Class 2 - University of Southern California
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Transcript Class 2 - University of Southern California
Module I: Investment Banking:
Mergers and Acquisitions
Week 3 –January 26, 2006
J. K. Dietrich - FBE 532 – Spring 2006
Motivation
Many
companies are in the process of
restructuring
– What are the major forms of restructuring?
– What motivates corporate restructuring?
– What are the consequences for investors and
for firms?
J. K. Dietrich - FBE 532 – Spring 2006
Overview of Restructuring
Two
Major Forms
– Expansion (Combining assets through M&A)
– Contraction (Breaking-up assets through
divestitures etc.)
– Other Forms
» Changing ownership structure (LBOs, buybacks,
etc.) and retaining control through defensive
strategies (Poison pills etc.)
J. K. Dietrich - FBE 532 – Spring 2006
Expansion: Mergers & Acquisitions
Merger:
the absorption of one firm by
another
Acquisitions: purchase of a firm’s voting
stock (tender offer)
Takeovers: Transfer of control from one
group of shareholders to another
– by merger, stock acquisition, asset acquisition,
proxy contest or by going private
J. K. Dietrich - FBE 532 – Spring 2006
Acquisition or Merger?
Stock
acquisitions do not require
shareholder meetings or votes, and are
frequently hostile
– The acquirer deals directly with target’s
shareholders, bypassing management
– Minority shareholders may hold out in tender
offers; complete absorption requires a merger
J. K. Dietrich - FBE 532 – Spring 2006
Types of Mergers/Acquisitions
Horizontal
– Same industry and level of value added
– E.g. petroleum production
Vertical
– Same industry but different level
– E.g. petroleum production, refining, marketing
Conglomerate
– Different industries
– E.g. gasoline sales and mini-marts
J. K. Dietrich - FBE 532 – Spring 2006
What Explains M&A Activity?
The
stated objective of all mergers and
acquisitions is the creation of value
– Other objectives - e.g., managerial hubris - may
also play a role but are usually not the stated
rationale for an acquisition.
What
are the sources of value? Two types:
– Strategic
– Financial
J. K. Dietrich - FBE 532 – Spring 2006
Strategic Sources of Value
1. Under-managed Target
- Look for strategic and operating errors that can
be corrected by replacing bad management
2. Efficiency Gain or Synergies
- Reduce costs through economies of scale and
scope in production, finance, research,
marketing, and through other indivisibilities
- Increase demand or raise product prices
through gains in market power
J. K. Dietrich - FBE 532 – Spring 2006
Strategic Sources of Value
3. Opportunities for restructurings
– Divest or liquidate businesses with poor fit or
poor results
– Sell unproductive assets that are retained by
managers who cannot or will not shed such
value destroying businesses
J. K. Dietrich - FBE 532 – Spring 2006
Financial Sources of Value
Target is undervalued
– Markets are inefficient
» Forecasted improvements or changes are not
reflected in the stock price
– Unused gains from the use or sale of
accumulated tax losses from net operating
losses
– Unused debt capacity (“Leverage Bargain”)
J. K. Dietrich - FBE 532 – Spring 2006
Dubious Reasons for Acquisitions
Diversification:
– However, shareholders can diversify their own
holdings at lower cost and greater efficiency
through the financial markets.
Securing
access to inputs or sales of
output
– This may be valid, but presumes there are
inefficient or uncompetitive markets
J. K. Dietrich - FBE 532 – Spring 2006
Bad Reasons for Acquisitions
Creating
the Appearance of Growth:
– Growth for its own sake does not create value
Use
of Excess Cash:
Increased EPS:
– By buying companies with higher EPS than
your own you raise your EPS. Naive investors
may believe this to be “growth” even if this
destroys value
J. K. Dietrich - FBE 532 – Spring 2006
Example of EPS Growth Strategy
Company A has
1,000 shares outstanding
and EPS of $1
Company B has 500 shares outstanding and
EPS of $2
A buys B and now reports higher EPS of
$1.33
If A paid more than B was worth, A’s
shareholders lost although A’s EPS rose
J. K. Dietrich - FBE 532 – Spring 2006
Higher EPS Strategy
Company A acquires B
EPS
A
J. K. Dietrich - FBE 532 – Spring 2006
B
Company A’s
reported EPS
after
acquisition of
company B
A
Defenses against Takeovers
Divestitures
– Sales of assets
– Spinoffs or issuance of tracking stock
Amendments
to corporate charter
– Supermajority vote needed
– Staggering terms of directors
Self-tenders,
going private, leveraged
buyouts
Poison pills, white knights, golden
parachutes, etc.
