Mergers Comp

Mergers & Acquisitions

What is a Merger? Merger: 2 firms combine all Assets and Liabilities Acquirer ⇔ Target Usually take a new name

Examples of Mergers JP Morgan/Chase Manhattan becomes JP Morgan Chase  Exxon and Mobil becomes Exxon-Mobil Sometimes target firms name disappears and combined firms are known by acquired name. Or sometimes, by a completely new name.  Burroughs/Sperry Rand became Unisys 

Mergers  

Key: Target firm shares disappear Target shareholders get either 1) Shares in new firm 2) Cash

Exchange Ratio = # shares in new firm given for each share of Target firm

Mergers 

Ex) # target = 250 million & ER = 1.25 # New = 1.25 x 250 M = 312.5 M



Buyer firm shares are kept as shares in new firm ( in effect their ER = 1).

Types of Mergers 

Horizontal when two competitors combine Ex) Exxon–Mobil, Daimler-Chrysler



Vertical when one company acquires a supplier/customer Ex) Helene-Curtis and Unilever

Types of Mergers (continued) 

Conglomerate when two firms from different industries combine



Ex) Citicorp and Travelers, Ciba-Geigy (contact lens, Ritalin, Maalox) and Sandoz (Gerber Baby Food, Ovaltine) - Novartis

Japanese Keiretsu Not unlikely for Japanese firms to grow via mergers and acquisitions Sony acquired CBS Records (1987) Sony acquired Columbia Pictures (1989) for $3.45 billion  Keiretsu involves a group of firms affiliated with a large bank, industrial firm, or trading firm. 

Japanese Keiretsu (continued) Participation involves significant reciprocal stock ownership (know not to sell these cross-held shares)  Provides protection 

History of Mergers 1) 1890 – 1905 Horizontal, US Perspective Large mergers of oil, tobacco, steel Sherman 1890 Act – restraint of trade Clayton Act – lessen competition

History of Mergers (continued) 1922 – 1929 Vertical, US perspective Public Utilities, Banking, Chemical, Mining, Food Processing Driven by technology changes and demographic changes  Mass Marketing, Market Extensions  Radio, Auto

History of Mergers (continued) 

1960s Conglomerate Motivation: diversity Capital Asset Pricing Model (CAPM) 1981-1989 Deal Decade, many and large 1984: 2,543 mergers for $122 billion Affecting 4.5 million employees

History of Mergers (1981 –1989) 

1981-1989 Deal Decade Many oil/gas – depressed stock prices Hostile Takeovers/Threats Many via LBOs

History of Mergers (continued) 

1992-1999 Strategic Mergers Very large in size and number 1998: over $1.5 trillion in deals Driven by: Deregulation, economic forces, technology, globalization Most done in cash (unlike 1980s)

History of Mergers (1992-1999) 

Examples:  Deutsche Bank – Bankers Trust  Citicorp – Travelers Insurance  (Reigle –Neal 1994, Bliley Act 1999)  AOL – Netscape

Regulation of Mergers 

United States Numerous Securities Laws may apply Disclose: Securities Act of 1933 Securities Exchange Act of 1934 RICO (1970) – Conspiracy repeated transactions (Mike Milken)

Regulation of Merger (continued) 

Sherman Act of 1890 Prohibits mergers – monopoly or undue market control Stopped merger of Staples – Office Depot and IBM – AT&T (1950s) Microsoft (1998)

Regulation (Microsoft) 1. 2. 3. 4.

Microsoft had 90% of market On 6/25/95, Microsoft and Netscape made an illegal deal to divide browser market Microsoft bundled its browser to its Windows operating system Microsoft pressured Compaq and AOL into exclusive agreements

Regulation (continued) Clayton Act 1914 FTC has power on mergers Competition adversely affected  Mergers guidelines of 1982 led to use of Herfindahl – Hirschman Index (HHI) to measure market concentration 

Regulation (continued) 

Let Xi = % market share of ith firm in an industry with N firms N

HHI =

x ∑ i= 1

2100 i

2

Ex) Industry with 1 firm x1 = 100 2 100 HHI = x

2 1

= 10,000

Regulation (continued) 

Ex) Industry with infinite # of firms Xi ≅ 0 for all i HHI = 0 HHI = [0, 10,000] Ex) Industry with 3 firms A,B,C Xa=50% Xb= 46% Xc=4% HHI = 50 2 + 46 2 + 4 2 = 4632

( )

2

( )

( )

Regulation (continued) 

If A acquires C then A + C = 54 B = 46 2 2 ( ) ( ) 54 + 46 HHI= = 5032 ∆ HHI = 5032 – 4632 = 400 Likely challenge

Regulatory Bodies United States:  Department of Justice  Federal Trade Commission  Individual States  Banks: Federal Reserve and FDIC  Radio/TV: Federal Communications Commission

Regulatory Bodies (UK) 

1965 Monopolies and Mergers Commission created (MMC)



1973 Office of Fair Trade (OFT) created with a Director General



These assess potential mergers

Regulation (Japan) 

