Australian

School of
Business

FINS5538 Lecture 2
Strategic Considerations in M&As
Peter Pham

Lecture Outline

Australian
School of
Business

Corporate Strategies for Growth

Strengths and Weaknesses of Alternatives to M&As?
M&As and Strategic Management
Does M&A Pay?
When do M&As Pay?

Australian
School of
Business

Paths for Expansion

Organic

Internal
Investment:
Make
Supply/sale
contract

Investment

Inorganic
Joint venture

Control stakes

M&As

More Control

Minority
investment

Tighter Contracts

Strategic
alliance

Make versus Buy

Australian
School of
Business

Neo-classical economic view of firms

Objective: maximise profits
Activity: using a technology to transform
resources into sellable products
Behaviour (under perfect competition):
expand until marginal cost = marginal
revenue

Problems with this view:

Black box conception of a production
function
Ignores abilities of firms to acquire new
technology / capability
Ignores incentive problems inside firms

Alfred Marshall

Make versus Buy

Australian
School of
Business

The world is NOT flat. Its has become more vertical (vertically integrated)
Upstreamness
index

Source: Antras et al (2012), Measuring the Upstreamness of Production and Trade Flows, American Economic Review

What wrong with the market?

Australian
School of
Business

Williamson (1971, 1975, 1985):

Why cant the market support efficient exchanges
of goods between firms?
Concept: Asset Specificity
Transactions between firms are often highly
complex
In many cases, they form a long-term relationship
Relationship-specific investments are often
required

Concept: Holdup problem

when one partys bargaining position is increased
the other makes irreversible investment
the held up party can be either the seller or the
buyer.

Resolutions:
Contract
Control

Oliver Williamson
Nobel laureate 2009

What wrong with the market?

Australian
School of
Business

WHAT ARE
THE BIG
RISKS FOR
APPLE?

Australian
School of
Business

Incomplete contract
All complex contracts are invariably incomplete:
Uncertainty
Opportunism / Free-rider problem (lead to monitoring costs)
Information asymmetry (protracted bargaining)

Difficult for courts to resolve contract disputes, due to lack of

knowledge
If market can be governed by contracts, there will be no firms
In real life a firm only has a few contracts

Incomplete contracts lead to the need to have:

Hierarchies, private ordering
Governance / monitoring structures
Incentive structures

Serves to minimize
transaction costs

Revision: Incomplete contract

Previously, Vought
Aircraft Industries

Source: Pol Antras, CREI Lectures: Contracts and the Global Organization of Production

Australian
School of
Business

Control and Holdup: A Classic Example

Australian
School of
Business

Fisher Body General Motors Supply Agreement

In 1919, Fisher signed a contract to supply car bodies to GM
This requires Fisher to make substantial specific investment in plant
and equipment to make wood framed and metal skinned closed bodies,
rather than wooden open bodies.
What would Fisher be worried about with this requirement?

To deal with potential holdup, 2 parties signed a 10-year exclusive

supply contract
The contract also set a reasonable (competitive) price formula:
Price = Fishers variable cost + 17.6% margin (to cover overhead)
What would GM be worried about with this contract?

As an incentive GM also bought 60% of Fishers shares but did not buy
the voting rights, which were retained by the Fisher bothers
In 1919-24, the contract worked well
Investment by GM used to fund plant relocation to near to GM facilities

Control and Holdup: A Classic Example

Australian
School of
Business

Fisher Body General Motors Supply Agreement (Cont.)

In 1925, contract disputes started as demand for closed body cars
jumped dramatically by 200% in 2 years
In 1926, the relationship between 2 parties started to turn sour
Variable Cost markup contract no longer competitive
The Fisher bothers refused to put up further investments according to GM
requirements, even though it was profitable for them to do so
Fisher refused to move Buick bodies production plant from Detroit to
Flint, where GM assembled the Buick
GM had to reduce production due to body shortages
Fisher started to supply to Chrysler, by expanding (and overstaffing) its
Detroit plant

Ultimately, GM bought the remaining 40% stake and acquired control,

at a very high premium
On the first day after the acquisition, GM announced $40 mil expansion plan
to move Fishers production to Flint
Fisher brothers joint the board of GM and remained executives at Fisher

A Modern Example: Tata Motors

Australian
School of
Business

Started in the 50s as a pure commercial vehicle manufacturer (e.g. buses)

Main capability: commercializing foreign-imported tech at very low cost
Joint venture collaboration with Daimler Benz: receiving technology/design (e.g. the
E220 Mercedes)
Limited to low-value-added assembly roles
The relationship failed in 2001, typical for a technology-based joint venture

Driving factors for change:

intense competition in the Indian car market
survival requires proprietary technology that is adaptive

Upstream and downstream internationalisation:

Acquired Jaguar Land Rover from Ford for $3 billion in 2008 (mid of the GFC)
Get a hand on both technology and distribution

Group structure and support

Internal capital market of about 15 independently listed firms, all under the control of
Tata Sons
Tata Group shareholding in Tata Motor increased from 30% to 39% to finance the
acquisition, despite difficulties from obtaining bridging loan finance.