J. K. Dietrich - FBE 532 – Spring 2006
Are Mergers Beneficial to Society?
Mergers
and acquisitions are usually
associated with layoffs and downsizing.
– This may or may not be associated with
increased economic efficiency.
But
M&A activity may facilitate exit from
an industry where there is overcapacity
J. K. Dietrich - FBE 532 – Spring 2006
Basic Argument
Suppose
that there are three firms whose
minimum efficient scale is 100 units
Average Cost
Efficient
Production
Zone
Price
J. K. Dietrich - FBE 532 – Spring 2006
67
100
Quantity
Example
Initially,
industry demand was 300 units, so
there was no over capacity
Now, demand has fallen to 200 and is not
expected to recover
Each firm produces 67 units, and makes
economic losses
The problem: If firm A exits, the benefits
are captured by B and C
J. K. Dietrich - FBE 532 – Spring 2006
Solution
Since
the benefits from exit do not accrue to
the exiting firm, each firm fights to stay on,
causing losses for all firms
Solution: If B (or C) were to takeover A,
the shareholders of A would capture the
external benefits from exit
In this sense, M&A activity is beneficial to
society.
J. K. Dietrich - FBE 532 – Spring 2006
Empirical Evidence
In
reality, most acquirers fare poorly with
modest declines in value
Targets receive most of the benefits of the
usually substantial run-up in price
associated with a takeover.
J. K. Dietrich - FBE 532 – Spring 2006
Example: Kodak and Sterling Drug
January
4, 1988: Hoffman LaRoche offers
$72 per share for Sterling Drug
January 18: Facing resistance, Hoffman
raises the offer to $81 per share
January 22: Kodak announces a friendly
bid of $89.50 per share for Sterling Drug
J. K. Dietrich - FBE 532 – Spring 2006
Price Reaction
Estimate
Kodak’s return net of the return
predicted by CAPM
The abnormal return is the actual return on
day t less the expected return
From CAPM, the expected return is
E[rt ] rf ,t (rm,t rf ,t )
J. K. Dietrich - FBE 532 – Spring 2006
Cumulative Abnormal Returns
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
12/2/87
J. K. Dietrich - FBE 532 – Spring 2006
1/22/88
3/18/88
Kodak Paid a High Premium
Value of Kodak’s Bid
$5.1
(in billions)
Less Sterling’s market
capitalization
$3.0
(30 days prior to
announcement)
Equals Kodak’s Premium
J. K. Dietrich - FBE 532 – Spring 2006
$2.1
..But Investors Were Skeptical
Kodak’s
market decrease was about $2.2
billion, almost the amount of the premium
paid for Sterling
Clearly, investors did not believe the deal
could add value. Why?
– Kodak’s past acquisitions were failures and it
was ignoring its core business
J. K. Dietrich - FBE 532 – Spring 2006
Why Do Acquires Fare Poorly?
Overbidding
– Over-optimism or Winner’s Curse
– Managerial hubris
» Mergers increase firm size and hence managerial
compensation, without adding value
Poor
fit between buyer and seller
– Clash of corporate cultures
Ignorance
of target’s industry
Failure to integrate operations carefully and
fast
J. K. Dietrich - FBE 532 – Spring 2006
Example of Winner’s Curse
Four
companies bid for mineral rights on
Federal land
True value is $100 million
Each company estimates value imperfectly
Valuations are unbiased, but noisy
J. K. Dietrich - FBE 532 – Spring 2006
Valuations
Company A:
Estimated Value is 80m
Company B: Estimated Value is 90m
Company C: Estimated Value is 110m
Company D: Estimated Value is 120m
– Average estimate is correct
J. K. Dietrich - FBE 532 – Spring 2006
Bidding
Second
price, sealed bid auction
The optimal strategy is to bid your
reservation price
Company D bids $120, and wins, paying
$110
Winner’s curse: Overpay by 10%
J. K. Dietrich - FBE 532 – Spring 2006
Can this be an explanation?
