Synergies can become one of the four big lies along with
“the check is in the mail”. Theoretically, they are just an expression of the
extra value a buyer can achieve from an acquisition target. They are key to
offsetting the premium paid to make the transaction work from the buyer’s point
of view. Unfortunately, they can be easily abused to justify over priced
acquisitions. In essence they can become the “plug” to legitimize any
transaction. As Warren Buffett notes “although many deals fail in practice-none
fail in spreadsheets”. I use the following tests when evaluating synergies:
1)
Premium: a premium exceeding 40% of the pre bid
target price is an indicator of the need for inflated synergies to make the
deal work-at least on paper.
2)
Projection Inputs: every valuation and its
underlying projections are based on six variables which should be compared
against the base rate-historical results and peers. The key variable are:
a)
Revenue Growth: revenue synergies are especially
suspect. Competitors have a nasty habit of quickly responding to attempted
market share gains.
b)
Operating Profit Margin Increases: cost
synergies are more believable than revenue growth. Nonetheless, integration
expenses and other unplanned items must be considered. Also, competitors may
crimp gross margins through decreased prices.
c)
Taxes: lower tax rate assumptions should be
questioned.
d)
CAPEX: growth requires supporting investment
infrastructure.
e)
Working Capital Increases: additional inventory and
receivables from growth should be expected.
f)
Weighted Average Cost of Capital (WACC): beware
of financial engineering and other sleights of hand. You should discount the targets cash flows at its unlevered cost of equity relevered for its new target capital structure-not at the acquirer’s WACC, which is usually lower.
3)
Reality Checks
a)
Value the Projections: if the value based on
believable inputs substantially exceeds the price, then ask why the acquirer is
so lucky to receive this generosity. The M&A market is relatively
efficient. Hence bargains are rare.
b)
Compensation: tie the projections into the
compensation of the deal’s proponents. They should be at risk just like the
acquirer’s shareholders.
c)
Covenants: bank loan covenants tied to the
projections for items including leverage and fixed charge ratios may give
management reason to reconsider its projections.
d)
Consistency: due diligence and integration plans
should support and be consistent with the synergy projections.
As President Reagan noted- trust, but verify. The same goes
for synergies.
J
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