Valuing Synergies

It has been a banner year for mergers.  Currently, Reynolds American is seeking to acquire Lorillard, Inc.  Comcast and Time Warner are trying to combine.  Meanwhile, Time Warner is rejecting an offer from 21st Century Fox.  And, of course, we've seen a wave of Pharma mergers recently.   As we've mentioned, the maximum premium a bidder should pay for a target is the net present value of the deal. Of course if you pay this amount, you are giving away all your expected value. Bargaining is the key to the division of gains.   But today's post is not on bargaining but on synergies, generally a large component of the NPV and unfortunately, often overestimated.  Because of their importance, we have written frequently about valuing synergies (See, for example, Synergies and Anticipating the Competition).  

There are three basic types of synergies: revenue enhancement, cost reduction and financial synergies.  Revenue enhancement derives from expanded market power, the ability to expand markets, and the ability to increase prices.  Cost reductions come from economies of scale, eliminating duplicative positions, tax reductions and increased power in bargaining for supplies.  Financial synergies are controversial.  In theory, they derive as the new firm is better able to bargain for financing, reducing the cost of capital.  While this is possible, there are many dangers in estimating financial synergies. (See, PE Magic).

Here are just a few of the many things to keep in mind when estimating and valuing synergies:

1) Synergies are often over-estimated.  Ask yourself why these synergies exist and why no one else has exploited them.

2) If there is disagreement among the executive team as to the amount of synergies, consider tying compensation to their realization.  That simple technique can have a sobering impact on the magnitude of estimates.

3) Remember you are not operating in a vacuum.  Consider how the competition will react.  (See Synergies and Anticipating the Competition).

4) Value synergies at a rate commensurate with their risk.  Safer, more certain, synergies can be discounted at a lower rate.

5) Don't forget point (1) or Warren Buffet's parable of unresponsive Toads kissed by managerial princes.  (Acquisition Returns and Unresponsive Toads).

Happy Hunting,

Ralph

Comcast-Time Warner Cable Acquisition and The Whole Deal Concept

The Comcast (COM) Time Warner Cable (TWC) Acquisition illustrates the importance of looking beyond just price to the whole deal when evaluating M&A. As Ralph likes to note, you can name the price if I can name the other terms, and I will win every time. As such, this complements Ralph's Post on the Comcast-Time Warner transaction by focusing on the tradeoff between deal price and non price terms.

TWC had been pursued by Charter Communications (CC) for months resisting three unsolicited bids-the last being a cash and stock offer valued at $132.50 per share. This February, COM surfaced as a White Knight with an all stock deal then valued at $158.82 per share for a total of $45.2B. That price was close to the $160 mentioned by TWC’s management as full value. Since that announcement, COM’s stock price has dropped almost 10% reducing the per share price to $143.55 per share-just 8% above CC’s last bid.

The COM deal is a Fixed Exchange Ratio (FXR) offer-2.875 shares for each TWC share.TWC shareholders will own 23% of the combined firm. Under a FXR the number of shares is fixed, but their value, and hence the transaction’s value, is not determined until closing. The seller bears the risk of a drop in the buyer’s share price until that time. It can gain, however, should the buyer’s stock appreciate. FXR are more common, as opposed to floating exchange ratio structures.

TWC could have mitigated its COM price risk by negotiating for a Collar specifying a range around the initial value within which the price could move. Collars are used in 15-20% of FXR deals. Another interesting feature is the absence of a break-up fee from COM to TWC should the deal not receive anti-trust clearance-which is a real concern here given the size of the firms.  My observations are:

1)     TWC wanted to get as close as possible to its stated full value of $160 per share to distance           itself from CC’s “inadequate” $132.50 price.

2)     Collar and break-up features are valuable options. COM’s offer price would have been                   negatively impacted had TWC insisted upon these protective provisions.

3)     TWC willingly gave up the protection to achieve a higher nominal share price.

4)     TWC’s bet has not worked out and the deal may be endangered. COM is increasing the size of         its share repurchase from $3B to $5.5B post close to support its stock price. Who knows -  the         stock may actually increase in value before the close.

The bottom line is to focus on the whole deal when evaluating transactions. TWC and COM used non price features to help close a price gap. COM could top-up its bid by offering more shares and suffer the resulting dilution. This depends on how concerned COM is with losing the upcoming TWC shareholder approval of the deal due to its falling stock price.

J

Acquisition Risk, Collars and the Comcast Time Warner Deal

An article in yesterday’s Wall Street Journal illustrates one of the risks in stock swap acquisitions – by the time the deal closes the stock price of either target or bidder could change, sometimes dramatically.  What once looked like a good deal could now fall apart.  In this case, the article notes that Comcast’s stock price has dropped nearly 10% since the deal was announced, reducing the value to Time Warner shareholders from $159 per share to $144 per share.  The deal is set to close in the summer.   By that time Comcast’s price could recover – or it could drop further.  Meanwhile Charter Communications waits in the wings with threats to renew its own bids for Time Warner.

