Why Do a Merger or an Acquisition?

There are many surface-level reasons for a merger or acquisition, but they all come down to the desire of management to improve the company's overall financial performance. Getting to that state of improved performance usually involves either internal (organic) growth, external growth through mergers and acquisitions, or both. Corporate leaders have been under increasing pressure to deliver growth and strong financial performance for many years. Especially when companies have already experienced substantial growth in their corporate history, and the demand for their products and services has waned, company executives have become accustomed to looking for growth through mergers, acquisitions, joint ventures and strategic alliances. The avenues that companies take when using acquisitions and mergers to achieve growth typically fall into one of the following categories: Growth in business scale, expansion into adjacent business domains, acquisition of new technologies, restructuring the existing business, or in a few cases, redefining the company's entire industry. It is useful to understand the motivations behind management's decision to pursue each of these avenues.

Growing the Scale of the Business

The most common reason cited by business for merging with other companies and acquiring other companies is growth in scale. Many companies have used these mechanisms to achieve industry leadership positions as a means of gaining competitive advantage. Growth in scale can be undertaken to achieve these advantages on several levels. Perhaps the highest possible level for such acquisitions is the one employed by General Electric, who has managed to diversify into an extremely broad number of industries through acquisition. The approach used by General Electric was to acquire companies that would immediately move them into leadership positions in the new industry. They generally moved to acquire companies that, with their additional reach and revenue streams, would move them into the ranks of the top few contenders in markets where GE already owned a business.

Most companies participating in an acquisition, however, are attempting to grow the scale of the company within their own primary industry. Often, these companies have concluded that organic growth is unlikely to yield the magnitude of growth in revenue and/or market share that they desire as quickly as an acquisition would. In some cases, that difference is not compelling enough for companies to invest the money and effort to do an acquisition. However, companies often perceive that there is a limited window of opportunity for their company which can only be exploited effectively if it is exploited quickly. Internal expansion often involves the development of technologies, distribution channels, and customer relationships which require months-long or even years-long gestation periods. In that time, competitors can eat away at the available opportunity, and momentum will be lost.

Even in cases where a company has developed a new product or service offering that provides a distinct competitive advantage over others in their industry, the time horizon of that advantage is always limited. The intellectual property protection that exists in the form of trademarks and patents will expire, and even before that occurs, other companies will develop competing technologies and offerings.

Geographic growth is often much more readily achieved through business acquisitions than through organic expansion, offering companies a relatively speedy way to capture new sales territories, distribution channels, and manufacturing sites in the heart of the targeted customer base. Especially when expanding into new countries, the acquisition has proven for many to be a lower risk way to achieve the desired foothold than building facilities, hiring and training staff, and learning the ropes of marketing into a different country from scratch.

Advantages offered by using acquisitions to reach this grander scale include heightened brand awareness, broader distribution channels, and greater purchase volumes (resulting in material and service cost reductions). These advantages, in turn, often make it more difficult for smaller competitors to produce adequate returns from participating in those same markets, since their cost of doing business without those advantages is comparatively high. In this situation, these smaller competitors often retreat from the markets, and sometimes go out of business entirely, resulting in even greater market share available to the new entrant.

Beyond these advantages, shareholders and Wall Street analysts generally expect most mergers and acquisitions to produce additional benefits stemming from synergies that enhance profitability. They anticipate that these synergy-based improvements will emerge from the combined strength and skill set of the newly formed enterprise[1]. Unfortunately, these synergy-based performance improvements fail to materialize more than half of the time. (One former CEO of a major aerospace & defense company that I interviewed recently was emphatic about this. His assertion was that synergy-based projections of improved financial performance are never an adequate reason on their own to justify the risks associated with a merger or acquisition.) All over the world, there is a great deal of skepticism in leaders who have been down this trail about synergy-based justifications for M&A activity.

Expanding Into Adjacent Business Domains

Another reason cited by companies that initiate M&A activity is movement into an adjacent market. Some of the most active companies in the field of acquisitions (GE, Emerson, Charles Schwab, Reuters for example) have done so largely to expand into market segments adjacent to those they previously served. IBM's acquisition of PWC in October of 2002 was such a move, bringing the already significant consulting base of IBM to a real "player" level in the management consulting realm. In many such cases, a major underlying motive is entry into market segments considered by management to be more profitable than the markets currently served. Especially in cases such as those mentioned earlier, where companies have encountered a stagnant period after enjoying a period of growth, management is often easily drawn to perceived "greener pastures".

