Superior value and associated risks in revenue-based M&A

(Excerpts from Chapter 3 of “The Art of M&A Strategy”, Smith & Lajoux, McGraw-Hill, New York, 2012.)

Revenue growth remains a key driver of strategy for most companies despite the challenges it brings. To be sure, bigger is not necessarily better, as the bankruptcies of titans have taught us. Yet growth in revenues does tend to be associated over time with growth in value—measured as returns to shareholders. In Grow to be Great: Breaking the Downsizing Cycle,[1] authors Dwight Gertz and Joao Baptista foresaw the limits of profit improvement without growth. When the book was written in the mid-1990s, many American corporations were obsessed with cost cutting to improve profits and boost stock performance.. However, they were not seeing a commensurate improvement in shareholder value over time. The book demonstrated conclusively that the most successful companies achieve top-line as well as bottom-line growth, and the market disproportionately rewards growth in revenue over growth in profit.

Importance of Revenue Growth

When the market values a company, it is valuing both its current performance and its future potential. Because the potential for cost cutting is finite (i.e., limited by the cost base), cost cutting offers at best a diminishing return without corporate growth. As Gertz and Baptista put it, “You can’t shrink to greatness.” However, as the top line grows so grows the potential for future returns.

This observation is borne out by the mathematics of valuation. While companies use a variety of approaches to valuing a company,[2] most valuation experts emphasize the net present value of future free cash flows.[3] Free cash flows (FCFs) are the cash a company will have left after debt payments, taxes paid, operating expenses, and capital expenditures.[4] While FCF is correlated with earnings in the long run, FCF is “real money,” whereas earnings are based on the particular accounting applied to cash and noncash items such as deferred revenue and capital depreciation.

Intrinsic value is generally calculated based on a few years of known or predictable FCF performance, plus the continuing value, where continuing value is the present value of ongoing FCFs based on certain assumptions about sustainable growth and performance trends. The standard formula for continuing value is FCF/(WACC – g), where

  • FCF is the first year FCF is expected to grow at rate g
  • WACC is the weighted average cost of capital (i.e., the discount rate to be applied in the net present value (NPV) calculation)

Note that FCF’s relationship with continuing value is linear. For example, a 10% higher assumption on FCF yields a 10% higher continuing value. However, continuing value is affected geometrically by g. In fact, as g approaches WACC, the continuing value approaches infinity.

Mathematics aside, this also makes intuitive sense. Potential returns are bounded by revenue. Growth in revenue releases that constraint. So an expectation of strong and continuing growth in revenue represents substantially more value creation potential, provided profitability is maintained.

The Risk Associated with a Growth Focus

Many companies that have put growth ahead of profitability have failed. Indeed, bankruptcies have resulted when good ideas have grown the company beyond its financial capacity, whether organically or through acquisitions. To cite an old proverb, the companies’ reach exceeded their grasp. Two examples will illustrate this point: Olympia & York and Allied Federated. 

Olympia & York

The Olympia & York Canary Wharf story illustrates the risks in organic growth. Olympia & York grew from a porcelain tile company in the 1960s into a highly successful commercial real estate developer by the late 1980s. It had major development projects in Toronto (First Canadian Place, the largest office development in Canada at the time); Manhattan (245 Park Avenue in midtown, three of the four towers of the World Financial Center, as well as One Liberty Plaza), and Boston (53 State Street). They also had corporate holdings including controlling interest in Sante Fe Railroad and the pulp and paper company Abitibi-Price.

The next big project was the development of Canary Wharf in London, a well-conceived but ill-timed project. Olympia & York acquired 71 acres along the Thames to expand London’s financial services industry beyond the City of London. The project was to build nine million square feet of office space that would accommodate nearly 50,000 office workers.[5]

This strategy proved overly ambitious. First there came the recession in late 1989. Second, somewhat related to the recession, London delayed the development of the London Underground to Canary Wharf—postponing a public transit link that was critical to gaining advanced lease commitments from tenants. Third, the recession so affected the value of Olympia & York’s other holdings that it could not access invested capital. Notwithstanding what has since proven to be truly visionary development of London’s Canary Wharf, the company ran out of cash and had to file for bankruptcy protection in 1991. (The company has since reemerged as a smaller player in real estate development but no longer holds most of its earlier prized properties.)

Note that this was not a reckless company; it was an otherwise well-run company highly respected in the financial communities of Bay Street, Wall Street, and the City of London. However, any investment in growth comes with some risk, and in this case the company was bankrupted by a confluence of negative events its leaders failed to anticipate and plan for.

Allied–Federated

The Allied–Federated department store merger serves as one example among many of the risks of growth through M&A. Allied had been founded in 1935 to succeed Hahn Department Stores, Inc., a holding company that managed Boston’s Jordan Marsh stores, among others. In 1950, Allied had been instrumental in the establishment of the first regional shopping center in the United States and had acquired the Stern Brothers and Block’s department stores over the course of its history. Federated had also grown through acquisition. Founded in 1929, it subsequently acquired the Bloomingdales and Burdines chains.

