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Sensible Motives for Mergers

Sensible Motives for Mergers

Mergers that take place between two firms in the same line of business are known as horizontal mergers. Recent examples include bank mergers, such as Chemical Bank’s merger with Chase and Nationsbanks purchase of BankAmerica. Other headline-grabbing horizontal mergers include those between oil giants Exxon and Mobil, and between British Petroleum (BP) and Amoco.

A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer. An example is Walt Disneys acquisition of the ABC television network. Disney planned to use the ABC network to show The Lion King and other recent movies to huge audiences.

A conglomerate merger involves companies in unrelated lines of businesses. The majority of mergers in the 1960s and 1970s were conglomerate. They became less popular in the 1980s. In fact, much of the action since the 1980s has come from breaking up the conglomerates that had been formed 10 to 20 years earlier.

With these distinctions in mind, we are about to consider motives for mergers, that is, reasons why two firms may be worth more together than apart. We proceed with some trepidation. The motives, though they often lead the way to real benefits, are sometimes just mirages that tempt unwary or overconfident managers into takeover disasters. This was the case for AT&T, which spent $7.5 billion to buy NCR. The aim was to shore up AT&Ts computer business and to “link people, organizations and their information into a seamless, global computer network.” It didnt work. Even more embarrassing (on a smaller scale) was the acquisition of Apex One, a sporting apparel company, by Converse Inc. The purchase was made on May 18, 1995. Apex One was closed down on August 11, after Converse failed to produce new designs quickly enough to satisfy retailers. Converse lost an investment of over $40 million in 85 days.

Many mergers that seem to make economic sense fail because managers cannot handle the complex task of integrating two firms with different production processes, accounting methods, and corporate cultures. This was one of the problems in the AT&T–NCR merger. It also bedeviled Novells acquisition of Wordperfect. That merger at first seemed a perfect fit between Novells strengths in networks for personal computers and Wordperfects applications software. But Wordperfects postacquisition sales were horrible, partly because of competition from other word processing systems but also because of a series of battles over turf and strategy.

The value of most businesses depends on human assets—managers, skilled workers, scientists, and engineers. If these people are not happy in their new roles in the acquiring firm, the best of them will leave. One Portuguese bank (BCP) learned this lesson the hard way when it bought an investment management firm against the wishes of the firms employees. The entire workforce immediately quit and set up a rival investment management firm with a similar name. Beware of

paying too much for assets that go down in the elevator and out to the parking lot at the close of each business day. They may drive into the sunset and never return.

There are also occasions when the merger does achieve gains but the buyer nevertheless loses because it pays too much. For example, the buyer may overestimate the value of stale inventory or underestimate the costs of renovating old plant and equipment, or it may overlook the warranties on a defective product. Buyers need to be particularly careful about environmental liabilities. If there is pollution from the sellers operations or toxic waste on its property, the costs of cleaning up will probably fall on the buyer.

Just as most of us believe that we would be happier if only we were a little richer, so every manager seems to believe that his or her firm would be more competitive if only it were just a little bigger. Achieving economies of scale is the natural goal of horizontal mergers. But such economies have been claimed in conglomerate mergers, too. The architects of these mergers have pointed to the economies that come from sharing central services such as office management and accounting, financial control, executive development, and top-level management.

The most prominent recent examples of mergers in pursuit of economies of scale come from the banking industry. The United States entered the 1990s with far too many banks, largely as a result of outdated regulations on interstate banking. As these regulations eroded and communications and technology improved, hundreds of small banks were bought out and merged into regional or supra-regional firms. When Chase and Chemical, two of the largest money-center banks, merged, they forecasted that the merger would reduce costs by 16 percent a year, or $1.5 billion. The savings would come from consolidating operations and eliminating redundant costs.

Optimistic financial managers can see potential economies of scale in almost any industry. But it is easier to buy another business than to integrate it with yours afterward. Some companies that have gotten together in pursuit of scale economies still function as a collection of separate and sometimes competing operations with different production facilities, research efforts, and marketing forces.

Vertical mergers seek economies in vertical integration. Some companies try to gain control over the production process by expanding back toward the output of the raw material and forward to the ultimate consumer. One way to achieve this is to merge with a supplier or a customer.

Vertical integration facilitates coordination and administration. We illustrate via an extreme example. Think of an airline that does not own any planes. If it schedules a flight from Boston to San Francisco, it sells tickets and then rents a plane for that flight from a separate company. This strategy might work on a small scale, but it would be an administrative nightmare for a major carrier, which would have to coordinate hundreds of rental agreements daily. In view of these difficulties, it is not surprising that all major airlines have integrated backward, away from the consumer, by buying and flying airplanes rather than patronizing rent-a-plane companies.

