Revenue Synergies in M&A – Part I

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

Strategy for a Consolidating Industry

(From “The Art of M&A Strategy”, Smith & Lajoux, McGraw-Hill, New York, 2012)

Many industries undergo periods of consolidation in which some companies identify opportunity to achieve competitive advantage through increased scale or scope, and others must follow in order to remain competitive. The opportunities are often triggered by changes in the market related to technology, globalization, or regulation that make larger scale or scope possible or more important.

It’s a compelling opportunity.  When companies in the same industry buy others to increase scale or scope, revenues are typically additive while costs are not. Simply put, it usually takes less than twice the costs to run a company twice the size in the same business. The availability of such cost savings has been the principal motivation of many corporate combinations.

However, such acquisitions have high failure rates, as measured by the shareholders of the acquiring company. Over the last 20 years of study, large acquisitions of in-market, like companies have proven 40% more likely to fail than other deals. It seems the greater the opportunity for cost synergies, the greater the failure rates. This is not to say that these combinations have not created value. Rather, the value has been transferred overwhelmingly to the sellers.

To develop successful M&A strategy for a consolidating industry, it is important to first understand why the industry will consolidate and what will drive value creation, and then to determine how to play based on opportunity and skills.

Triggers of industry consolidation

Most industry consolidations are the result of the natural progression of an industry through its life cycle from differentiation in growth to similarity in a mature or declining market. When companies start up, their value usually lies in offering something new and different to the marketplace. However, innovations tend to attract imitations, and profitable markets attract competitors. Products and services that were once unique become standard or even commoditized. Examples range from resource-based industries such as paper to consumer goods such as cell phones.

In fact, the economies of scale are so compelling in manufacturing that competing brands will source from the same factory in many industries (e.g., auto parts, home appliances, computer chips). Industries with expensive networks of infrastructure are natural monopolies, which is why regulators watch the consolidation of the railways and airlines, and why AT&T once had to be broken up.

Understanding what might trigger consolidation, or the next round of consolidation, can put a company in a position to influence or anticipate the change, and can therefore be the source of strategic advantage.

A downturn in the economic cycle is the most frequent trigger of consolidation as industry capacity suddenly becomes underutilized. That there will be another economic downturn is as certain as the next sunset, yet, when times are good, many players behave as if high prices will last forever. Those that plan for the next cycle and invest in efficiencies when they don’t have to, are more resilient to the cycles and typically become the buyers when the next downturn comes along.

Change in the relevant market is another common trigger of consolidation. Markets can become larger as a result of market integration across geographies or product categories. Free trade agreements, such as NAFTA, have triggered cross-border acquisitions. The emergence of larger consumer markets due to globalization has led to global brands and, in turn, advantages for global companies.  US bank consolidation, still ongoing, is the result of changes in interstate banking regulations twenty years ago. At the same time, integration of banking and insurance products has triggered bank-brokerage acquisitions in the US and bank-insurance mergers in Europe.

Value creation strategies, risks, and required skills

Opportunities to create value through consolidation exist along the value chain:

• In research and product development
• In operations,
• In sales and marketing.

Each of these three key areas warrants careful strategic consideration.

Research and development: While combining research and development functions across two companies reduces the cost of overhead in the short term, the more significant benefits come from managing R&D effectively across a larger, more diversified portfolio. This is best exemplified in the consolidation of pharmaceutical industry where strengthening the R&D pipeline has often been a primary motivator for mergers.

The primary benefit in the consolidation of R&D, (and most socially important in the pharmaceutical industry), is potential integration of good science to advance development. In addition to good science, however, there are several components of effective R&D management that can provide the strategic rationale for consolidation. There is first the opportunity to have a more proportional number of drugs at every stage of the pipeline. If one company has gaps in the R&D pipeline, then it cannot achieve a consistent pattern of revenue growth longer term. This clearly diminishes the net present value of that company through a lower growth rate and higher volatility (or beta) in future cash flows, and therefore a higher discount rate when projecting future cash flows. However, if the company combines with one that has drugs at complementary stages of the R&D pipeline, then the combined pipeline provides for both higher growth and lower volatility, and hence a lower discount rate. So complementary drug pipelines have more than an additive affect on value: 1 + 1 = 3.

The second R&D consolidation benefit lies in the fact that a larger laboratory provides more degrees of freedom for R&D optimization. One of the core competencies of R&D management is the ability to stop probable failures early and redeploy resources to higher-probability projects. The larger the lab, the more opportunities there are for effective redeployment, so all other things being equal, a larger lab, managed well, is more efficient.