One of the topics that always draws considerable interest in our Acquisition Course in Amsterdam is how to mitigate risk in acquisitions.  In the case of the Comcast – Time Warner deal, the risk associated with the change in stock prices could be mitigated through the use of collars.   A collar, comes in various forms, but basically outlines how the value of an offer must change with variations in stock price at deal completion.

The two basic forms of a collar are illustrated below in a chart from an article by Micah Officer.   The formal names of Fixed Exchange Collar and Fixed Price Collar are illustrated graphically by the diagrams and humorously by Micah’s nicknames of Travolta’s and Egyptian’s, respectively.  (Presumably, one can imagine John Travolta striking a similar pose as panel A in Saturday Night Fever.)

Panel A shows the fixed exchange-ratio collar.  This is the most basic collar, setting a minimum and maximum share price at which a deal would be completed.  Imagine striking a deal somewhere in the middle of the chart on the sloped portion of the payoff line.  Small deviations in the bidders stock price produce deviations in the value received (paid) by target (bidding) shareholders at deal completion.  Both sets of shareholders receive some protection from extreme swings in stock price, however. If the bidder’s stock price has increased at deal completion, target shareholders gain and bidding shareholders pay more, but only up to a pre-determined threshold.  Beyond that threshold, the maximum price is reached, illustrated by the upper, horizontal line.   

Conversely, a drop in the bidder’s stock price at deal completion results in target shareholders receiving less and bidding shareholders paying less, but again, only to the point of a pre-determined threshold.  In this case, the lower barrier identifies the minimum value that target shareholders would receive.  Thus, bidders are protected on the upside and target shareholders are protected on the downside.

Perhaps more difficult to understand is the fixed price collar.  In this case the amount received and paid is fixed within a given middle range but varies at the extremes.  Thus, target and bidder are certain of the deal price in some (perhaps plausible) range.   Beyond the thresholds, however, target and bidding stockholders share upside gains and downside losses in response to changes in the bidder’s stock price at closing.   (Still, it is hard to imagine target shareholders suffering extreme losses on the downside without at least trying to walk away from the deal.)

In the case of Time Warner shareholders, there is currently no collar in place.  It will be interesting to watch the vote for approval in the summer if Comcast’s stock price remains low.

All the best,

Ralph

Comcast, Time Warner and the Myth of the Cable Industry

Last week Comcast (CMCSA) announced a $45 million dollar acquisition of Time Warner Cable (TWC).   The announcement sent shock waves through financial markets and raised numerous questions.    

For companies that compete in the same market, there are obvious concerns about future strategies.  Charter Communications (CHTR) for example, wanted to buy Time Warner and bid low.  There is some speculation that they would attempt to revise their bid, but it is not clear that Charter could (or would choose to) handle the increased debt that would come with such a revision. 

Other companies that compete in the same space (note I didn't say 'Cable Industry') have to wonder if further consolidations help them achieve their own potential.  Some have suggested CableVision could be a target or even that privately held firms like Cox Communications would be involved in acquisitions.

As investors, we also wonder about the market reactions to rivals of targeted companies and what it means for future acquisitions.  In our research, when a bid like this occurs, the prices of target firms react in direct proportion to the probability that they will become targets themselves. (See Abnormal Returns to Rivals of Acquisition Targets.)  

There has also been much talk about the regulatory issues such a combination would raise.  For regulators the concerns will be whether the merger is a restraint of competition resulting in predatory pricing of consumers.  We have noted in a previous post that one of the main tools for such an analysis is the Hirfindahl Index or the related Concentration Ratio. (See Concentration Ratios: The Case of Anheuser Busch and Modelo.)  

But in that post, we also note that to create a measure of concentration in an industry, one must first define the industry.  And that brings us to the myth of the cable industry.  In a very interesting article entitled, The Comcast-Time Warner Merger Is Not a Sign of Strength, Larry Downes makes a convincing argument that fears of market dominance here are overrated.  To quote, 

"There is no cable industry.  Cable is just a technology, increasingly one of many, for transmitting information, whether video, voice or data.

Where cable was once the only technology used to distribute television programming—a vast improvement in speed, quality, and quantity over antennas—it now competes with fiber, copper, satellite, and mobile broadband, each with their own pluses and minuses, and each promoted by companies large and small, who together continue to spend heavily to upgrade their assets."

Indeed, the story is so much more than a merger of cable companies, even well known companies.  It is another event in the evolving battle for the vast market for entertainment.

Stay tuned.

Ralph