A Modern Example: Tata Motors

Australian
School of
Business

2002 2012
Range Rovers

TODAY Range Rovers

Types of Contractual Relationships

Australian
School of
Business

Sales contract
Contains conditions on product services, return policies, financing, etc.

Licensing agreement:
Renting a technology or brand, paying royalties

Co-development agreements
Agreements to share costs of and expertise in R&D

Joint purchasing agreements

Agreements to combine purchase orders

Joint marketing agreements

Agreements to combine selling effort

Franchising
Agreements to invest in a successful business model from the franchisor
using funding and human capital from the franchisee
often in a clearly defined market boundary

More Implicit Contracting

Australian
School of
Business

Strategic alliance
A more serious and complicated relationship
More detailed contracts, but also involves exchange of talents,
capabilities, and resources
Example: Microsoft and Nokia in 2011
Nokia to use Window Phone as its platform
Nokia to contribute technology to improve Window Phone platform
design, and ultimately its market penetration beyond Nokia phones
Nokia contents to integrate with Window Marketplace (aka iTunes)
Others: Phones to use maps from Nokia, Bing from Microsoft

Would holdup be a serious issue in this relationship?

More Implicit Contracting

Australian
School of
Business

Joint Ventures
A separate entity is created, jointly owned by the partner firms
Extensive agreement specifying

investment rights
operational responsibilities
voting control
allocation of returns

How can holdup be alleviated with this arrangement?

More Implicit Contracting

Australian
School of
Business

Minority Stakes
One firm holding a substantial but less than controlling stake in
another
In Japan, firms cross-hold stakes in one another to form Keiretsus
Eg. Mitsubishi groups have at least 44 listed firms in one of my studies

In Continental Europe, crossholdings are less elaborate but involve

many large corporations
E.g. Allianz, Dresner Bank and Munich Re used to own about 20-25%
of one another

How can hold up be alleviated in this arrangement?

Controlling Stakes
One firm holding a partial but controlling stake in another
Benefits: no more holdup and less capital required than full M&As
Costs: operations of two firms cannot be fully integrated

Australian
School of
Business

Summary
Organic
Investment
Make

Contracts

Alliance

Joint
Venture

Partial
Acquisition

M&As

Transaction /
contracting costs

Lowest

Highest

High

Moderate

Low

Lowest

Control

Highest

Lowest

Low

Moderate

Moderate

High

Capital Required

Highest

Lowest

Low

Moderate

High

Highest

Time required

Highest

Lowest

Low

High

Moderate

Moderate

Share of return

Full

Lowest

Low

Moderate

High

Highest

Questions to Consider Before M&As

Australian
School of
Business

Whats the firms competitive positions?

Whats the firms resources?
Capabilities, core competencies and sustainable competitive
advantages

What are the target firms complementary resources?

What are the key impediments to combining these
resources through contracting?
Is a merger or an acquisition really necessary?
Can the merits of the acquisition be clearly
communicated to both target and acquirer shareholders?
What are regulators likely reactions?

Strategic Management Toolkits in M&As

Australian
School of
Business

SWOT (strengths, weaknesses, opportunities and threats)

Useful to understand acquirers and targets sources of value creation
given the industry competitive landscape

Boston Consulting Group matrix

Graphic presentation of competitive positions along growth and market
share dimension
Increase in market share can lead to more than proportional increase in
market power and return

Problems
BCG matrix ignores the multi-dimensionality of corporate resources
SWOT analysis does not specify whether complementary resources exist
and can be combined
Both ignore how valuation can impact on value creation
Both ignore how M&As should be a solution rather than contracting

BCG Matrix

Australian
School of
Business

Strategic Management Toolkits in M&As

Australian
School of
Business

Porter 5-force model

Barriers to entry, threat of substitutes, conduct of existing rivals:
inform about possibilities of horizontal M&As
Customer power, supplier power: inform about possibilities of
vertical M&As
Threat of substitutes: also inform about needs for diversifying
M&As

Traditional Competitive Advantages

Low cost leadership

Differentiation
Focus or specialisation
Implication for M&As: dont get stuck in the middle

