Mergers & Acquisitions

Table of Contents

1. Introduction

2. Course Summary

3. Are M&As value enhancing?

4. Practical Example: Disney acquires Pixar
4.1. Company Profile Disney
4.2. Company Profile Pixar
4.3. Aims and objectives
4.4. The acquisition sequence
4.5. Wealth Effects
4.6. Any other issue of importance

Bibliography

Appendix

Table: Calculation CAR

Calculation Dollar Gain

Chart Disney (6 months)

Chart Pixar (6 months)

1. Introduction

This paper is the final paper for the course “Mergers & Acquisitions”. In chapter 2, I will give a summary of the most important aspects of the course. In chapter 3, I will deal with the question, whether M&As are value enhancing. Finally, I will describe a practical example of a M&A, namely Disney’s acquisition of Pixar.

2. Course Summary

The course started with a definition of the terminologies. Generally, M&As refer to traditional mergers and acquisitions, takeovers, corporate restructuring, corporate control and changes in the ownership structure of companies in general. We focused on traditional mergers and acquisitions. It is usually distinguished between mergers and tender offers respectively:

illustration not visible in this excerpt

Source: own graphic

Mergers are negotiated deals between the members of the two boards of the companies, while tender offers are direct offers to the shareholders of the target company (the company, which makes the offer is called bidder) and is usually hostile. These offers can either be conditional (bidder requires a minimum amount of shares) or unconditional and restricted (bidder says a maximum amount of shares he is willing to buy) or unrestricted. It could be a two-tier offer, where the bidder first buys a bit more than 50% of the target company to get control and buys the rest later on. Another possibility is a three-piece suitor, which is similar to a two-tier-offer, however, before buying 50%, the bidder just buys a few shares to get a toehold (this first step was just taken by the Nasdaq in order to the London Stock Exchange and may result in a three-piece suitor).

M&As are generally made because of strategic and financial objectives and are driven by several forces, which usually work together. Technology (e.g. internet), globalization (e.g. WTO, EU) and deregulations (e.g. liberalisation in European postal markets) may be the most important ones. Mergers can be horizontal, vertical or conglomerate. Horizontal mergers occur between companies in the same business activity, in order to reach synergies and economies of scale and scope. As these kinds of mergers could result in a loss of competition, governmental antitrust regulations have to be considered. Vertical mergers occur between companies in different stages of production, like for example the acquisition of a supplier. These kinds of mergers happen due to increasing information and transaction efficiency, as information can flow quicker within a company after a merger and no time for contracting is being wasted any more. Conglomerate mergers are mergers between companies in unrelated types of businesses.

There are lots of regulations and laws concerning M&As. Several regulations which set the rights for minority shareholders exist, as they are considered to be the weak part in any M&A. Other regulations regulate insider trading (i.e. trades based on information that is not available for the general public) or disclosure requirements (i.e. when announcements have to be made). Another important point is antitrust policy. M&As can lead to a loss in competition (governments measure this using the HHI or the concentration ratio) and may in the end lead in a prohibition for certain M&As. These issues are usually very delicate as M&As can also be a sign of a competitive process and leading to more efficiency, lower costs and therefore in the end to lower prices for consumers. The management of the target company has the right to fight against takeovers from other companies; however, in the case that they can not prevent it, they have the legal duty to get the best price (fiduciary duty).

Managers have to consider that M&As are just one way to grow and it is not always the best one. So, it depends on the situation whether a M&A is a good strategy. The most important part of creating a strategy (for both a general strategy and a M&A strategy) may be the awareness of a constantly changing environment, which should therefore be monitored continuously to identify external opportunities and threats. This includes an analysis of the industry, competitors, suppliers, customers and substitute products. A good strategy takes the interests of stakeholders, the company’s culture and the company’s capabilities and limitations (their strengths and weaknesses) into account. The strategy is also influenced by the organizational structure of the company. This is especially important for M&As as the acquired company must fit to the buyer’s company. Two companies with very different kinds of structures are very difficult to integrate.

Several reasons for M&As exist. Managers assume better efficiency through economies of scale (a decline of average costs when producing more), economies of scope (e.g. using the waste of one product as the input for another product), organization capital (i.e. the ability to produce at lower costs), organization reputation and human capital resources. In general, M&As are useful, when the two companies together are performing better than the two companies on their own (2 + 2 = 5). This is usually reached through synergies, like increased efficiency, as mentioned above. Other points could be better growth opportunities, a reduction in the variability of cash flows or tax advantages.

Mergers tend to happen in waves. At the beginning of the 20th century, in the first movement, mainly horizontal mergers occurred, as a result of the completion of the American market (i.e. completion of railroads) and the use of electricity. The second movement, between World War I and II, the third movement of conglomerate mergers in the 60s, the deal decade in the 80s were followed by the period of strategic mergers from 1992 to 2000. In that time the economy was very strong and the stock markets literally skyrocketed (until the stock bubble popped). This made it cheap for companies to acquire other companies as shares are a common mean of payment in M&As (higher share prices and therefore a higher Tobin’s q makes it cheap for companies to do acquisitions). In addition, the environment changed rapidly, notably technology (e.g. information technology), globalization and deregulation. Generally it can be said that mergers happen in times with fundamental changes in the environment and the existence of some economic factors (e.g. rising share prices, low interest rates).

Lots of empirical test of M&A performance have been undertaken, which I will deal with in chapter 3.

