Do mergers & acquisitions create shareholder wealth?

Following on nicely from my last blog which discussed different valuation methods which are vital in determining the price to pay for company - this blog is going to focus on the motives behind mergers and acquisitions and discuss whether such activity impacts shareholder wealth. We hear regularly in the news of mergers and acquisitions and last week (25^th March) was no exception. It was announced on Wednesday (25^th March) that US food giant Heinz plans to merge with Kraft Foods Group which could create the world's fifth-largest food and drink company (BBC, 2015). It was revealed that Heinz will hold the controlling interest with shareholders owning 51% of the combined company and Kraft holding a 49% stake (BBC, 2015). 

So what are the motives behind this possible merger?

This is an example of a horizontal merger as both Heinz and Kraft are engaged in similar business activities (Stillman, 1983). By doing this it is likely the combined organisations will benefit from synergies – the idea that the combined entity will operate more efficiently and be of more value than if the two organisations were to remain separate (Davis & Wilson, 2008). Both of the companies are finding it difficult to deal with a transition in the US where consumer attitudes are changing. Consumers are storing less packaged and processed foods, demanding fresh foods which has resulted in limited growth for the companies. Therefore by combining the companies they are hoping to operate more efficiently by benefiting from economies of scale following the merger.

One of the motives behind the merger, as stated by Alex Behring the chairman of Heinz, is to create “a strong platform for both US and international growth”. Given that Kraft generates 87% of its revenue within the US and Heinz generates around 60% of its revenue outside of the US I believe this is a good fit for the combined company. This will enable Heinz to use their global presence to expand Kraft’s products into new markets, as well as allowing Heinz to benefit from Kraft’s strong and established presence in the US. Consequently the merger is likely to facilitate growth both within the US and internationally which could result in high revenues and likewise increase shareholder wealth. 

Another motive behind the merger is that the combined company hopes to make significant cost savings, aiming to cut costs by $1.5bn by 2017. However this is likely to include changes which come at the cost of employees where large amounts of jobs are expected to be cut as well as slashing job perks. Linking this to stakeholder theory it would suggest that organisations should consider the needs of all of their stakeholders however it appears this was not the case whilst agreeing the merger. If they had followed stakeholder theory the merger may not have progressed to this stage as they would have considered the large potential of job losses and without these they may not achieve such large cost savings. In contrast, looking at this from a shareholders perspective, this merger could increase shareholder wealth if the combined entity is to make the planned cost savings it may allow any cash saved to be paid in dividends.

So are motives always in the best interests of shareholders? Unfortunately not.

There may have also been managerial motives behind the merger. This can result in managers making decisions which are in their own best interests, to maximise their utility rather than aiming to maximise shareholder wealth (Amihud, 1986) thus the agency problem is present. There are a number of reasons why managers may do this. Firstly, by merging the two companies the managers will have to be paid significantly more as a result of managing and controlling such a large company, linking to another possible motive of having a desire to build an empire - the prospect of securing an increased remuneration package is likely to be very attractive to managers and could be a significant motivation. Similarly it will increase the status of the managers involved as they would be seen to be leading the merger of the two well-known established companies which will receive a lot of publicity and is likely to be seen as a significant achievement. In addition, given that both companies are experiencing limited growth, it could be argued that the managers at Heinz may have considered this merger to protect their jobs. They may believe that they could be a target for a takeover and in order to protect themselves from being sacked or dominated by an acquiring firm, they made the decision to grow and merge with Kraft to prevent this. Again acting in their personal best interests rather than making decisions which will maximise the wealth of shareholders. Therefore if the motive behind this merger was due to managerial motives it is likely it will destroy shareholder value given that mergers have been shown to decrease wealth.

This leads nicely onto the effects the proposed merger has had for shareholders. Mergers and acquisitions have been heavily researched in order to determine the impact such activity has on shareholder wealth - what impact did the announcement of this proposed merger have for shareholders? Did it create wealth?