Of course, along with the opportunities associated with such moves, significant risks are involved. Probably the biggest risk is that the profitability of the targeted market segment is temporal. It may not last, or it may at least be seasonal or cyclical in nature, leaving the post-acquisition enterprise bigger without having commensurately greater revenue or - even more commonly - without having commensurately greater earnings. The basic economic principle that provides above-average returns to companies in difficult-to-enter markets serves to challenge those companies who seek entry into these market segments - even when they are adjacent ones. Adjacency certainly softens that obstacle, but many of the challenges that comprise barriers to entry remain. Still, the expansion into adjacent markets is an increasingly popular reason for acquisitions. One example of a company that has employed this device effectively, and continues to do so, is WebMD.

Acquiring Intellectual Capital and/or Technology

Another reason cited for acquisitions with some regularity is the capture of new technologies or intellectual capital. Certainly, access to a disruptive technology that greatly enhances the product or service offerings of the company is very attractive to companies seeking competitive advantage. During the course of my interviews in preparation for writing this article, the capture of an enabling technology or intellectual capital was often listed by C level executives as one of the best reasons for moving ahead with an acquisition. It serves to gain the competitive advantages of the new technology while denying them to competitors. As we discussed previously, when the new technology makes a critical difference in the marketplace, it is important to capture it as soon as possible. The acquisition is often regarded to be a much faster approach than attempting to develop a competing technology internally, and in some cases, it may be the only practical path to achieve the desired offering in time to capture the bulk of future demand.

One fairly recent example is the Johnson & Johnson acquisition of Inverness, a company specializing in products such as blood testing devices for self-management of diabetes. In their press release on May 23, 2001, James T. Lenehan, Johnson & Johnson's worldwide chairman of their Medical Devices and Diagnostics Group, is quoted as saying: "Inverness has a very strong near-term pipeline of blood glucose meters and test strips; and a promising long-term pipeline of emerging new technologies."[i] Especially in the post-internet era, there has been a propensity for high-tech companies to utilize this approach. Some companies in recent years have basically replaced internal R&D with a systematic process of scanning the horizon for applicable and desirable new technologies that would enable them to expand into additional lines of business or substantially heighten a competitive advantage in existing lines, and acquiring them. Cisco and Intel are good examples of this phenomenon; they have both made the process an integral part of their growth strategies.

Restructuring the Business

There is often a close relationship between the advent of new technologies, the general restructuring of an industry, or the emergence of a new body of knowledge and the need for companies to move quickly toward re-inventing themselves. If the management team of a typewriter manufacturing company did not recognize the move toward word processing in the 1970s, for example, its days were numbered. There are times when the existing leadership team of a company simply lacks the technology-specific education, knowledge, and skills to get the company through a period of disruptive change and onto a new operating platform. In these cases, it may behoove the owners of the company to merge with or acquire a company that understands the new technology and the new business environment, in order to transition rapidly.

We have seen more of this activity as technology has advanced. Certainly Cisco and Nortel have both exhibited this type of behavior between 2001 and today. But many other examples exist in different industries, including healthcare and financial institutions. One example of a company that utilized acquisitions as an opportunity to restructure its service offerings is UMB Bank.

Redefining the Industry

The incidences of using acquisitions and mergers to reconfigure the playing field for an entire industry are fewer, but they are still quite significant. This occurs when a company changes the boundaries of competition, reconfiguring its own business to incorporate elements that yield an intrinsic competitive advantage. When this happens, competitors are usually forced to emulate the new business model of the disruptive enterprise, and the leader in these cases almost always has a sustainable advantage in the marketplace.

Certainly, one of the most familiar and frequently cited examples of this phenomenon is the merger of AOL and Time Warner, which some analysts believe to be the harbinger of a restructuring in the communication and entertainment industry. I think a stronger example is the $6.6 billion acquisition of Medco Containment Services in 1993 by Merck & Company. At the time, Merck was the largest pharmaceutical company in the world, and Medco was the largest prescription benefits company. Merck leadership became aware that decisions related to which drugs were being prescribed for use by patients was increasingly influenced by managed care organizations, and that the decision-making power of physicians in this realm was diminishing. Through their acquisition of Medco, Merck was able to market much more effectively to managed care providers. The result? Competitors were forced to follow suit, with Eli Lilly purchasing PCS Health Systems for $4.1 billion in 1994 and Roche Holdings acquiring Syntex Corporation for $5.3 billion in 1995.