Japan FTC reviews mergers (only 30 days) Stock-for-stock transactions do not need government approval

Regulation (Europe) 

European Commission (EU) has exclusive authority to review mergers – it can defer to individual country antitrust authorities. Focus: on community impact. Does merger create or enhance a dominant position? EC can recommend to Minister of Competition of the European Union (EU)

Regulation (EC examples) Boeing-McDonnell Douglas merger announced 12/96  EC concerned about Boeing’s dominance of market and Boeing’s aggressive purchase contracts with major U.S. airlines (would make it difficult for Airbus to compete)  EC announced objections on 5/21/97 

Regulation (continued) 

Boeing: EC could fine Boeing and seize planes in Europe Boeing made concessions for approval



GE-Honeywell rejected by EC in 2001

Why should mergers occur? 

One reason only: to create value Value added known as synergistic value Value of the combined firms should be more than the sum of the individual firms values

Synergy Operating:

Financial:

1. Lower Costs

1. Lower Taxes

2. Higher Sales or Profits

2. Debt Capacity 3. Use of idle cash

Why should mergers occur? 1)

4)

Marketing Gains Inefficient media/advertising, poor product mix, weak distribution network Economies of Scale Reduce unit costs, blend expertise, quality discounts, etc.

Why should mergers occur? 1)

Cheaper to buy than to make Tobin Q Ratio Q-Ratio=Market Price/Replacement Cost If Q>1.20 – Capital goods boom, cheaper to make If Q<.80 – Merger Activity Cheaper to buy than make – Oil Companies

Why do mergers occur? 1)

4.

6.

Diversification Conglomerate mergers Usually a bad reason Gain Market Share Horizontal Mergers Strategic Realignment (1990s) Due to economic, technology changes

Why do mergers occur? 1)

3)

5) 6)

Technological Changes Auto, TV, Computer, Biotechnology Regulatory Change Banking in U.S. Globalization & Freer Trade Executive Gains Larger is safer, More control power

Why do mergers occur? 1) 2)

Signal (information) to market Tax benefit

Who benefits/losses? Shareholders of acquirer  Shareholders of target company  Management of both firms  Employees and Community  Consumer  Government  Related Firms 

Evaluating Mergers

Mergers – PE Model 

Firm 1 acquires Firm 2 ER=exchange ratio =# of shares of 1 given per share of 2 P= Price per Share E=Earnings S=#of Shares EPS=E/S PE=P/EPS

Mergers – PE Model 

Firm #1 acquires #2 Want : P12 ≥ P1 # 1 better P12=PE12 EPS12 ≥ 1 EPS12= (E1+E2)/(S1+S2 ER1) Thus: P1 ≤ PE12 (E1+E2)/(S1+S2ER1) S1+S2 ER1 ≤ (PE12/P1)×(E1+E2) ER1 ≤ - S1/S2 + (E1+E2)/(P1S2) PE12

Mergers – PE Model

3) 4)

E 200 200

S 100 100

EPS 2 2

PE 10 20

P 20 40

ER1 ≤ -100/100 + (400)/(20×100) PE12 ER1 ≤ -1 + 1/5 PE12

Mergers – PE Model Also want #2 better off New value ≥ Old value ER2 P12 ≥ P2 P12 ≥ P2/ER2 PE12 EPS12 ≥ P2/ER2 PE12 (E1+E2)/(S1+S2 ER2) ≥ P2/ER2 ! ER2 ≥ (P2S1)/(PE12(E1+E2) – P2S2) 

Mergers – PE Model 

ER2 ≥ (P2 S1)/(PE12(E1+E2) –P2S2) Previous examples: ER2 ≥ (40 × 100)/PE12 × 400 – 40 × 100 ER2 ≥ 4000/(400PE12 - 4000) ER2 ≥ 10/(PE12 - 10)

Mergers – PE Model  Find ER*, PE12*

ER1 = ER2 PE12 = 10/(PE12-10) (1/5)PE PE12 = 0 -1 + (1/5)

12 - 3 =

PE12[(1/5)PE12-3)] = 0

PE12* = 15 PE

Abnormal Returns 

Abnormal returns on Security i = Actual Returns -What CAPM predicts ei = Ri- [RF + ßi(RM - RF)] if ei > 0

positive, did better

if ei = 0

zero, did what was expected

if ei < 0

negative, did worse

Stock or Cash? 

Major change from 1980s to 1990s firms bought with stock now versus cash before 1988 1998 # 4,066 12,356 $ 378.9B 1.63B % cash 60 17 (>$100M)

Stock or Cash? 