Ultimately, the strategic opportunities in R&D consolidations relate to the ability to manage along a well-balanced pipeline, to better optimize deployment, and to diversify R&D risk. Mergers that fail in R&D consolidation can often be traced to poor skills in the fundamentals of R&D management applied to a larger combined lab or product development function.  Effective management of the integration process is also important and is a particularly subtle task in R&D, where culture and motivation are so fundamental to success.

Operations: Operations consolidation is usually about reducing unit costs through larger scale. Larger-scale operations can purchase more cheaply and benefit from scale economies in fixed manufacturing, distribution, head office and back office costs.

Cost synergies such as these are the most obvious and, ironically, the most illusive. The fundamental problem with operating-cost synergies is that, especially in a consolidating industry, the cost-synergy potential is easy to calculate and thus transparent to all possible bidders. A clear example is bank consolidation, where every bidder can count the branches and determine which ones would be rationalized. Since the market for corporate control is competitive, the value of these clear and calculable synergies will tend to be negotiated away in the bidding process. The “winning” bidder has often been the most aggressive about what synergies can be achieved and how quickly, and has bid accordingly, thereby transferring much or all of the value of the synergies to the seller and simultaneously setting savings goals that are nearly impossible to achieve.

Therefore, the operations consolidator must have superior implementation skills to win the bid and still create value.  Competitive advantage is most likely to reside in functions that are more difficult, and therefore less common, than simple asset rationalization.  For example, cost savings in purchased goods and services (e.g. office supplies, computer equipment and software, professional services, etc.) will be greater for the buyer with superior sourcing capability, where the best in the industry is often spending 15 to 20% less than others.

Another difficult function to consolidate is IT.   IT costs are somewhat less transparent than fixed assets and purchasing costs, and for most companies implementation of IT integration takes longer and achieves less than expected.  So again, the company with superior IT management skills and, in particular, a successful track record of IT integration, has a competitive advantage in a consolidating industry.

Marketing and sales: The cost synergies in marketing start with elimination of redundancies in the organization as the two organizations combine sales staffs. The savings in sales staff can be very substantial if there is a large sales force, whether it is a company sales force or is outsourced. Mergers of consumer goods companies illustrate this well. For example, if both companies market confectionary products, even if these products are not directly competitive, the merger can reduce sales calls by up to 50% because one visit to each retailer replaces what were two visits when the companies were separate.

There are also savings in marketing costs from consolidation of advertising agencies and, depending on how much the products were competing with each other, savings in advertising and promotion.

When the products and markets of the merging companies are complementary rather than overlapping, there are fewer cost synergies but the revenue synergies can be substantial. For example, the globalization of consumer goods markets provides many opportunities for merging companies with complementary product and geographic strengths to use each others’ marketing and sales channels to enter or better penetrate new markets. For example, the reach of Adam’s Brands expanded when Adam’s Brands was acquired by Cadbury in 2002 and again when Kraft acquired Cadbury in 2010.

Note that this is not a cost synergy, but a positive revenue synergy stemming from market integration. The revenue gain results from the companies’ products being somewhat different but with potential in each others’ market channels.

Notwithstanding the generally positive revenue synergies in complementary product–market combinations, the sales and marketing synergies in consolidation plays often turn negative due to revenue losses. Unlike cost synergies, which are under the control of the merging companies, revenue synergies are ultimately under the control of the customer. Again, superior marketing skills are required to derive such benefits and achieve strategic advantage in a consolidating industry.

Buy, sell or get out of the way

Companies can grow and prosper without acquiring or merging. McCain Foods Limited, Wal-Mart, and Research In Motion Limited (RIM) built leading international companies in food, retail, and technology, respectively, mostly organically. However, each of these companies had a new and distinct product or business model and was prepared to invest heavily in expansion.

Companies in consolidating industries that lack such a distinct advantage must buy or they will eventually be targets. Selling into a consolidating industry is not necessarily a bad strategy if the company believes that it can capture more value by selling and if the company prepares to be an attractive target.  Alternatively, some companies in consolidating industries retreat into a defendable niche, less subject to commoditization.  For example, some fine paper companies and ethnic banks continue to operate profitably without the economies of scale of the larger players.

