Mergers and Acquisitions

Learning Objectives

• Types of mergers and trends in merger activity will be covered
• Stock price reactions to takeover announcements will be discussed
• Reasons to acquire another company will be evaluated
• Major steps in the takeover process will be followed
• Main takeover defenses will be the subject of discussion
• Understanding factors that determine who gets the value-added in a merger will be addressed

Background and Historical Trends

• The market for corporate control includes the "acquirer" who is also known as the "bidder" and the "target" that is being acquired
• Acquisition and merger are two primary mechanisms in the market for corporate control
• Merger waves entail peaks of heavy takeover activity followed by troughs of few transactions
• Merger activity is greater during economic expansions than contractions, and correlates with bull markets
• Mergers tend to occur in distinct waves, with the recent waves occurring in the 1980s, 1990s, and 2000s

Types of Mergers

• Horizontal mergers involve a target and acquirer in the same industry
• Vertical mergers are when the target's industry buys or sells to the acquirer's industry
• Conglomerate mergers occur when the target and bidder are in different industries
• Stock swap is where target shareholders swap their old stock for new stock
• Cash merger or acquisition payment plans can be complex and utilize a combination of forms of payment

Market Reaction to Takeover

• Acquisition premium is the excess amount paid over the pre-merger price
• Premium paid over pre-merger price averages 43%
• Announcement price reaction for the target company averages 15%
• Announcement price reaction for the acquirer averages 1%
• There are several questions that arise regarding the market reaction to takeovers
• Why do acquirers pay a premium?
• Why does the price of the target rise by less than the premium?
• If the merger is a good idea, why does the acquirer’s price not have a large increase?

Reasons to Acquire

• Synergies can enable the acquirer to add economic value as a result of the acquisition
• Economies of scale entail savings from producing goods in high volume
• Economies of scope entail savings from combining the marketing and distribution of related products
• Vertical integration involves the merger of two companies in the same industry that make products required at different stages of the production cycle and improves coordination
• Expertise acquirement can lead to purchasing a company for its talent pool that is already a functioning unit
• Monopoly gains are achieved through antitrust laws
• Efficiency gains include the elimination of duplication and improvement in poor management
• Tax savings from operating losses cannot be written off. unless there is a profit elsewhere as losses in one division can be offset by profits in another division.
• Combining companies can yield higher earnings per share than premerger, even without economic value creation
• Acquiring a low-growth potential company can raise earnings per share but lowers the overall growth rate

Taxes for a Merged Corporation Example

• Yin Corporation and Yang Corporation either make $50 million or lose $20 million every year with equal probability
• Firms' profits are perfectly negatively correlated: when Yang earns $50 million, Yin loses $20 million, and vice versa
• The corporate tax rate is 34%
• To calculate after-tax profits in profitable and unprofitable states, multiply profits by (1 - tax rate)
• Compute expected after-tax profits as the weighted average of after-tax profits in profitable and unprofitable states
• Combined profits would always be $30 million ($50 million - $20 million), so after-tax profit is always $30 million * (1 - tax rate)
• With Yin Corporation, after-tax profits are $50m * (1 - 0.34)= $33m in profitable state, -$20m in unprofitable state
• Ying Corporation's expected after-tax profits are 33(0.5) + (-20)(0.5) = $6.5 million
• Considering Yang Corporation has identical expected profits, its are also $6.5 million
• Total expected profit of both companies operated separately is $13 million
• The merged corporation, Yin-Yang Corporation, would have after-tax profits of $30 million * (1 - 0.34) = $19.8 million
• Yin-Yang Corporation has significantly higher after-tax profits than the total stand-alone after-tax profits of Yin Corporation and Yang Corporation because the losses on one division reduce the taxes on the other division’s profits