Studies have consistently shown that in a merger the target company’s shareholders gain significantly. Jensen and Ruback (1983) found that on average a target company’s share price will increase by 20% (Jensen & Ruback, 1983). Looking at Kraft’s share price (Figure 1) it increased significantly following the announcement of a possible merger and is therefore consistent with this theory, demonstrating how the proposed merger has increased the wealth of Kraft's shareholders. This could be because investors recognise that the merger will bring benefits from synergies and cost savings which essentially could increase their dividends in the longer-term.

Figure 1: Kraft Share Price (Bloomberg, 2015)

 

In terms of the bidding company's share price, Jensen and Ruback’s (1983) findings suggest that the shareholders would experience no gain nor a loss if the merger was successful. Given that Heinz is a private company I am unable to gain access to the share price to determine whether the movement complies with this study. However since Jensen and Ruback’s (1983) study, other studies have provided findings showing how in the short-term the bidding company either experiences no impact or a reduction in shareholder wealth. The results of longer-term studies are less consistent, some showing how it can significantly reduce wealth, some indicating it is value-neutral whereas a few show there is a possibility of increasing wealth.  
 

In contrast, if this merger is unsuccessful, we would expect to see a 5% loss on Heinz’s share price and a 3% loss on Kraft’s share price (Jensen & Ruback, 1983).  Currently we do not know whether the merger will be successful however research has shown that generally mergers are unsuccessful (Banal-Estañol & Seldeslachts, 2011). This could be due to the managerial motives, as discussed above, or hubris which is the concept of managers being over-confident and considering themselves to be better than and above everyone else (Petit & Bollaert, 2012). This can lead to managers being over-confident in their own abilities and very optimistic when considering possible mergers as they believe they have the ability to create a better business. It could be argued that the managers of Heinz have were over-confident when considering the merger as it could be very challenging to merge two companies which are currently experiencing little growth and make the changes required to allow successful growth in the US market which continues to be a challenging environment. In addition, in cases where there is free cash flow there is also scope for managers to reduce value. For example, if there is excess cash, following the objective of shareholder wealth maximisation, managers should look to distribute this back to shareholders. However in reality managers may want to keep this money under their control as distributing this to shareholders could be seen as reducing their power and control therefore they may use this to buy other firms which in turn links back to the managerial motives of status and remuneration. Overall this could reduce shareholder wealth.

To conclude, there are many motives which could be argued to be behind the merger of Heinz and Kraft including benefiting from cost savings and tackling the challenging business environment to managerial motives which have significant scope to destroy shareholder value. Given that studies have consistently shown that the bidding company often experiences a reduction in wealth, I believe it is vital merger and acquisition decisions are made with correct motives in mind, for example to benefit from synergies in order to increase shareholder value. Whilst both of these companies are currently facing difficulties, I think if the merger was successful, it would benefit both of the companies in the long-term as they can combine their expertise and experience in order to expand and enter new markets, creating value for shareholders whilst doing this.

 

References

Amihud, Y. (1986). Conglomerate mergers, managerial motives and stockholder wealth. Journal of Banking & Finance, 10(3), 401-410. doi:10.1016/S0378-4266(86)80029-2

Banal-Estañol, A., & Seldeslachts, J. (2011). Merger failures. Journal of Economics & Management Strategy, 20(2), 589-624. doi:10.1111/j.1530-9134.2011.00298.x

BBC (2015). Kraft shares soar on Heinz merger. Retrieved 29^th March 2015, from http://www.bbc.co.uk/news/business-32050266

Bloomberg (2015). Kraft Foods Group Inc. Retrieved 29^th March 2015, from http://www.bloomberg.com/quote/KRFT:US

Davis, D. D. & Wilson, B. J. (2008). Strategic buyers, horizontal mergers and synergies: An experimental investigation. International Journal of Industrial Organization, 26(3), 643-661. doi:10.1016/j.ijindorg.2006.12.004

Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control. Journal of Financial Economics, 11(1), 5-50. doi:10.1016/0304-405X(83)90004-1

Petit, V., & Bollaert, H. (2012). Flying too close to the sun?: Hubris among CEOs and how to prevent it. Journal of Business Ethics, 108(3), 265-283. doi:10.1007/s10551-011-1097-1

Stillman, R. (1983). Examining antitrust policy towards horizontal mergers. Journal of Financial Economics, 11(1), 225-240. doi:10.1016/0304-405X(83)90012-0

 

Valuing companies – Where to start?