However, the companies that can lead consolidation have the greatest potential to create value. For example, in the consolidating mining sector, handsome premiums were paid for Alcan, INCO, and Falconbridge, but these premiums pale in comparison to the value created in the development of mining consolidators such as Xstrata, BHP Billiton, and Barrick Gold. Belgium’s InBev Brewing grew from $3 billion to $60 billion by leading the consolidation of global brewing, eventually accumulating the financial strength to acquire America’s brewing giant Anheuser-Busch. There are many other successful acquirers that have built shareholder value in a range of consolidating industries: R.R. Donnelley & Sons Company in graphics, Magna in automotive supply, Thomson-Reuters in information services, Deutsche Telekom in telecommunications, Kraft in consumer goods and others.

Acquisitions are considered high risk, but in a consolidating industry, there may be greater risk for companies that choose not to participate. They will become subscale in the consolidated industry and, unless they operate in a defendable niche, they will become uncompetitive and ultimately unattractive as a target.

A more comprehensive treatment and examples can be found in Chapter 2 of “The Art of M&A Strategy”, Ken Smith and Alexandra Reed Lajoux, McGraw-Hill, New York, 2012.

BLACKBERRY SALE AND WHY EVERY COMPANY NEEDS AN EXIT STRATEGY

(Excerpts from The Art of M&A Strategy, Smith & Lajoux, McGraw Hill, New York, 2011, updated)

 

“You got to know when to hold ’em, know when to fold ’em,

Know when to walk away and know when to run.”

Kenny Rogers—The Gambler

 

Most companies have to consider acquisitions and divestitures at different stages of development. Ultimately, most companies will also be faced with an opportunity to sell the entire company, and in some cases there will be little choice if shareholders like the premium being offered.  Yet, many companies do not consider acquisitions, divestures or, in particular, the ultimate sale of the company as part of strategy development.

How should a company decide to be a buyer or a seller and when? A case in the business press at the time of writing serves to illustrate the importance and difficulty of these questions.

Research in Motion/Blackberry

Research in Motion (RIM), now known as Blackberry, is the company that invented the Blackberry pager. By any measure, the company was hugely successful up to 2010. The very idea of “push” wireless e-mail exchange on handheld devices was new when RIM was founded and launched the Blackberry in 1999.[i] The product quickly became an essential business communications device and was indeed the sole means of communications for thousands in the financial industry two years later during the tragedy of 9/11.

A tech startup from Waterloo, Canada, RIM passed $1 billion in revenue in less than five years and was operating worldwide. Wall Street was so dependent on and comfortable with the Blackberry that even as smartphones added e-mail capabilities at the millennium, the money men preferred to carry two devices on their belts rather than give up their Blackberries. Ultimately, RIM added telephony to the Blackberry, initially with a device that required a headset and then with integrated speaker and microphones in 2003. By 2006, the Blackberry was second to only Nokia in smartphones globally and dominated the US market.[ii]

RIM’s success to this point was in part due to its singular focus on serving the business segment. For example, RIM’s 2006 annual report stated that it provided “software and services to keep mobile professionals globally connected to the people, data and resources that drive their day” (emphasis added).

However, perhaps reluctantly, RIM was drawn in to compete with consumer offerings. In particular, Apple’s iPhone bridged the consumer and business markets and surpassed RIM and Nokia in sales.[iii] Blackberry responded with more consumer-friendly smartphones and a tablet to compete with Apple’s iPad. In the 2010 annual report, the earlier emphasis on the professional is muted, and RIM speaks more of “customers” and “consumers.”[iv]

By the middle of 2011, the market was indicating considerable pessimism about RIM’s future in this new competitive arena. RIM’s valuation fell about 50% from a year earlier,[v] and there was speculation that RIM could be a takeover target. Now, two years later, it has declared a refocus on professionals and laid off thousands of staff, discussions of stock value have turned to the value of patents versus a going concern, and it is desperately seeking a buyer to avoid a continuing death spiral.

This leads to a series of questions about if and when RIM should have sold or found a partner.

Should RIM have sold their patent or their company when they had merely proven the success of the idea? Most tech startups sell early, and the inventors and investors make a few million, perhaps to invest in their next venture. They leave the business-building and its rewards to others. The founders of RIM went on to create billions in value for shareholders by commercializing their invention, ultimately revolutionizing modern business communications.

Should RIM have sold when telephony became an expected feature of PDAs? While somewhat slow to respond, RIM developed telephony capability and became the leading smartphone in the United States for a time. Whether or not it was the intent at that time, the Blackberry smartphone also succeeded in penetrating the high-end consumer market.

Should RIM have sold when it became clear that the business and consumer markets would converge? This forced RIM out of its comfort zone and placed it in direct competition with the consumer tech giants.