In 1986, Campeau Corporation saw the opportunity to merge Allied with Federated Department Stores. Allied was acquired for $3.6 billion in a hostile, debt-financed takeover. The combined company then acquired Federated in 1988, also financed with debt. This created a massive retail conglomerate with opportunity for significant cost and revenue synergies. However, as already noted, in 1989 a recession cooled the retail market and depressed the cash flows intended to finance the debt. Federated and Allied filed the second-largest nonbank bankruptcy on record and entered the largest, most complex restructuring in the retail trade. Federated emerged from bankruptcy protection in 1992 and subsequently acquired Macy’s, Broadway Stores, and Fingerhut. The company was renamed Macy’s Inc. in 2007.[6]

While the circumstances of these two examples were very different, these bankruptcies have the following in common: (1) good concepts with high potential for value creation through growth, (2) large upfront investment required exposing the company to unforeseen circumstances, (3) a confluence of events delaying the cash flows.

Short-termism Drives a Focus on Cost Cutting

With the constant pressure on CEOs to improve performance, cost cutting offers short-term results that can be directly achieved by management. Top down direction can accomplish staff reduction and reductions in marketing and expense budgets almost immediately, whether or not such reductions are in the best interests of the corporation over the long term.

In contrast, revenue growth takes time and investment and usually introduces additional risks. Organic growth may require investment in new products or facilities, the launch of new marketing or branding initiatives, expansion of the sales force, or entry into new markets, all of which require time to make an impact and none of which are guaranteed to work. Even if successful, such initiatives often pay off for the successors of the current management team. For example, many of the CEOs that took their corporations into China in the 1990s, such as Jack Welch of GE in 2001 and Matt Barrett of Bank of Montreal in 1997, were well ahead of their competitors and the payoff. They knew they had little hope of a return on their watch, but these investments ultimately paid off handsomely for their successors or their successors’ successors. Few leaders today take such a long-term view, due in part to the short-term nature of the markets.

Even in acquisitions that offer both revenue growth and cost reduction opportunities, the greater focus is usually put on the cost reduction opportunities introduced by the merger. The cost reduction measures can be directed top down and have immediate impact. For the experienced acquirers in the US bank consolidation, for example, postdeal staff reduction was down to a routine. Signet Bank employees were notified within 48 hours of the close of the acquisition by First Union in 1997 as to which day employees at each level of the hierarchy would find out their fates—top level week 1, second level week 2, and so forth, whereas the revenue synergies in these mergers were seldom achieved at all.

Given the challenges and risks, in Part II we look at specific revenue-based M&A strategies that work, including successful examples.

Notes

[1]. Dwight Gertz and Joao Baptista, Grow to be Great – Breaking the Downsizing Cycle, (New York: Free Press, 1995) .

[2]. For an explanation of all the accepted approaches, see Robert A. G. Monks and Alexandra R. Lajoux, Corporate Valuation for Portfolio Investment: Analyzing Assets, Earnings, Cash Flow, Market Value, Governance, and Special Situations (New York: Bloomberg/Wiley, 2011). For data on prevalence of use among public companes, see the 2011 Public Company Governance Survey, reporting the following usage of valuation techniques for 1,300 public companies (multiple choices allowed) for the purpose of compensation. The survey asked “When linking pay to corporate performance, how do you define ‘performance.’” The answers were as follows: profits 67.5 percent, sales 45.2 percent, ratios such as EPS 34.8 percent, cash flow 33.9 percent, stock price 30 percent, hybrid measures such as EVA or CFROI 16.1 percent, assets, 11.3 percent, other 21.5 percent. The survey aslo reported on the prevalence of nonfinancial metrics such as customer satisfaction, employee morale, and diversity.

[3]. See Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies (New York: Wiley, 2010). Valuation provides an explanation along with empirical evidence that market valuations correlate strongly with intrinsic value, calculated as the net present value (NPV) of future cash flows.

[4]. Of course, the challenge in valuing future cash flow lies in predicting the future in the first place. As William Phillips has observed, “cash flow analysis is in essence discounting a series of known or estimated payments and receipts, ranged over a time scale, at interest either to obtain a present value (positive or negative) at a given interest rate, or valuing them at various rates to derive a yield that equates the present values of payments and receipts.” Cited in Monks and Lajoux, op. cit, note 3

[5]. “Olympia and York Moves into London,” New York Times, July 18, 1987, accessed October 9, 2011 from http://www.nytimes.com/1987/07/18/business/olympia-york-moves-into-london.html?scp=10&sq=Olympia%20and%20York&st=cse

[6]. “Federated Shareholders Approve Name Change to Macy’s Inc.”, company press release May 18, 2007, accessed October 9, 2011 from http://phx.corporate-ir.net/phoenix.zhtml?c=84477&p=irol-newsArticle&ID=1004322&highlight