M&A: Adding Up the Numbers
April 16 2012 by Russ Banham
How does one define M&A success? Chief Executive reached out to two respected corporate performance consultancies—EVA Dimensions and Applied Finance Group—and put the question to them. Each came up with what they consider to be the truest test of a flourishing or regretful M&A transaction. The firms applied their metrics to six M&A deals, analyzed in full on the following pages.
Before we get to the results, let’s look at each firm’s quantitative methodology: As the table on page 46 illustrates, Applied Finance Group (AFG) scrutinized each of the six deals through the lens of Total Shareholder Return (TSR), which combines share price appreciation and paid dividends to reveal the total return to the shareholder. While the absolute size of TSR varies because of stock market movements, the relative position reflects the market perception of overall performance as compared to a reference group, such as an industry or market.
This evaluation methodology considers the TSR over a five-year period because most companies tend to develop five-year strategic plans, and presumably this is a long enough period for the synergies and integration benefits to shine. It further includes EM or economic margin, a company’s spread or return above its cost of capital. As a way to help readers understand the expectations of an acquisition, AFG developed two EM add-ons—Invested Capital and Productive Capital. The difference between them is that EM-Invested Capital considers the cost of intangible assets, whereas EM-Productive Capital does not.
Why is this important? “When the EM Differential between the two ratios is high, it indicates that the company paid an excessive amount for future growth and cash flows that have not yet materialized,” explained Michael Burdi, AFG portfolio consultant. By contrast, an EM Differential that is low indicates the company got a good deal at the time, not that this alone promises success. That’s why we’ve provided the expectations reflecting the EM Differential (high or low) along with the execution (good or bad).
EVA Dimensions, on the other hand, measured the acquirer’s stock price return from two weeks before the deal announcement to two weeks after, and then compared this to the S&P 500 return over the same period. It also calculated how much the acquirer’s shareholders as a group were ahead, or behind, compared to investing in the S&P 500 (labeled as “MVA Impact Test” in the table on page 47). MVA, for market value added, is the difference between the capital invested in a company and its market value, or to put it more bluntly, the measure of how much wealth a company has created or destroyed. “The initial MVA reaction tells us whether investors think the buyer is getting more value or less than what it’s paying,” says Bennett Stewart, CEO of EVA Dimensions.
Another method of establishing success or failure is following profit performance in the wake of a deal. To do that, EVA Dimensions computed how much EVA (economic value added) profit the buyer had earned when the deal was announced, versus five years later. EVA is a measurement of profit minus the cost of invested capital, including both equity and debt. As Stewart sees it, “It asks, ‘Did management earn a decent return on the total capital it paid, or did it pay too much for the benefits that were achieved?’”
To delineate this, EVA Dimensions computed “EVA Momentum,” a measurement of the five-year change in each buyer’s EVA, divided by its sales in the period leading up to the deal. It then subtracted the EVA Momentum generated by the S&P 500 over the same five-year interval. What’s left is the “Alpha,” an indication if the buyer generated more or less EVA profit growth than other large companies.
Still with us? The purpose of the metrics is to lend financial credence to calling a deal a success or a failure. As for the tales told within, we turned to a group of M&A specialists. Their comments are useful to companies of all sizes plotting an acquisition strategy.
Proctor & Gamble/Gillette
While the metrics indicate P&G set high expectations in acquiring Gillette—represented by the high price it was willing to pay—the deal ultimately paid off for shareholders. “It’s a story of pretty good timing and synergy,” says Burdi. “Even though they didn’t steal the company, they had complementary products that eventually created revenue and cost synergies.”
Sharing this view is Robert Bruner, dean of the Darden Graduate School of Business at the University of Virginia, where he teaches business administration. “P&G could bundle Gillette’s products with its own products, resulting in significant distribution savings,” says Bruner, author of the M&A book Deals from Hell. “Since they each distributed to drugstores, supermarkets and the like, they would now only need one distributor, providing economies of scale and possibly even a volume-based discount.”
Another academic and author, Mitchell Marks, professor of business at San Francisco State University and author of Joining Forces—Making One Plus One Equal Three in Mergers and Acquisitions, chalked up the transaction’s success to P&G’s vaunted strategic deal capabilities. “Like Cisco and Google, they’ve built an internal competency in M&A management,” Marks explains. “They don’t pick up the phone and call McKinsey when they want to make a deal; they’ve got their own SWAT team in-house. At most companies, they turn to someone who has a full-time job in finance or legal and toss M&A integration at them. The problem is there are only so many hours in a day.”
Stewart has a different take: “It’s a story of great management overcoming an overpriced acquisition. Still, this was an awfully expensive way to get there.”
Key Takeaway: Paying a high price won’t kill a deal, unless there is no strategy for integration.
Ask most anyone for the worst M&A deal in history and invariably they will respond “AOL/Time Warner.” The metrics indicate high hopes for the transaction to rain dollars on shareholders. Instead, it just rained.
What went wrong? “AOL at the time of the announcement had a stupendous market value of about $123 billion and had invested capital of just around $8 billion, so it was trading for an MVA premium of $115 billion, which is incredible,” says Stewart.