As a result of globalization and technology (technology is portable and can be transferred to other countries easily) more and more international takeovers take place. This is because companies want to combine complementary capabilities, find new markets and achieve critical mass. The US is regarded as an attractive market in terms of political and economic factors and therefore lots of foreign companies invest in US-companies. On the other hand, also many US-firms acquire foreign companies. In cross boarder M&As exchange rates play an important role and managing risks concerning this topic is essential. An interesting point is that foreign bidders pay higher premiums than domestic bidders and are therefore advantageous for the shareholders of the target company.

Not all M&As are welcome and therefore targets developed methods of preventing M&As or just to raise the price. Some financial characteristics like low q-ratio, good cash flows or low P/EPS ratios can make companies attractive for other companies. As a reply they could for example decrease excess cash (as excess cash is a signal of bad management; Free Cash Flow Hypothesis) and increase dividends. Other defences include corporate restructuring like buying other companies to create antitrust problems for the bidder or selling parts of the company – in which the bidder is especially interested (“selling off crown jewels”) – to somebody else. Other defence tactics include greenmailing (target offers the bidder a good price for repurchasing its own shares), the Pac Man defence (target bids for bidder’s shares), the search for a white knight (i.e. another company which is willing to buy the target and is favoured by the target), Poison Pills or golden parachutes (i.e. giving the board a large sum in the case the company is being bought). Furthermore, the company could set up a constitution, which makes it harder for the bidder to acquire this particular company. This for instance can include supermajority requirements (e.g. 80% of all votes are needed to change control in the company), fair-price amendments (in order to protect against two-tier offers, so that the bidder has to offer a “fair” price for the rest of the shares once he got control) or classified boards (e.g. just one third of the board is elected every year and thus the buyer needs time to get control over the target).

After a M&A it is essential to bring the two companies together, which is a challenge for management. Like for every other investment a M&A is favourable if it has a positive net present value. To reach this, it is important for management not to overpay (see winner’s curse) and to integrate the acquired company. To be favourable the equation has to be 2 + 2 = 5 and therefore the two companies have to be related in some way to reach that. In addition, the post-merger phase is the most important part of any M&A, especially different company cultures can lead to problems. Therefore the acquirer has to be willing to use its best managers for the integration of the target, but also have to take care of the remaining employees of the target company.

3. Are M&As value enhancing?

The basic reason for every M&A is to create value for the shareholders. Therefore we can evaluate the success of a M&A by the development of the share prices of the two companies.

The ideal case of a M&A is that there are gains for both, the target and the acquirer. This was seen in the recent merger of Lucent and Alcatel, where both share prices increased after the announcement of the merger, as the market expected efficiency improvement, synergies (2 + 2 = 5) and increased market power. However, when the acquiring company overpays, simple as a result of the ego of the bidder’s company (hubris) or as a result of a bidding contest, where the winner is in fact the loser (as he overpays; winner’s curse) there may not be any positive effect of a M&A. M&As could also lead to a destruction of value, as a result of agency problems (i.e. management is different from ownership and therefore have different interests. This is especially shown in M&As as management’s compensation depends on the size of the company and therefore management has an interest to increase the size of the company, e.g. through M&As) or mistakes in the acquisition process, like that the two companies do not fit together (2 + 2 = 3).

All empirical studies show that a M&A increases the value of the target company and this has been increasing over time, as there are more and more governmental protections, better defence tactics and more opportunities to find competing bidders. The result of any bid is an increase in demand for that company’s shares and therefore – according to the principles of a market – lead to higher prices. In practise this is shown by the fact that the acquirer has to pay a premium for the target. Generally hostile offers result in higher premiums than friendly takeovers, multiple bidders increase the price and cash-for-stock deals offer higher prices than stock-for-stock deals (as the bidder has to compensate taxable cash-for-stock deals with a higher price).

The gains to the acquirer can either be positive or negative depending on the “fit” of the target company and the price being paid. Empirical studies show that the gain for the acquirer is somewhere close to zero. The event return, i.e. the development of the share price on the 1st day of the M&A announcement, to bidding companies have decreased over the decades and usually a M&A announcement results in declining share prices of the bidder.

According to empirical studies, the overall return from M&As is positive, as for example Schwert pointed out. As according to his studies on average abnormal returns to bidders were not significantly different from zero and the abnormal returns to the target were up to 40%, the overall return (also called total wealth change) is positive. Weston and Johnson investigated event returns from many M&As and found out that there were positive total gains in about 2/3 of the cases. In addition, as Healy, Palepu and Ruback found out, also some accounting variables improved after mergers, like for instance operating cash flows.

Much more difficult than calculating the abnormal returns from the day of the bid until the completion of the merger, as done above, is finding out the long-term consequences of M&As. Different results on that issue occurred as a result to different benchmarks employed. The problem in measuring long-term performance is the question how to measure performance, i.e. which benchmark should be employed. All in all, in my opinion, measuring long-term performance could not be done reliable, as every selection of a benchmark is arbitrarily.

To conclude, empirical studies show that M&As are value enhancing, at least in the short run. The long-term effects are unknown. In my opinion, M&As are on average value enhancing, but certain circumstances, like hubris, agency problems or simply overpaying, can destruct value for bidder’s company shareholders. This means that M&As are only beneficial if the two companies performing together better than both alone. It is important to judge every M&A individually and not generalize.

4. Practical Example: Disney acquires Pixar

As a practical example for a M&A I have chosen Disney’s acquisition of Pixar, which was announced on 24 January 2006. It is the fifth-largest entertainment deal of the past 10 years and the second-largest acquisition announced so far this year. It can be characterized as a smooth, fast and strategic acquisition. Firstly, I will give a short introduction of the two companies involved. Secondly, I will deal with the aims and objectives of the acquisition followed by the acquisition process. Then I will calculate the abnormal returns and will end with other important issues concerning this acquisition.

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