Monday, February 17, 2014

Synergies: Dreams or Nightmares?

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.


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