deals of this nature tend to be made by companies acquiring peers or large players seeking accelerated growth, such as when an East Coast-based operator of mechanical service shops acquires a West Coast operator of mechanical service shops.
“Consolidators” constantly need to enter new markets in order to maintain their growth trajectories. Consolidators are companies seeking a plurality or majority market share in an industry – think: CVS & Walgreens; Staples & Office Depot; Lowes & Home Depot.
- New Customers: As discussed above, a company looking to diversify its customer base may seek to acquire a peer (or a competitor) in its existing market that has different customers (such as a retail repair chain that wants to add fleet accounts so it’s not too dependent upon its advertising success). Similarly, companies will acquire others with a different customer base with the hope that the buyer can subsequently offer its other services or products to the new-acquired customer base.
- New Employees: Service-based companies and corporations with valuations weighted heavily on their intangible assets often credit their workforces for their value creation. Thus, deals often are motivated by the opportunity to get access to industry “thought leaders”, high quality / well-trained workers and/or those employees who maintain strong relationships with their employers’ customers. When the target is a very small consulting firm, the deal often is referred to as an “acqui-hire”.
- Old Employees: Huh?!? That doesn’t make any sense. Well, not so fast… Not chronologically old, but the current employees of the buyer. Many business owners will acquire peers or competitors with the hope that the larger organization will yield better or more opportunities for their existing employees. Growing companies add layers of management and expand corporate functions – these are opportunities that retain good employees. Employees get to grow professionally as the business grows.
- New Products / Services: Companies such as Bloomin’ Brands have acquired multiple restaurant chains (e.g., Outback Steakhouse and Carrabba’s Italian Grill). Despite having numerous locations located next to each other, it works because they know their customers occasionally will want lasagna instead of a steak. Similarly, a dealership knows that its customers occasionally will need collision work, or PDR, or a new windshield, etc. Companies will acquire others to get access to a unique service or patented product. Clearly, they believe it’s easier to buy than to reverse engineer and build; a less obvious consideration is that in certain circumstances, acquisition costs go straight to the balance sheet, which means the all-important earning per share measurement is unaffected (unlike the costs of building a new division that reduce profits / EPS).
- “Multiple Arbitrage”: I’ve intentionally saved the most interesting for last. This term seems both technical and sophisticated. In reality, the motivation is easily understood, albeit difficult to implement, and is the reason behind a lot of the deals happening throughout the automotive aftermarket. Throughout the economy, regardless of industry, there tends to be a “size premium” – an increase in relative valuation that larger companies enjoy over smaller companies. In other words, with all other things being equal, each dollar of sales usually is worth more if it is earned by a large corporation than if it’s earned by a small business. This is true for both publicly held and private companies, and is due to the notion that larger companies tend to be less risky and more likely to continue to grow than small companies. [NOTE: I have not found credible research to support the widely-held belief that 90% of small companies fail. However, there is limited academic research that shows the failure rate for small businesses exceeds that of larger businesses.] Portfolio theory can explain this belief best: if I hold in my 401(k) shares in 10 different businesses, I have a lower chance of losing all of my money than had I invested the same money into only one business. Similarly, if I own and operate 10 tire installation shops that collectively generate $10 Million of sales, those sales are less likely to all disappear than if I owned one tire installation shop that has $10 Million of sales.
Thus, Multiple Arbitrage has led to hundreds of deals in the automotive industry over the years as companies borrow money to acquire other companies in the same industry at relatively lower valuations. These acquired companies are then integrated into the buyer and eventually the shareholders of this large, acquisitive company sell it. A common term used to describe this investment strategy is Buy & Build: buy multiple companies at 3x-7x EBITDA, build a corporate infrastructure and meld the companies together, and then sell the amalgamation for 12x-15x EBITDA. If they are able to use borrowed money to fund the acquisitions, then the return on their invested capital is significantly enhanced. This is a page out of many private equity playbooks.
Comments / questions / criticisms? Are you contemplating a deal that might fit into one of these categories and you want to ensure you’re making a sound decision? Feel free to e-mail me: firstname.lastname@example.org. Our next article will examine the buying process from the seller’s perspective, along with breaking down the stages of a deal. Until then, happy dealing!