Diversification and Conglomeration

Diversification is the process of growing through expansion into markets outside the company's existing industry category. Especially prevalent during the 1960s, many companies in that era pursued diversification strategies to attempt to become business conglomerates. It was, unfortunately, also characterized by what some refer to as "creative financial techniques that temporarily caused the acquiring firm's stock price to rise while adding little real value through the exchange."[ii] The results of the bulk of the mergers and acquisitions centered on diversification that were executed in that era did not fare well, and as a result, many of the conglomerates formed during the 1960s were the fodder for spin-offs and divestitures over the following two decades. General Electric probably stands as the single greatest exception to that syndrome. GE diversified into markets that truly are diverse, spanning aircraft engine production, insurance, television networks, plastics manufacturing, and medical equipment. They were exceptional, at least in part, because of their sheer size. GE was able to acquire companies that put them in a top tier position within an industry, typically in industries where they already had a small holding that provided some experience. Most companies participating acquisitions simply do not have the financial wherewithal to take that approach. This same process has proven successful for other companies as well, including Allied Signal.

However, looking at the broad population of companies that have attempted to become conglomerates through acquisition-based diversification, it is clear that few are very successful. One study performed by Ravenscraft and Scherer carefully examined the performance of stock prices for the top 13 conglomerates that had grown substantially as a result of widespread acquisitions during the 1960s. The results demonstrated that, by 1988 (the year the study was published), only three of the thirteen had really performed well. Another three performed slightly better than the S&P 500, and all the rest were worse performers.[iii] Other subsequent research projects that appeared to indicate superior performance in companies with diverse industry participation, such as Elgers' and Clark's study in 1980, were also interesting in the sense that they revealed a higher return to shareholders when the conglomerates' industry holdings really reflected horizontal and vertical acquisitions rather than acquisitions that moved completely outside existing industry experience.[iv] Finally, a larger study conducted by Berger and Ofek covering merger and acquisition activities occurring between 1986 and 1991, concluded that diversification resulted in a loss of firm value that averaged 13% to 15%.[v]

Types of Synergy Pursued Through Acquisitions and Mergers

The existence and the value of financial synergy has been a matter of controversy in corporate financial circles for many years. Nevertheless, it is a key element in the business case for most merger and acquisition activities. These business cases are designed to sell the deal to outside investors, and to shareholders of both of the companies involved.

Revenue enhancement is often a primary objective of acquisition and merger activities, and it is among the objectives most often achieved. Companies take many different avenues in pursuit of revenue enhancement objectives as they acquire or merge with other businesses. Cross-selling between the newly paired product lines, broadened brand-name application to increase market acceptance of fledgling lines, expansion into additional geographies and bundling of services and products are common approaches.

One example from the telecommunications industry of late was the acquisition of Cable & Wireless America by SAVVIS Communications in March of 2004. A SAVVIS Communications press release describing the event said: "ST. LOUIS, MO. - February 22, 2005 - SAVVIS Communications Corporation (NASDAQ: SVVS), a leading global IT utility, announced today that revenue for the fourth quarter of 2004 totaled $166.3 million, up 140% from $69.4 million in the fourth quarter of 2003. Results for the 2004 quarter included revenue attributable to the Cable & Wireless America ("CWA") operations acquired in March 2004."[vi] In SAVVIS' case, operating margins also improved dramatically.

However, as is common in such cases, the costs associated with performing the acquisition were substantial, and the enterprise remained in a net loss position at the end of the following year: "For the full year 2004, revenue totaled $616.8 million, compared to $252.9 million in 2003. Gross margin doubled, to $178.9 million in 2004 from $89.3 million in 2003. SAVVIS' consolidated net loss for the full year 2004 was $148.8 million, compared to $94.0 million a year earlier. The loss in 2004 included $27.7 million of acquisition and integration expenses specifically related to the integration of CWA operations. Adjusted EBITDA of $14.4 million was a $15.6 million improvement from negative Adjusted EBITDA of $1.2 million in 2003."[vii] More interesting, in my view, are two numbers that did not appear in the SAVVIS press release. While gross profit did indeed increase from $89.3 million to $178.9 million, gross profit margin dropped from 35.3% to 29% in that same period. Still more important to shareholders, the diluted earnings per share (EPS) from continuing operations dropped from a negative $1.34 per share to a negative $1.64 per share.[viii]