We always read in the news of mergers and acquisitions – but how do companies go about valuing companies in order to determine a fair offer? There are a number of methods which companies can use but there appears to be no one preferred or “correct” way to do this and there are a lot of assumptions involved - within this blog I am going to look at two recent cases to discuss the possible methods behind this. The first case is BHS, where it was announced on 12^th March that owner Sir Philip Green had sold the company which he bought for £200m in 2000 for just £1 to Retail Acquisitions (Financial Times, 2015). The second case is TSB who received a takeover approach from Sabadell, a Spanish bank, for £1.7bn (Financial Times, 2015). Clearly there is a big difference in value here – so how may have the companies determine these prices?

Firstly looking at stock market valuation which simply takes the number of issued shares and multiplies them by the market price. This is a simple technique and gives an idea to the buying company as to what the purchase price could be. Technically if the efficient market hypothesis applies then using this technique should give an accurate value of a company. However as discussed in my second blog, the stock market is not perfectly efficient and so it is unlikely this method will give a true valuation. It must be considered that managers within the organisation are likely to have internal information which could significantly impact the value of the firm. This could result in a target company rejecting a bid as they believe it does not provide a true reflection of the value of the company. Whilst this method is not widely used, it could be argued that Sabadell used this approach to value TSB as they offered 340p per share which was only 4% above their share price on the day the offer was made.

However there are limitations of using stock market valuation. Firstly the quoted share price does not reflect the value of all of the shares as these shares are only a fraction of the total amount and therefore does not fully represent a true value of a company. Another problem with this approach is that whilst it gives the buyer a possible share purchase price it does not reflect a company’s true worth giving no appreciation of future cash flows. Given that BHS was part of a wider group which was not listed on the stock exchange, this method could not have been used during valuation. With Sabadell offering slightly higher than what TSB's share price was, this could be due to the value which comes with TSB’s established brand name and reputation.

Another approach which can be used to value a company is net asset valuation (NAV). This technique uses the value of net assets from the balance sheet in order to determine the value of a company and includes two techniques; book value and net realisable value (ACCA, 2012). Book value is based on historical costs which are easily available as they are simply taken from the balance sheet. However a problem with this approach is, for example, an asset bought 10 years ago it is unlikely to be worth the same value today and therefore provides an inaccurate figure. In addition, given that it solely relies on balance sheet figures it gives no consideration to intangible assets such as a company's brand name or research and development. Net realisable value is likely to be a slightly more accurate approach in comparison because it uses the amount which would be generated if a company was to sell its assets on the open market today.

However there are significant limitations with utilising either of the NAV methods. Firstly, the value determined from this approach does not take into consideration future profits of the company, dividends or growth prospects as it is entirely based on the company’s assets. In addition, it does not include intangibles, for example a company’s brand, reputation and employees. These intangible assets for many organisations are likely to be of significant value to a company, particularly for organisations which are serviced based. Therefore this method is inappropriate to value TSB given that it is primarily a service based organisation and therefore relies heavily on having experienced employees as well as maintaining a strong brand name which is not captured using this method. It could be argued that this approach could have been used to value BHS. Whilst it is a well-known company and recognised brand, it is a loss making company and given this situation, the future prospects of the company are very poor.