Why? “Because MVA has to come from the present value of the EVA profit a company can earn in the future,” he explains. “As a result, AOL would have had to increase its EVA profit, at the time running at $66 million, by over $1 billion each and every year, for the next 20 years, to justify that kind of MVA. A little math and economic logic would have shown the utter folly in taking AOL stock as currency for the sale of Time Warner.”
Burdi concurs: “Time Warner shareholders paid an astronomically high price for AOL, setting them up for failure from the beginning. Plus, they bought an unproven business with unproven cash flows—a veritable recipe for disaster.”
Key Takeaway: Theories are not a replacement for strategy, timing and stiff price negotiations.
By contrast, HP’s acquisition of Compaq came at a good price and performed admirably over the five-year span, even though HP’s board initially expressed reluctance. “Hewlett’s son, who sat on the board, was dubious, at best, and a big battle ensued,” says Marks. “But, in the long run, they had very good execution, a consequence of HP’s sharp transition teams. Both companies also agreed to build one new company with one new culture, as opposed of pockets of this and that, and it worked.”
Bruner agrees. “Carly Fiorina (HP’s CEO at the time) touted the cost savings and revenue growth synergies, even though the board at first demurred, and she made good on them within three years,” he says. “Over the five-year horizon, Compaq strengthened HP’s franchise with a strong offering in the server market, not to mention the consulting services that HP was moving into.”
“It was the longest running soap opera in business when it was announced,” Stewart says, “but the good news is that both companies happen to be in a great business and they were able to ride the next wave up, even though the initial stock price reaction was horrible. HP surprised people by how well they were able to integrate Compaq and make it a pretty successful PC business, at least for a while. They saw the PC becoming a commodity and captured a strong niche at the lower end.”
Key Takeaway: A well-executed post-merger integration of two companies will overcome critics’ initial skepticism.
There are good integrations and then there are truly terrible ones—the case with Sprint’s acquisition of Nextel. Making matters worse was that the telecom paid too much and, as Stewart comments, “still didn’t build the scale it would need to battle the giants—AT&T and Verizon.”
Faisal Hoque, founder and CEO of management solutions provider BTM Corporation, is equally critical. “It exemplifies poor integration from a product, cultural, infrastructure and organizational standpoint,” he charges. “The end result was a nosedive for shareholders. The deal was a disaster—the company wrote down nearly $30 billion of the $36 billion it paid for Nextel, wiping out 80 percent of Nextel’s value at the time of the acquisition.”
The integration was made especially difficult by the companies’ technological incompatibilities. “Nextel’s ‘push-to-talk’ network, which runs on a unique technology called iDEN, was unsuited to Sprint’s, and this limited its selection for smartphones,” explains Hoque, author of The Power of Convergence.
Marks agrees. “They had serious network incompatibilities, which should have been considered in the due diligence,” he says. “But, they overlooked it, probably because of the ego of the CEO and senior team. They got so caught up in closing the deal because walking away would’ve been viewed as a failure by shareholders and the business press. Of course, losing billions of dollars in shareholder value is a much larger failure.”
Key Takeaway: One apple plus one apple equals two apples; one apple plus one orange makes one apple plus one orange. Make sure the pieces fit.
Timing is everything. Just ask Conoco and Phillips Petroleum, two integrated oil and gas companies that merged as oil prices began rising. Not only did the deal carry a fair price, the partners pulled off a quick and commendable execution.
“Most of what is called M&A today is a behemoth scooping up a much smaller rival, but this was a real merger of equals or as close to that as possible,” says Hoque. “Phillips shareholders would own 56.6 percent of ConocoPhillips, with Conoco shareholders coming away with 43.4 percent. That’s still pretty close to equal.”
Burdi agrees. “As the EM differential (1.7) indicates, Conoco didn’t pay a premium when the companies merged—it was a true merger of equals,” he says. “The deal was very carefully set up so all the synergies were identified and in place once the ink was dry.”
Marks, who worked on the integration in a consulting capacity, confirms that “both companies’ leaders and managers were prepared for the rigors of the M&A process,” he says. “It took about six months for the deal to get approved, but nobody sat around navel-gazing. They conducted a series of workshops for managers to understand what would be needed once they gained approval. Legally, they can’t open the kimono too much to the other side, but they could do things like address the types of data they would need to collect for the integration. These were real team-building sessions that established a high level of collaboration.”
After the merger got the nod from the government, oil prices began their stratospheric rise. As Stewart puts it, “Both companies were the lucky recipient of an appreciating asset, but there was still real value to be had through cost synergies and consolidation.”
Key Takeaway: Get the integration process ready to go the day the deal closes.
Our last example also comprises high expectations (high price) with a bad execution. “The EM differential was very high, not surprising as Boston Scientific was in a bidding war with Johnson & Johnson and topped its bid, paying a whopping $27 billion,” says Burdi.
In retrospect, it should have sat on the sidelines. “J&J had uncovered some issues with Guidant’s main products (defibrillators and pacemakers) and lowered its bid,” says Marks. “This didn’t stop Boston Scientific, which paid 80 times Guidant’s earnings to buy it.”