Cost reduction is the second most commonly cited reason for merger and acquisition activity, and is generally tougher to achieve for many industries, because it requires substantial effort, as opposed to the mere combination of revenues from previously independent entities. Such synergies can arise from economies of scale; decreases in unit costs that are derived from an increase in size (revenue). This benefit usually results from the larger purchasing power of the newly expanded company. They may also arise from reductions in the total number of employees and other business assets in the combined enterprise operation, as redundancies in the business are identified and eliminated.

These opportunities are easier to realize in some industries than others. For example, manufacturing companies often get to the heart of these efficiencies by identifying and fully utilizing enterprise-wide capacity of critical business processes, especially their most value-added manufacturing equipment, wherever it exists within the enterprise. Doing so requires an effective understanding of enterprise-wide processes and systems, and most companies simply don't have an adequate handle on these things. Other industries such as financial institutions often find it somewhat easier to gain similar efficiencies, when they are able to identify overlaps in territories and eliminate branches where those overlaps exist without significantly impairing customer relationships.

For example, in their Economic Letter of August 1999, the Federal Reserve Bank of San Francisco reported the results of a study conducted on more than 1,000 banks between 1985 and 1999. They observed that those banks who were involved in mergers during that period had achieved ROA improvements as a result of cutting occupancy and other noninterest costs: "After adjusting for accounting revaluations, bank mergers in 1993-95 shaved adjusted total noninterest expense by 0.1% of total assets, which is equivalent to a 10% boost in an ROA of 1 percentage point."[ix] The authors of the article, Simon Kwan and James Wilcox, concluded: "We find evidence that bank mergers have reduced operating costs. Both labor costs and occupancy expense are found to decline significantly after the merger."

Beyond the standard cost reduction and revenue enhancement benefits, there are other motivations as well. Many times, the expected series of events is that the combined cash flows of the merged companies will lower the volatility of enterprise level cash flow, stabilizing earnings and reducing risk. Acquisitions and mergers are expected to lower the cost of capital and thereby unit cost for the service or product delivered. But beyond the lower unit costs expected to flow from better asset utilization, larger companies often experience other benefits as a result of their size, such as better access to financial markets and lower costs related to raising capital.

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[1] Synergy is considered to exist when the sum of the parts (in this case, the combined business entity following a merger or acquisition) is more valuable and more financially productive than the two businesses were as independent companies.

[i] http://www.jnj.com/news/jnj_news/20020604_165439.htm

[ii] Patrick A. Gaughan, "Mergers, Acquisitions, and Corporate Restructurings", John Wiley & Sons, Inc., New York, 2002

[iii] David Ravenscraft and Fredrick Scherer, "Mergers and Managerial Performance", in John Coffee, Louis Lowenstein, and Susan Rose Ackerman, eds. Knights, Raiders and Targets (New York: Oxford University Press, 1988), pp. 194-210.

[iv] Peter T. Elgers and John J. Clark, "Merger Types and Shareholder Returns: Additional Evidence," Financial Management 9, issue 2 (Summer 1980), pp. 66-72.

[v] P.G. Berger and E. Ofek, "Diversification's Effect on Firm Value," Journal of Financial Economics 37, no. 1 (January 1995), pp. 39-65.

[vi] http://www1.savvis.net/corp/News/Press+Releases/Archive/SAVVIS+Reports+FourthQuarter+and+FullYear+2004+Results.htm

[vii]

http://www1.savvis.net/corp/News/Press+Releases/Archive/SAVVIS+Reports+FourthQuarter+and+FullYear+2004+Results.htm

[viii] http://www.hoovers.com/savvis/--ID__99142,period__A--/free-co-fin-income.xhtml

[ix] http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-25.html

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Management consultant Bill Duncan helps companies boost their earnings through aligning and strengthening their business processes and information systems. To learn more about Bill Duncan's new book, Enterprise Optimization: Making Acquisitions Pay Off, visit http://www.earningsperformance.com/. There you can get his report: The Secret Path to Improve Earnings (a $19.95 value) absolutely free!