Do not assume that more vertical integration is better than less. Carried to extremes, it is absurdly inefficient, as in the case of LOT, the Polish state airline, which in the late 1980s found itself raising pigs to make sure that its employees had fresh meat on their tables. (Of course, in a centrally managed economy it may be necessary to raise your own cattle or pigs, since you cant be sure youll be able to buy meat.)

Nowadays the tide of vertical integration seems to be flowing out. Companies are finding it more efficient to outsource the provision of many services and various types of production. For example, back in the 1950s and 1960s, General Motors was deemed to have a cost advantage over its main competitors, Ford and Chrysler, because a greater fraction of the parts used in GMs automobiles were produced inhouse. By the 1990s, Ford and Chrysler had the advantage: They could buy the parts cheaper from outside suppliers. This was partly because the outside suppliers tended to use nonunion labor at lower wages. But it also appears that manufacturers

have more bargaining power versus independent suppliers than versus a production facility thats part of the corporate family. In 1998 GM decided to spin off Delphi, its automotive parts division, as a separate company.After the spinoff, GM can continue to buy parts from Delphi in large volumes, but it negotiates the purchases at arms length.

Many small firms are acquired by large ones that can provide the missing ingredients necessary for the small firms success. The small firm may have a unique product but lack the engineering and sales organization required to produce and market it on a large scale. The firm could develop engineering and sales talent from scratch, but it may be quicker and cheaper to merge with a firm that already has ample talent. The two firms have complementary resourceseach has what the other needsand so it may make sense for them to merge. The two firms are worth more together than apart because each acquires something it does not have and gets it cheaper than it would by acting on its own. Also, the merger may open up opportunities that neither firm would pursue otherwise.

Of course, two large firms may also merge because they have complementary resources. Consider the 1989 merger between two electric utilities, Utah Power & Light and PacifiCorp, which served customers in California. Utah Powers peak demand came in the summer, for air conditioning. PacifiCorps peak came in the winter, for heating. The savings from combining the two firms generating systems were estimated at $45 million annually.

Heres another argument for mergers: Suppose that your firm is in a mature industry. It is generating a substantial amount of cash, but it has few profitable investment opportunities. Ideally such a firm should distribute the surplus cash to shareholders by increasing its dividend payment or repurchasing stock. Unfortunately, energetic managers are often reluctant to adopt a policy of shrinking their firm in this way. If the firm is not willing to purchase its own shares, it can instead purchase another companys shares. Firms with a surplus of cash and a shortage of good investment opportunities often turn to mergers financed by cash as a way of redeploying their capital.

Some firms have excess cash and do not pay it out to stockholders or redeploy it by wise acquisitions. Such firms often find themselves targeted for takeover by other firms that propose to redeploy the cash for them. During the oil price slump of the early 1980s, many cash-rich oil companies found themselves threatened by takeover. This was not because their cash was a unique asset. The acquirers wanted to capture the companies cash flow to make sure it was not frittered away on negative-NPV oil exploration projects. We return to this free-cash-flow motive for takeovers later in this chapter.

Cash is not the only asset that can be wasted by poor management. There are always firms with unexploited opportunities to cut costs and increase sales and earnings. Such firms are natural candidates for acquisition by other firms with better management. In some instances better management may simply mean the determination to force painful cuts or realign the companys operations. Notice that the motive for such acquisitions has nothing to do with benefits from combining two firms. Acquisition is simply the mechanism by which a new management team replaces the old one.

A merger is not the only way to improve management, but sometimes it is the only simple and practical way. Managers are naturally reluctant to fire or demote themselves, and stockholders of large public firms do not usually have much direct influence on how the firm is run or who runs it.

If this motive for merger is important, one would expect to observe that acquisitions often precede a change in the management of the target firm. This seems to be the case. For example, Martin and McConnell found that the chief executive is four times more likely to be replaced in the year after a takeover than during earlier years. The firms they studied had generally been poor performers; in the four years before acquisition their stock prices had lagged behind those of other firms in the same industry by 15 percent. Apparently many of these firms fell on bad times and were rescued, or reformed, by merger.

Of course, it is easy to criticize another firms management but not so easy to improve it. Some of the self-appointed scourges of poor management turn out to be less competent than those they replace. Here is how Warren Buffet, the chairman of Berkshire Hathaway, summarizes the matter:

Many managers were apparently over-exposed in impressionable childhood years to the story in which the imprisoned, handsome prince is released from the toads body by a kiss from the beautiful princess. Consequently, they are certain that the managerial kiss will do wonders for the profitability of the target company. Such optimism is essential. Absent that rosy view, why else should the shareholders of company A want to own an interest in B at a takeover cost that is two times the market price theyd pay if they made direct purchases on their own? In other words investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses better pack some real dynamite. Weve observed many kisses, but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses, even after their corporate backyards are knee-deep in unresponsive toads.

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Taken from Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers (7th edition)

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