Or should RIM have bought or merged? When its stock was a valuable currency, should RIM have sought business combinations in anticipation of the business-consumer market convergence? And if such foresight is unreasonable to expect, should it have acquired simply because it could, and because with the high valuations of its stock it could have acquired real options covering a range of market outcomes along with building greater scale and R&D capacity?

Moreover, did RIM need an exit strategy and/or an M&A strategy beyond its singular focus on the professional market well before facing the challenges of the past 3 years?

Our purpose is not to second-guess RIM’s strategy, which is too easy and perhaps unfair to do in hindsight, but rather to illustrate that these questions are relevant even for the most successful companies.

Learn from the Portfolio Companies

Portfolio companies buy and sell companies as a primary business activity. Their top executives have the advantage of being one step removed from the businesses in the portfolio, which can bring greater objectivity. They also face buy and sell decisions as often in a year as most executives do in a career.

Successful portfolio companies have a clear idea of how they will add value, well matched to the interests and competencies of the parent company. They understand the value of growth – how the cumulative size of such a company provides it with the means to raise cash and with the financial scale to look at larger deals. For the portfolio companies that are publicly held, a value-creating growth trajectory also supports high stock valuations, which reduces the likelihood of unwanted takeover.

Most successful portfolio companies define exit strategies in advance, with the possible exception of companies that actively develop synergies between or among their holdings. Berkshire Hathaway, for example, will hold an asset “as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.”[vi] GE’s mantra is to be first or second in each industry or get out. In the past three decades, GE has sold six out of ten acquisitions. Newscorp has grown by acquisition but has also sold hundreds of companies along the way.  Thomson’s transformation to an information services company (now Thomson-Reuters) was in part funded through the sale of its newspaper assets.

In all these examples of portfolio companies, there is a long-term view of shareholder value creation through pursuit of growth by acquisition, including defined sale criteria so that funds can be redeployed to the best use within the defined growth strategy.

The approach of the successful portfolio companies can be applied in most businesses. Looking at the company as a portfolio of assets can lead to new ideas for value optimization, including acquisitions and asset sales. Such an outside-in, objective view puts management in the role of the parent company of a portfolio of assets; that is, considering what the company is worth and what a dispassionate new owner would do to maximize value.

Consider the Sale Value of Every Asset

In theory, if selling an asset maximizes value then sale should be considered. Considering all assets as salable can change how they are managed, usually for the better. Public companies concerned about takeover sometimes conduct a portfolio review or “Raider Analysis” to pinpoint value gaps and divesture options. Most companies that undertake to restructure in this way don’t sell everything that could fetch a premium, but they usually improve financial performance of retained assets, become more tightly focused, and are better positioned for growth.

This also applies to the total enterprise. If the sale value is higher than the value the company can achieve by remaining independent, then sale or merger should be considered.  However, too many companies are let go for a premium over value “as is”, i.e. without adequate consideration for potential value.

The question really comes down to timing. On the one hand, consider that virtually every company will ultimately be sold in whole or in parts in the long run. Of the Fortune 500, only 62 companies have appeared on the list every year since the magazine began publishing it in 1955. Another 2,000 or so have come and gone. In a little more than half a century, 88% of what were the largest companies were gone from the original list: acquired, broken up, or shrunken. So in one sense it is not a question of if but when.

Taking a cue from the portfolio companies, the exit strategy should be considered even if there is no intention to sell in the short term. Considering the exit strategy can lead to good questions about how to maximize value. Every company that considers exit can then consider the optimal time and circumstances, and how to get to the optimal position and performance. In most cases, consideration of exit will result in more aggressive growth plans. Once a company determines that a strategic partner (i.e., a merger or sale) is necessary ultimately, it might accelerate growth and performance improvement programs so that they could be positioned well for a desirable partner.

On the other hand, most companies sell too early or cede industry leadership to a more ambitious competitor. More often than not, there is more value created in corporate growth than in invention and early-stage development. For example, when it comes to intellectual property, patents are valuable, but it is what a company does about its patents that determines long-term success. Part of the power of Thomas A. Edison was that he was not only in the laboratory inventing things, but he was also in the boardroom leveraging them.[vii] So his legacy is not only the light bulb but also in General Electric.

For mature companies in restructuring industries, there is yet more value created by industry leaders. Companies like Xstrata in mining, InBev in brewing, Kraft in consumer goods, Manulife in financial services, and Thomson-Reuters in information services have all created more value than the premiums of all the companies that sold to them combined.