Cash – Target assumes no risk Stock – Not clear who acquirer More hostile in 1980s, more negotiated in 1990s Market reaction less clear with stock

Corporate Restructuring

Corporate Restructuring    

The reverse of a merger Intent is the same: increase value Takes many forms Specific Reason: 1) Need to meet global competition 2) Better align interests of managers and shareholders

Corporate Restructuring  2)

3)

Specific Reasons (continued): Many done in 1980s to reverse conglomerate mergers of 1960s Make the firm more attractive to investors (e.g. “Pure Play”)

Types of Corporate Restructuring 1)

Spin-Offs: A company owns or creates a subsidiary whose shares are distributed on a pro rata basis to the shareholders of the parent company Parent usually retains some ownership of sub – 10 to 20%

Types of Corporate Restructuring Spin-Offs (continued): Often Spin-Offs follow an IPO sale of under 20% of shares (this is an equity carve out – see later) Sub becomes a public firm No cash flow generated

Many Spin-Offs: Sears spin-off of Dean-Witter  Discover Card $530 Million  Dole Foods, General Mills, Marriott, ITT, US West  Kimberly Clark spin-off Midwest Express Airlines 

Many Spin-Offs: Ralston Purina spin-off Agribrands in 1998 granting 1 share in Agribrands for every 10 in Ralston  Hilton spin-off Park Place Entertainment Corp (casino business) – 1 share-for-1 share  Market reaction has generally been positive (abnormal returns) to spin-offs 

Equity Carve-Outs 1)

It is the IPO of some portion of the common stock of the subsidiary Sometimes known as “split-off” IPO This is like a seasoned equity offering of parent in that cash is generated but differs in that this initiates public trading of sub Equity claim is on sub assets and not parent

Equity Carve-Outs 

Examples: Delphi was captive supplier of GM it supplied components, integrated systems, and modules. In 1999, GM did a carve-out and spin-off of Delphi – Delphi had many customers (GM is protected)

Split-Ups 1)

When a firm splits into 2 or more entities – usually accomplished with carve-outs and spinoffs of individual parts Example AT&T Sept ’95: spilt AT&T into 3 publicly traded companies and the 4th business was sold

Split-Ups – AT&T 1) 2) 3) 4)

AT&T: AT&T wireless and AT&T long distance, credit card business Communications Systems, later named Lucent Technologies (W/Bell Labs) Global Information Solutions (later NCR) At&T shareholders received shares in all 3 companies. Split-up was 2 spin-offs

Split-Ups – At&T 

Motivation: Regional Bells (“Baby Bells”) AT&T split long-distance and equipment because equipment would supply Regional Bells and long-distance would compete with Regional Bells – separate roles as supplier and competitor

Split-Ups – At&T Before restructuring AT&T worth $75B  1 year after completion, 1/98, 3 companies worth $159B 

Divestiture Sale of segment of a company to a third party for cash and/or securities  Examples: Volvo AB sold passenger business to Ford for $6.5B AT&T sold Global Network (see previous) to IBM for $5B 

Divestiture LT Credit Bank of Japan sold its US loan asset portfolio to GE Capital for $4B  Hoechst AG sold its Paint Division to DuPont for $2B 

Motives for Divestiture 1) 2)

3)

Dismantling conglomerates Abandoning core business  1987 Greyhound sold bus business  Eastern Airlines sold NE Shuttle Changing strategies 1988 Allegis sold hotel/car rental units to become UAL and operate United Airlines

Motives for Divestiture 1)

3)

4)

Adding Value by Selling into a better fit 1988 IBM sold copier business to Eastman Kodak Large Additional Investment required Gould sold antisubmarine warfare business to Westinghouse Electric Harvest past successes

Motives for Divestiture 1)

3)

Discard unwanted business from prior acquisitions Pullman sold Bruning Hydraulics Finance prior acquisitions done before LBO Campeau acquired Allied Stores then sold 16 Allied Divisions to pay down bank debt

Motives for Divestiture 1)

3)

Ward off takeover Brunswick sold Medical Division to American Home Products Meeting Government requirements 1988 Santa Fe required by ICC to sell railroad division

Leveraged Buyouts (LBOs) LBO is purchase of a company by a small group of investors, financed heavily with debt and usually entails going private  LBO involves large ownership by managers  Usually to turn firm around 

Leveraged Buyouts (LBOs) Some large LBOs in U.S.:  RJR Nabisco (1998) $24.6B (1st)  Beatrice Companies (1985) $5.4B (2nd)  Safeway Stores (1986) $4.2B (3rd)  Borg-Warner (1987) $3.8B (4th) 

Leveraged Buyouts (LBOs) LBO interim financing usually bank debt  Permanent financing  Bank Debt (Senior, Secured)  High-Yield Bonds (Junk Bonds)  LBOs popular in 1980s, coming back in the late 1990s 

Hostile Mergers   

Bidder Unwanted Popular in 1980s Defenses: 1) Amend Corporate Charter 2) Standstill Agreement Bidding firm agrees to limit its holdings in target

Hostile Mergers 1)

3)

Targeted Repurchase Target firm agrees to buy back some shares from bidder (usually at a premium) Exclusionary Self-Tender Firm makes offer to buy back its own shares (w/limit) while excluding targeted shareholders

Hostile Mergers 1)

4)

Poison Pills Calls with contingent strike prices Issued to shareholders Legislation

Other Hostile Merger Jargon Golden Parachutes  Crown Jewels  White Knights  Lock Ups  Shark Repellents  Green Mailing 