Thursday, March 28, 2013

Catalysts for Merger

We've talked before of motives for merger.  This time let's talk about what causes an entire industry to suddenly be the target of acquisition attempts or similarly why an industry suddenly starts making bids for other firms.

Think of an industry where no firm has been targeted for acquisition and imagine that this situation has prevailed for some time, say at least a year.  Metaphorically, the waters are still, the pond is flat, with no acquisition activity causing disruption.  The first bid for a firm in this industry is going to cause waves, possibly large waves, in this industry - like a rock thrown in the middle of the pond.

What causes this sudden activity?  Presumably some managerial team has decided that the assets of the target firm are worth more to this team than their current market value.  Hence a bid takes place.  Will this signal other bids in the industry?  Perhaps.  In another post we'll talk about merger waves.  For now, let's assume that the first firm to be targeted does indeed signal the possibility of other bids.  What are the reasons for this sudden activity?

The reasons are that something has occurred to cause the value of the target firm to increase in the view of the bidder.  What causes this shift?  In terms of the present value equation some catalyst must have caused an increase in the estimated cash flows or a decrease in the discount rate.  Either (or both) of these will increase value.   

As one example, there were a multitude of oil mergers in the 1980s.  One reason is that exploration and development became a value-losing proposition.  Why did this occur?  Because the price of oil (a fundamental component of cash flows) dropped from over $40 a barrel to $10 a barrel and simultaneously, interest rates rose from single digits to double digits.  As a consequence, the present value changed from a positive cash flow to a loss for each barrel discovered.  For Gulf Oil, the present value impact was about $50. per share.  A popular Harvard case makes these points and others in explaining how Gulf Oil could be trading for $38 today and receive a bid of $80. per share tomorrow.  

So what are these shocks, these catalysts?  Common catalysts include: shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology.

Shifts in regulation cause firms to adjust their behavior.  New regulation increases the costs of operating a firm.  Reduced regulation creates new opportunities.  Both types of shifts can make it more profitable for firms to combine.  In some cases firms reduce costs through economies of scale.  In other cases, firms are able to exploit synergies in situations previously blocked by regulation.  A good example is the banking industry where regulations prohibited growth in a (new) state unless a bank already had a presence in that state.  One way to establish a presence was merger with an existing bank.  

When consumer tastes shift, so do the estimates of future cash flows.  Investments that previously seemed unattractive (or attractive) are reversed.   As as result, targets find it beneficial to merge with other firms to exploit new synergies or merge as an attempt to reduce over-capacity in the industry. Firms that fail to adjust to shifts in tastes (e.g. Chrysler) are forced to merge to avoid bankruptcy (General Motors).  In addition to an industry example like automobile manufacturing, one can think of company specific examples like Dell or Hewlett Packard or Yahoo.  All were dominate within their industry until they failed to keep up with changing times.  

Changes in the factor of production can include changes in the cost of supplies, or changes in the cost of wages, or changes in other elements used in producing or delivering products and services. As one example, some products depend more heavily on oil in their manufacture.  As the price of oil changes, so do the costs of these products.   In many cases, mergers occur to capitalize on these changes.  Vertical mergers will occur as bidders seek to control supply, reducing uncertainties and costs in the process.  Horizontal mergers will occur to erase overcapacity and develop economies of scale

Competition from unexpected sources occurs as new competitors enter what was once a protected business environment.  This could be accompanied by a shift in regulation like increased interstate banking or from the entry of foreign companies into what was primarily a domestic market.  It also happens when products are suddenly put to additional uses that infringe on new territory.  For examples, think of how the various applications for the cell phone have eroded traditional markets.  Garmin once profited by selling stand alone GPS units, now a smart phone application does the same thing.  

Changes in technology cause firms to adapt or become obsolete.  Polaroid and Kodak are good examples.  Banking is facing overcapacity with the advent of the internet.  I sometimes challenge executives to think of the new products and services that have existed only in their lifetime.  They mention Personal Computers, the Internet, Digital Cameras, and even things like Rock and Roll and Viagra!  Each new product and each new technology is a catalyst for change and a potential force for mergers in a particular industry.  (See our related posts on Do Unto Yourself and Anticipation, Acquisitions and Bidder Returns as well as posts on Dell and HP.)

Obviously, many of these catalysts are interrelated.  New smartphone applications that reveal calorie counts on specific food items can lead to shifts in consumer tastes.  Similarly, scanners on smart phones may lead customers to buy online, a new source of competition.

Any of these or other catalysts can lead to merger either for a particular firm or for an entire industry.  We'll follow up down the road with a related post on merger waves.  

All the best,


1 comment:

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