The third approach which can be used to value a company is categorised as an income based valuation method; discounted cash flow (DCF) valuation. This requires the combined cash flows post-acquisition to be determined and estimate a discount value to make adjustments to this (Penman & Sougiannis, 1998). Using this method, the maximum a company should be prepared to pay is the difference between the present values of cash flows before and after the acquisition. If the combined entity’s is less than the separate entities then this will destroy shareholder value - and thinking about it logically why would companies want to merge if the combined entity is of less value? A benefit of using this approach is that it incorporates the time value of money, therefore appreciates that money available at a later date is worth less than money available now because of future earnings potential.

Like the other approaches to valuation, discounted cash flow valuation also has its limitations. Firstly it is difficult to decide an appropriate discount rate as well as the number of years of which future cash flows are discounted over and determining when this will end. It is important to note that it may take a few years before a newly formed entity could begin to recognise its true earnings potential. Secondly, in reality when valuing a company for an acquisition it is very hard to predict what benefits will arise from the combined entity and therefore it is difficult to incorporate this into the future cash flow predictions. In reality, it is likely that there will be a big difference between what is predicted compared to what actually happens. Furthermore deciding the growth rate of the cash flows can be difficult and various business risks and challenges need to be taken into consideration when doing this. Therefore DCF is subject to a number of assumptions, which altered, could provide different values. It is unlikely this method was used for BHS as I believe Sir Philip Green simply wanted to get rid of the company due to the difficulties it was facing. Even if this was not the case it will be very difficult to forecast cash flows given that it is currently a loss making company. On the other hand, for valuing TSB, this may not be the preferred method as the company has not long been separated from Lloyds TSB therefore the recent cash flows are unlikely to be a true representation as to what future ones may be and therefore provides very little guidance to predict future cash flows, particularly as a combined entity. This reinforces the point that predicted cash are likely to be very different to actual cash flows which could have lead Sabadell to coming to a very inaccurate value.

Another income based valuation method is the PE ratio. This is one of the most popular methods and it considers risk and gives an indication of future company performance (Arnold, 2012). However, like all valuations methods as discussed, it also comes with its limitations. The ratio needs to be compared with other firms otherwise it provides very little meaning. It is usually difficult to select these firms as there are many factors which this selection could be based on, for example size, revenues and profitability. Like DCF, it also requires cash flows to be forecasted for the combined entity and assumes they will remain the same over time - when in reality this is likely to change. 

To conclude, there are many methods which can be used to value a company and as demonstrated throughout this blog they are all subject to their limitations. It is very difficult to judge which method, if any at all, was used to come to a value for BHS because I think Sir Philip Green just wanted to sell the company regardless of how much it was worth due to the losses it is making. I think it would have been inappropriate for Sabadell to value TSB using NAV given that it does not give any consideration to intangibles, which as discussed are a significant part of the company. The company may have used a combination of methods - whist I have discussed methods within this blog, it is important to recognise that there are other methods which could have been used and in most cases it is unlikely that we are able to judge which method a company has used. I believe there is no ideal method to value a company and I believe companies should use a variety of methods which will provide a range of figures allowing a company to gain a greater appreciation and perhaps come to a more accurate value. Therefore I think it is fair to conclude that valuing companies is more of an art than a science.

References

ACCA (2012). Business Valuations. Retrieved 23^rd March 2015, from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_feb12_f9_valuationsv2.pdf

Arnold, G. (2012). Corporate financial management. (5^th ed.). New York: Pearson.

BBC (2015). TSB confirms £1.7bn takeover move by Spain's Sabadell. Retrieved 23^rd March 2015, from http://www.bbc.co.uk/news/business-31848517

Financial Times (2015). Sir Philip Green sells BHS for £1. Retrieved 23^rd March 2015, from http://www.ft.com/cms/s/0/70dfb9c8-c8a6-11e4-8617-00144feab7de.html#axzz3VD2iJ52f

Penman, S. H., & Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings approaches to equity valuation. Contemporary Accounting Research, 15(3), 343-383. doi:10.1111/j.1911-3846.1998.tb00564.x