Mergers and Earning Per Share Example

• OldWorld Enterprises is a mature company with few growth opportunities, 1 million shares outstanding priced at $60 pre-merger, with earnings of $5 per share
• NewWorld Corporation is a young company with lucrative growth opportunities, 1 million shares outstanding, its stock price is $100 per share pre-merger
• NewWorld acquires OldWorld using its own stock, and the takeover adds no value
• The post-takeover value of NewWorld is 100 * 1 million + 60 * 1 million = $160 million
• NewWorld must pay $60 million to acquire OldWorld
• $60 million is the amount NewWorld must issue shares to pay OldWorld shareholders
• The amount of NewWorld shares issued to OldWorld shares will give us the exchange ratio
• Total earnings divided by new total number of shares provides the earnings per share
• Deal requires issuing 600,000 shares to pre-takeover stock price of $100 per share, calculated as $60 million/$100
• OldWorld's shareholders exchange 1 million shares for 600,000 NewWorld shares
• The exchange ratio is the 600,000 issued shares / 1 million exchanged shares = 0.6
• Each OldWorld shareholder will get 0.6 shares in NewWorld for each share in OldWorld
• New World is valued at $160 million and there are 1.6 million shares outstanding, giving the stock a price of $100 per share
• Prior to the takeover, both companies earned $5/$1 million= $5 million
• The combined corporation thus earns $10 million, with 1.6 million shares outstanding, so NewWorld’s post-takeover earnings per share is $10 million / 1.6 million = $6.25/share
• NewWorld has raised its earnings per share by $1.25 by taking over OldWorld, and the combined is simply a portfolio of New World and OldWorld
• Although the portfolio has higher total earnings per share, it drops since it has combined the low-growth OldWorld with the high-growth NewWorld
• The higher current earnings per share comes at the cost of lower earnings per share growth

Mergers and the Price-Earnings Ratio

• The price-earnings ratio is price per share divided by earnings per share
• NewWorld's price per share is $100 both before and after the takeover
• Its earnings per share is $5 before and $6.25 after the takeover
• Before the takeover, NewWorld's P/E is $100/$5 = 20, but After the takeover its P/E is $100/$6.25 = 16
• The price-earnings ratio drops because more of the value of NewWorld comes from earnings from current projects than from its future growth potential

Reasons to Acquire: Managerial Motives

• Managerial motives to merge include conflicts of interest, and more prestige for a larger company
• Overconfidence causes CEOs to pursue mergers with above average abilities that cannot succeed

The Takeover Process: Valuation

• The target is compared to similar firms via rough estimate which excludes synergies
• Discounted cash flows are harder to implement, but include synergies

The Takeover Process: The Offer

• A public announcement offers a cash transaction or a stock swap with an exchange ratio
• There is a positive NPV transaction if the share price of the merged firm exceeds the premerger acquirer price

Stock Swap & NPV

• Stock Swap is a positive Net Present Value (NPV) if (A+T+S) / (NA​+x) > A/NA
• Where:
  • A = premerger value of acquirer
  • T = premerger value of target
  • S = value of synergies
  • NA​ = shares outstanding of acquirer premerger
  • x = number of shares issued in the merger
• Equation solved for the maximum value of x that will still give a positive NPV: x < (T+S / A) * NA
• Calculated Exchange Ratio = x/NT where x is the amount over NT - which is the number of issued shares
• Rewrite the equation using premerger target and acquirer ratios

Maximum Exchange Ratio Example

• Given the takeover in December 2004, Sprint stock was trading for $25 per share, Nextel for $30 per share
• Projected synergies were $12 billion, and Nextel had 1.033 billion shares outstanding
• We can compute the maximum shares Sprint could offer and still have a positive NPV
• For the cash offer, calculate the synergies per share and add that to Nextel’s current share price
• Exchange Ratio equation calculates that Sprint could offer up to 1.665 shares of Sprint stock for each share of Nextel stock at given values
• Using the cash offer, synergies are $12 billion/1.033 billion shares which is $11.62 per share, Sprint could offer up to $30 + $11.62 = $41.62
• The cash amount and exchange offer are $25 × 1.665 = $41.622 which have the same value
• $41.62 is the most that Nextel is worth to Sprint , paying full price plus Nextel shareholders for all synergy gains which leaves none for Sprint shareholders
• Paying $41.62 is calculated as a zero-NPV project

Takeover Process: Tax and Accounting Issues

• The form of payment affects taxes of target shareholders and combined firm
• Cash received triggers immediate tax liability, but stock swap defers taxes until shares are sold
• Step up increases the book value of a target’s assets to the purchase price when a company purchases those assets versus purchasing target stock
• Higher depreciable basis reduces future taxes and goodwill can be amortized

Takeover Process: Board and Shareholder Approval

• Approval can happen via friendly takeover or hostile takeover by a corporate raider
• A board may not approve even when offering a premium because the offered price may be too low
• Alternatively, it could be that the board thinks an acquirer is overvalued if swapped in stock
• Another alternative motive could be self interest (agency problem), many times a whole team of managers are changed
• The target board’s duty is to act in the best interest of target shareholders, because of Revlon duties
• Must seek the highest value using the "Unocal" principles
• Defensive actions are subject to extra scrutiny and defenses must not be coercive or designed to preclude a deal