Not every company can come out on top—there must be buyers and sellers—but every company should evaluate the buyer/consolidator option as well as the exit option and then weigh the returns against their competencies; the ambition of the company, its board, and its shareholders; the risks of trying and failing; the risk of selling too late; and the opportunity cost of selling too early.

By Ken Smith, Corporate Development advisor and author of “The Art of M&A Strategy” with Alexandra Lajoux, McGraw-Hill, New York, 2012 

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[i]. http://us.blackberry.com/newsroom/news/press/release.jsp?id=702.

[ii]. Research in Motion, 2006 Annual Report; share as reported by Gartner Group.

[iii]. Matt Hartley, “Apple Tops Global Smartphone Rankings, RIM Slides to No. 4,” Financial Post, August 5, 2011.

[iv]. Research in Motion, 2010 Annual Report.

[v]. Research in Motion (RIM) report in the Global and Mail website. http://www.theglobeandmail.com/globe-investor/markets/stocks/chart/?q=rim-T

[vi]. “Letter to Shareholders,” Berkshire Hathaway Inc., 2009 Annual Report.

[vii]. Julie L. Davis and Suzanne Harrison, Edison in the Boardroom: How Leading Companies Realize Value from their Intellectual Assets (Hoboken, NJ: John Wiley, 2001); Suzanne Harrison and Patrick Sullivan, Edison in the Boardroom Again (Hoboken, NJ: John Wiley, 2012).

Canadian Telecom Policy Overreaching, Again

With apologies to Sir Walter Scott, what a tangled web of policy we create when first we practice to manipulate.

Getting the policy right for the Canadian telecom industry is difficult now largely because we’ve had it wrong for so long in so many ways.

First, the industry was protected long after it was necessary to protect it for national security (the initial basis of protection of the telecom industry in most western jurisdictions).  With no foreign competition, the CRTC and The Competition Bureau had to make sure there was adequate domestic competition and thus limited the scale of domestic players.  As recently as 2007 when Bell was in play, the merger of Bell and Telus was discouraged.  So decades of protection of the Canadian industry left Canadian companies with uncompetitive scale relative to international players.

In the same period, American telecom players were able to merge and then grow internationally on the strength of their much larger domestic scale.  Other markets opened up to international competition and grew international competitors.  For example, Deutsche Telekom, once a bloated, German utility, was protected just long enough for it to become internationally competitive and only then were foreign competitors unfettered in Germany, which resulted in a competitive German market and an internationally competitive national champion.

Second, a belated effort to open the Canadian market gradually by offering spectrum only to new players in 2008, failed to recognize the importance of scale within Canada.  Spectrum granted to small players created a flurry of new consumer offers, but no viable competitors to Telus, Bell and Rogers.  Unable to grow fast enough against entrenched players, these new entrants are on the ropes now seeking more policy favours, merger partners or perhaps bankruptcy protection in the future. 

This has now led to the policy change to allow foreign acquisitions of up to a 10% market share limit, inviting the Verizon proposal to acquire Wind Mobile.  Now, the industry is claiming that the policy favours such foreign competitors:  they have access to spectrum not available to the major Canadian players; they can acquire companies that the Canadian players are forbidden to acquire; and they can piggyback on the pre-built infrastructure.  In addition, buyers like Verizon have scale that the Canadian players were not allowed to achieve historically. 

A playing field now tilted in favour of foreign competitors is the unintended consequence of policy that over-reached, trying to construct a desired outcome.

How do we untangle this mess? 

Policy should provide a framework of competition, i.e. the rules for a fair fight and a referee; it should not strike blows for one side or the other.  The Canadian telecom policy framework needs to change but should not be used to manipulate the industry toward a particular outcome.

If it is desirable to have more large-scale competitors, then they will have to come from abroad.  However, the same access to spectrum and acquisitions should be available to all.   If Verizon is allowed to enter and does, (and it would surely be followed by others), then there would no longer be a case to keep Bell, Telus, Rogers or others apart.  If it deemed no longer necessary to protect the Canadian industry, then let them fight on a level playing field for spectrum, acquisition targets and foreign partners. 

In the latter case, we could expect most, if not all, of the Canadian industry to be sold to larger scale international competitors – perhaps a poetic consequence of decades of protective policy, but it would be yet another Canadian industry sold off and regulators would then be left with the task of forcing affordable service coverage to the far corners of the nation.

 

As printed in the Toronto Star, August 25, 2013.