Common M&A Strategies

Market dominance drive
Overcapacity consolidation
Geographic roll-ups
Product extension & geographic extension
Acquisition of technology & R&D capability
Industry convergence, new industry evolution

Australian
School of
Business

Australian
School of
Business

Product Extension & Technology

Acquisition Example

Johnson & Johnson: medical device maker and pharmaceutical company

Did 50 acquisitions between 19952005
In 2005 it tried to do its largest deal - $25.4 billion acquisition of Guidant
Company Acquired
Conor Medsystems
Pfizer division
Alza
Centocor
Depuy
Scios
Cordis
Inverness Med. Tech.
Neutrogena
Closure
Biopsys Medical
Peninsula Pharmaceuticals

Primary Focus
Stents
Consumer products
Drug delivery
Immune-related diseases
Orthopedic devices
Cardiovascular diseases
Vascular disearses
Diabetes self-management
Skin and hair care
Topical wounds
Breast cancer
Life-threatening infections

Date
2006
2006
2001
1999
1998
2003
1996
2001
1994
2005
1997
2005

Size in Billions
1.4
16.6
12.3
6.3
3.6
2.4
1.8
1.4
0.9
1.4
0.3
0.3

Do M&As Create Wealth?

Australian
School of
Business

What to look for?

Takeover premium = offer price pre-announcement price
What creates takeover premium?

Targets share price reaction upon takeover announcement

Bidders share price reaction
Combined reaction
What does this capture?

Long-term performance of combined firms

Long-term performance of target firms (in partial acquisitions)

What not to look at as a wealth creation indicator?

Increase in earnings per share and price-earnings ratio
These can create illusion of wealth gain, despite mergers
creating no real economic benefits

Australian
School of
Business

Bootstrap Game EPS Bump

Fast Lane Ltd merges with Steady & Stable Ltd in a 1:2 stock deal. Steady and Stable shareholders receive 1 Fast Lane
share for every two shares held. Fast Lane issues 50,000 shares to create the merged entity

Fast Lane Ltd

Steady & Stable Ltd

Fast & Stable (merged entity)

$2.00

$2.00

$2.67

2. Price per share

$40

$20

$40

3. P/E ratio

20

10

15

4. Number of shares

100,000

100,000

150,000

5. Total earnings

$200,000

$200,000

$400,000

$4,000,000

$2,000,000

$6,000,000

$0.05

$0.10

$0.067

1. Earnings per Share

6. Total market value

7. Earnings per $1 invested

Can M&A Destroy Wealth?

Australian
School of
Business

Yes if two critical problems exist at the acquiring firm

Agency problems
Empire building
Entrenchment
Free cash flows

Managerial hubris
Overpayment
Over-expansion
Optimistic synergy forecast

Unchecked Quest for Growth:

Worldcom Example

Australian
School of
Business

WorldCom was built by Bernie Ebbers from a small,

Mississippi telecom resellerLDDS founded in 1983
He acquired many companies from the 1980s to 1990 to
become one of the largest telecom companies in world
1993: Merged with Resurgens Comm. and Metromedia
Comm.
1994: Acquired IDB Comm. had 200 operating
agreements in foreign countries
1995: Acquired WilTel had large fibre optic network
1996 Acquired MFS Comm.- $14 billion deal
Acquired Brooks Fiber, Compuserve from H&R Block

Unchecked Quest for Growth:

Worldcom Example

Australian
School of
Business

September 1998 merged with MCI

$37 to $40 billion deal
WorldCom now became a leading telecom company

2000 WorldCom tried to merge with Sprint in $155

billion deal
Justice Department rejected this deal on antitrust grounds

Financing

WorldCom took on high debt partly to finance deals

2002 Total debt rose to $30 billion
2002 Interest payments - $170 million
2003 Interest scheduled - $1.7 billion
2004 Interest scheduled - $2.6 billion

Australian
School of
Business

Unchecked Quest for Growth:

Worldcom Example
120

100

80

60

40

1/98 WorldCom/
CompuServe
complete $1.8 billion
merger
1/98 WorldCom/
Brooks Fiber $2.5
billion merger
completed

10/99 MCI WorldCom

announces proposed
acquisition of Sprint for $155
billion in stock
9/98 WorldCom
completes $37 billion
merger with MCI

12/96 WorldCom
completes $14
billion merger with
MFS

7/00 Justice
Department blocks
Sprint acquisition

20
8/89 WorldCom (formerly LDDS) goes public through
merger with Advantage Companies