Takeover Defenses

• Proxy fight: the acquirer attempts to convince target shareholders to support acquirers' candidates for election to the target board
• Several strategies to stop this process include forcing a bidder to raise the bid, and further entrench management
• Giving existing target shareholders a right to buy shares in the target at a discount can serve as "poison pills," which makes it hard to replace managers
• A firm's stock price also drops when adopting a "poison pill", and those who adopt usually have a below average financial performance
• Staggered boards divide term of directors so that 1/3rd of directors are up for election each year
• White knights: the target looks for a friendlier company to acquire it
• White squire: A large, passive investor or firm agrees to purchase substantial shares in a target with special voting rights
• Golden parachutes is compensation to senior managers guaranteeing a lucrative severance package if the firm is taken over and the managers are let go
• Company changes capital structure to make the operation less attractive to potential suitors, i.e. paying out a large dividend is recapitalization
• Defensive strategies could be requiring a supermajority, use restricted voting rights for large shareholders, and determine "fair" price
• Acts governing regulatory approval are the Sherman Act, Clayton Act, and Hart-Scott-Rodino Act

Who Gets the Added Value From a Takeover?

• The free rider problem assumes HighLife Corporation has 1 million shareholders, each holding 1 share since the management is not doing a good job, so shares are traded at a discount
• Shares are currently trading at $45 per share, if well managed they could be worth $75
• A simple majority is needed to make decisions, so control can be bought with just 50% of outstanding shares
• T. Boone Icon wants to remedy the situation by making a tender offer at $60 per share
• If 50% of shareholders tender, T. Boone makes a large profit of $15 per share if performance improves
• Tendering shareholders profit considering that the offered price exceeds the current price at $60 - $45 = $15 per share
• Remaining shareholders make a higher profit given a successful tender, earning $75 -$45 = $30 per share by tolerating the presence of other shareholders to tender
• Since all shareholders will know this, then the offer will not succeed and so T. Boone will need to make the offer for at least $75 per share to encourage shareholders
• The raider ends up giving up his profit and since existing shareholders do not have to invest time and effort into the transition, they are called "free riders."
• Toeholds are an initial ownership stake acquired by a corporate raider, up to about 10% of stake
• T. Boone can then buy another 40% for $75 per share and realize a profit from his initial 10%
• Corporate raiders perform an important service because management knows that they are there

The Leveraged Buyout

• A lower cost mechanism for corporate raiders than other options
• T. Boone announces a tender offer for half the outstanding shares at $50 per share
• By using shares as collateral, he can borrow money.
• A successful tender offer enables T. Boone to merge the target with the debt-owed shell corporation, and encourages shareholders to tender so shares will be worth $50 after the takeover

Leveraged Buyout Example

• FAT Corporation stock is is trading at $40 per share, with 20 million outstanding shares, and with no debt
• A firm specializing in leveraged buyouts determines that replacing the management could considerably improve the corporation, estimating that this would increase the value of the company by 50%
• You decide to make a leveraged buyout and give a tender for at least 50% of the shares
• Given the company is valued at $40 * 20 million = $800 million, the estimated 50% adds an additional 50%, or $400 million
• Borrowing $400 million and replacing management will make the company increase by 50% to be worth $1.2 billion
• Attaching $400 million in debt to the company results in the equity post-takeover value with $400 million in debt being the focus of calculations
• Repeating the process but assuming you borrow more than $400 will result in the same end total
• Total Equity is $1200 m - $400 m = $800 m that equals the company's premerger shares
• Since owners own half the shares, those are worth $400 million, and are paid nothing for them, because they have captured whatever value has been added to FAT
• Assuming you borrow $450 million has the value of shareholders shares will be $750 rather than the $800 million pre merge price
• In the United States and Canada, all shareholders must be offered that earlier share
• However all shareholders are going to sell off the debt for that total amount

Freezout Merger

• The merger is used to acquire other firms, and leverages that by using leveraged buyouts with investor groups
• An acquiring company makes a tender offer at a small or slight premium offering
• Given a successful result, the acquirer gains control and merges into a new corporation offering all previously non-tendering shareholders the right to receive tender offer price
• Competition in the takeover market drives benefits to target shareholders
• Given a raised bid, the competition will be higher and another company will then submit an appropriate amount

Summary of Key Points

• Mergers can be horizontal, vertical, or conglomerate
• Mergers happen in 'waves'
• Synergies are the most common explanation behind mergers and acquisitions
• Steps in the valuation and the takeover process will need to be completed to be successful
• A target board may use several measure to defend from a merger (poison pill, staggered board, white knight)
• There are specific beneficiaries of takeovers that you will need to identify