Winner’s
curse can explain over bidding in
this simple one-shot game
But in a repeated game, firms will recognize
this problem or learn from other’s bids
However, if takeovers are isolated events,
the winner’s curse may still hold
J. K. Dietrich - FBE 532 – Spring 2006
II. Contractions
In
the 1980s and 1990s, firms that operate
in fewer numbers of industries do better
than widely diversified firms.
Restructurings that result in more focus are
rewarded by higher stock prices
– Example: Dun & Bradstreet, a major
information provider, split in three. The stock
price reaction was positive, with a subsequent
rise of 8%
J. K. Dietrich - FBE 532 – Spring 2006
Why is Re-Focusing in Vogue?
Corporations
made several errors including
– Expanding into industries they didn't know
– Overestimating the gains from synergy and
diversification
– Complex structures allowed mistakes to go
undetected
– Internal conflicts arose over the allocation of
capital and direction of future projects
J. K. Dietrich - FBE 532 – Spring 2006
Types of Contractions
Spin-offs:
Creates a new legal entity;
shares are distributed on a pro rata basis to
parent’s shareholders:
– Separation of control over time without cash
flows. Example: In 1995, US West spun off its
cable and cellular businesses.
Split-off:
some shareholders get stock in a
subsidiary in exchange for parent stock
– Immediate separation of control
J. K. Dietrich - FBE 532 – Spring 2006
Spin-Offs
Previous shareholders
Original Firm
New Firms
A Spin-Off does not yield cash inflows
J. K. Dietrich - FBE 532 – Spring 2006
Motivations for Spin-Offs
In
recent years, spin-offs and split offs have
become increasingly popular as companies
try to “refocus” on their core business
– Example:
» ATT split up into three entities in 1995; NCR,
Lucent Technologies and ATT
J. K. Dietrich - FBE 532 – Spring 2006
Contraction: Divestitures
Divestitures:
Sale of part of the firm to
outsiders
Equity Carve-outs: Sale of stock in
subsidiary to outsiders
– In both cases, there is an immediate separation
of ownership and control
– The parent also receives cash inflows
J. K. Dietrich - FBE 532 – Spring 2006
Divestitures
Firm
Original
Owners
Assets
Cash
New
Owners
Divestiture is a Sale of part of the Firm
J. K. Dietrich - FBE 532 – Spring 2006
Example: VLSI and Compass
In
1997, VLSI Technology, a San Jose
based semiconductor firm had a whollyowned subsidiary, Compass.
Compass developed CAD/CAM-type
software to design new computer chips
Compass licenses its software for profit; the
parent company, VLSI, receives a
substantial price discount
J. K. Dietrich - FBE 532 – Spring 2006
Example: VLSI and Compass
VLSI
argues that divesting compass would
result in higher input costs for itself, putting
it at a competitive disadvantage.
But Compass executives believed that as an
independent company, it could license its
software to many other chip manufacturers
who are currently unwilling to pay a
subsidiary of their rival
J. K. Dietrich - FBE 532 – Spring 2006
What Should VLSI Do?
If
Compass is correct, a split-off would
have the following effects:
– Compass’ value would increase
» It could charge VLSI more
» It could sell more to other chip makers
– The new VLSI would be worth less
» It would have to pay Compass market prices for
software products
J. K. Dietrich - FBE 532 – Spring 2006
Case: Outcome
Since
the extra costs paid by VLSI upon
divestiture are equal to the extra revenues
of Compass, shareholders are no better or
worse off
But since Compass will have new sales,
shareholders would benefit from divestiture
VLSI sold Compass in 1997
J. K. Dietrich - FBE 532 – Spring 2006
Conclusions
Corporate
restructurings can take many
forms.
Restructurings are motivated by the creation
of value
But in practice, evidence suggests that
strategic and financial motives for
acquisition rarely produce value gains.
J. K. Dietrich - FBE 532 – Spring 2006
Next Week – February 2
Allocate
team tasks associated with group
write-up and do necessary work
Hand in Red October case write-up at the
beginning of class on February 2, 2006
Review contents of Chapter 19
Read and begin to identify critical financial
issues in the John Case Case discussed in
week 4
J. K. Dietrich - FBE 532 – Spring 2006