0
1989

1990

1991

2/02 WorldCom
announces second
quarter charge for $15-20
billion
3/12/02 SEC investigates
Worldcom accounting
practices
4/02 WorldCom slashes
$1.4 billion from '02
revenue projections
4/30 Ebbers resigns as
CEO

1992

1993

1994

1995

1996

7/22/02
WorldCom
files for Ch11

7/01 WorldCom buys Intermedia

Comm. for $3 billion

1997

1998

1999

2000

2001

2002

Unchecked Quest for Growth:

Worldcom Example

Australian
School of
Business

Hubris and the roles of investment bankers

WorldCom generated $107 million in fees for Salomon Smith
Barney (SSB)
Jack Grubman, its telecom analyst, issued very strong positive
recommendations
Cheapest S&P large cap growth stock at the time (October
1998)
The must own large cap growth company at the time
(February 1999)
Single best idea in telecom
Any investor who did not take advantage of current prices to
buy every share of WorldCom should seriously think about
another vocation.

Unchecked Quest for Growth:

Worldcom Example

Australian
School of
Business

Postscript
February 15, 2005: Verizon acquired MCI (formerly
WorldCom) for $6.8 billion
MCI just came out of bankruptcy
September 1998: WorldCom paid $37 billion for MCI
Bernie Ebbers was tried for $11 billion corporate accounting
fraud
In July 2005 he was sentenced to 25 years in prison

Takeover Premium

Australian
School of
Business

Australian
School of
Business

Event Studies in M&As

Estimation period

Pre-event window

Event window

Post-event window

Event date

Examine market reactions to takeover announcements

How to measure market reactions
Using cumulative abnormal returns over an event window (in
days) surrounding the takeover announcement
Daily abnormal returns are estimated for the event window as
ARit = Rit (E(i)+ E(i)Rmt)
Expected (Normal) Return, predicted by the CAPM model

Key Findings
General consensus:
ACQ gains are zero on average
TGT gains significantly on average
On average net gain from takeovers

This is from a stream of studies:

Jensen and Ruback (1983)

Bradley et al. (1988)
Andrade et al. (2001)
Moeller and Schlingemann (2005)
Moeller et al (2004, 2005)

Australian
School of
Business

Key Findings
Average cumulative
excess returns
211 successful and
91 unsuccessful
target firms from 60
days before until 60
days after the
merger day in the
period 1962-76
(Asquith, 1983)

Australian
School of
Business

Australian
School of
Business

Key Findings

Research Paper

Year

Window

Target
Return

Bidder
Return

Comb.
Return

Bradley et al

1988

-5,+5

31.8%

1.0%

7.4%

Kaplan,
Weisbach

1992

-5,+5

26.9%

-1.5%

3.7%

Servaes

1991

-1, uncon.

23.6%

-1.1%

3.7%

Mulherin, Boone

2000

-1,+1

20.2%

-0.4%

3.6%

Andrade et al

2001

-1,+1

16.0%

-0.7%

1.8%

37

What Influence Acquirer CARs

Australian
School of
Business

Payment method
Market reacts more negatively to stock acquisitions

M&A strategies
Market reacts most negatively to diversifying acquisitions

Target status
Market reacts more negatively to publicly listed targets

Approach
Market reacts more negatively to hostile deals

Acquirer financing
Market reacts more negatively to deals announced by acquirers with
high leverage and free cash

Valuation
Market reacts more negatively to deals involving overvalued acquirers

What Influence Acquirer CARs

Australian
School of
Business

Size
Market reacts more negatively to deals involving large acquirers

Profitability
Market reacts more positively to more profitable acquirers

Profitability
Market reacts more positively to deals involving acquirers with high
productivity

Governance
Market reacts more positively to deals involving acquirers with strong
corporate governance regimes
and to deals involving targets with poor governance regimes

Moeller et al (2004, 2005)

Australian
School of
Business

Situation:
Wealth destructions on a massive scale: $250 billion in the 80s and 90s
Many value-destroying takeovers in the 1990s seemed to involve large
firms

Issue:
Does the market react more negatively to large ACQs acquisitions than
to those of small ACQ?
Does this merely reflect other things such as method of payment?
If not, why does the market react negatively to large ACQs acquisitions

Findings:
The market does react more negatively to large ACQs acquisitions
Likely because size induces managerial hubris
Small firms are better acquirers

Australian
School of
Business

Conclusion

Theory
Efficiency/
Synergy

Combined
Gains

Gains to
Target

Positive

Positive

Gains to
Bidder
NonNegative

Agency
Costs/
Entrenchment

Negative

Positive

More
Negative

Hubris

Zero

Positive

Negative