“Then bad things happened,” Burdi notes. Boston Scientific had to fork over $296 million to the federal government after Guidant pleaded guilty to criminal charges for selling defective defibrillators, followed by another $22 million to settle charges that Guidant’s sales reps gave kickbacks to doctors who bought the defibrillators, and another $234 million to settle more than 8,000 claims by patients using the device.
What else? How about more than $2 billion to settle patent infringement lawsuits brought by J&J. “Obviously, Boston Scientific had to adjust its profits downward and write-off the deal (an eye-opening $4.4 billion),” says Bruner. “The buyer hadn’t done the careful due diligence so necessary in M&A.”
Boston Scientific “was guided by price, not strategy,” says Marks. “It jumped at the chance to buy Guidant, rather than do the slower and safer work of studying its options, setting a strategy and finding a target that fits it.” He adds, “Doing a deal to get back at a competitor (J&J) just isn’t a smart move.”
Key Takeaway: Bagging a target may bring some early accolades, but your legacy will be determined by the eventual results.
The Total Return Test
Conoco-Phillips netted the best outcome in an outcome measurement based on total shareholder return and
|P&G/Gillette||HP/Compaq||Conoco/Phillips||AOL/Time Warner||Sprint/Nextel||Boston Scientific/Guidant to Lane via Insite|
|EM – Productive Capital||20.9||4.8||5.1||13.1||6.4||13|
|EM – Invested Capital||6.5||-2.1||3.4||-54.6||-2.5||=26.2|
|Summary||High Expectations/ Good Execution||Low Expectations/ Good Execution||Low Expectations/ Good Execution||High Expectations/ Bad Execution||High Expectations/ Bad Execution||High Expectations/ Bad Execution|
A high EM differential indicates a company paid an excessive amount for future growth and cash flows that have not materialized.
EM = Economic Margin, or return above cost of capital; TSR = Total Shareholder Return
The MVA Impact Test
The metrics below bring in various factors such as market value added (MVA) and economic value added (EVA) to establish a method of comparing an acquirer’s shareholder value versus the S&P 500 over a particular duration. For instance, the Conoco/Phillips merger generated 25.6% more economic value than the S&P 500 over five years, while the AOL/Time Warner merger lost a comparative 101.28% in value. Procter & Gamble’s acquisition of Gillette exceeded the S&P 500, but the other deals—Sprint/Nextel, Boston Scientific/Guidant and Hewlett-Packard/Compaq—all lost economic value.
|P&G/Gillette||HP/Compaq||Conoco/Phillips||AOL/Time Warner||Sprint/Nextel||Boston Scientific/Guidant to Lane via Insite|
|Stock Price 2 Weeks Before||$46.76||$21.80||$20.17||$152.38||$20.77||$24.74|
|Stock Price 2 Weeks After||$43.83||$14.18||$20.09||$120.06||$22.08||$23.15|
|S&P 500 Price 2 Weeks Earlier||$1,184.52||$1,171.41||$1,071.38||$1,328.92||$1,190.33||$1,254.42|
|S&P 500 Price 2 Weeks After||$1,205.30||$1,038.77||$1,087.20||$1,364.30||$1,213.55||$1,273.83|
|$ MVA2 Impact||-$9.54 Billion||-$9.99 Billion||-$0.29 Billion||-$26.7 Billion||$1.33 Billion||-$1.62 Billion|
|TFQ Sales In Quarter Deal was Closed||$55,445||$45,226||$30,449||$6,886||$25,024||$6,288|
|TFQ EVA3 in Quarter Deal was Closed||$4,013||$1,121||$(435)||$(62)||$(892)||$769|
|TFQ EVA 5 Years Later||$3,973||$2,704||$9,628||$(6,799)||$(6,595)||$(1,434)|
|Buyer’s 5 Yr EVA Momentum4||-0.07%||3.50%||33.05%||-97.84%||-22.79%||-35.04%|
|EVA Momentum for S&P 500: Aggregate Results for S&P 500 Companies, as of deal-close dates|
|TFQ Sales in Quarter Deal was Closed||$5,672,875||$4,273,644||$4,136,326||$3,438,032||$5,840,504||$6,381,602|
|TFQ EVA in Quarter Deal was Closed||$148,267||$9,478||$(31,455)||$99,411||$164,477||$221,829|
|TFQ EVA 5 Years Later||$132,358||$261,856||$276,137||$217,539||$175,100||$264,064|
|S&P 500 5-Year EVA Momentum||-0.28%||5.91%||7.44%||3.44%||0.18%||0.66%|
|Excess EVA Momentum5||0.21%||-2.40%||25.61%||-101.28%||-22.97%||-35.71%|
1. Alpha = an indicator of whether a buyer generated more or less EVA profit growth relative to its peer companies; 2. MVA = Market
Value Added, the difference between capital invested and current market value; 3. EVA = Economic Value Added; 4. EVA Momentum = delta
EVA/base period sales; 5. EVA Momentum = Company’s EVA momentum minus the S&P 500 company momentum