Deciding to Acquire: Tales from the Trenches

Introduction
In this post we introduce our first M&A “Tales from the Trenches”.  While edited to protect client confidentiality, these real-world examples nonetheless illustrate the implications of applying or neglecting the precepts discussed elsewhere in this blog.  We’ll be including these sections periodically to break up the more academic topics with a little light reading. 
 
Tale #1: Vertical Transactions
Recall our discussion of vertical transactions from February’s post:
The objective of a vertical deal is to eliminate a “middleman” and thereby realize either:

• Cost synergies (acquiring a supplier) or
• Revenue synergies (acquiring a B2B customer)

The reality is often neither are realized, and again we will discuss the reasons and provide examples in future posts.  Vertical transactions will, in most cases, also require that the acquirer perform substantial integration activities if extra-accretive synergies are anticipated.

You’ll notice that we promised to shed additional light on vertical transactions in a future post, and our first Tale from the Trenches does just that. 

Tale from the Trenches: Thanks, But No Thanks

Company C was a household products manufacturer, and one of their major customers was a national chain of roughly 60 retail stores.  A significant portion of Company C’s sales came thru this channel, and leadership decided that purchasing the retailer would generate synergies via improved customer insights, better product placement, and capture of the retailer’s portion of the margin.  Company C paid just over $70 million for the acquisition, exclusive of transaction and integration costs. 

Five years later Company C was eager to unload their investment, and asked a private equity firm to evaluate the transaction.  The offer on the table was for Buyer to take all of the assets and liabilities for a cost of $0; furthermore, Company C would throw in an additional $40 million in cash to fund operations, providing Buyer agreed to operate for at least a full year prior to liquidating.  Yes- they were literally willing to pay $40 million to have this taken off their hands! 

The PE firm was excited to begin analysis, but as they looked at the numbers that excitement quickly faded.  Leases were at 150-175% of fair market value.  The assortment in the stores was entirely wrong for the customer base, and lead-times for replacement products were in excess of a year.  The stores had been remodeled in such a way that shrink (retail-speak for theft) was rampant.  To cut a long story short, they weren’t able to get the numbers to work, even with very aggressive assumptions about cost reductions.   They said thanks, but no thanks.

So, what went wrong, and why are vertical transactions so problematic?  The answer usually boils down two basic problems:

1. The acquirer’s skills, capital structure, and operating practices don’t align well with the needs of the acquired business, and/or
2. It is difficult to improve operations to the extent required to achieve extra-accretive synergies across verticals, but valuations will usually require such synergies for the deal to be profitable

Company C had learned the hard way that retail is a complex business, with a cost structure, real estate footprint, and personnel model quite different from manufacturing!  Operating losses over the holding period were in excess of $170 million, even though the retailer had been profitable prior to acquisition.  While this is a somewhat extreme example, it nonetheless is a true story that illustrates well just how problematic a vertical transaction can be.
 
Tale #2: Ignoring Strategy Frameworks
We’ve stated previously that strategic analysis is critical, and yet is often neglected due to the onset of “deal fever”.  Our next Tale from the Trenches illustrates why it is worthwhile to slow down and take the time to consider strategy.

Tale from the Trenches: Double Trouble

Company A had historically enjoyed high profitability on their subscription-based market offer; however, adjacent businesses had developed or acquired similar products, and were providing free subscriptions to these substitutes as part of their overall go-to-market strategy.  With viable free substitutes flooding the market, Company A's revenue was declining, and the future of the business in doubt.

Company A decided that the solution was to purchase another product line that sold subscription services to a similar customer base, bundle the products into a new offer, and thus compete effectively with the freeware by offering a combined value proposition.  Given the difference in the offer attributes, Company A knew it was unlikely that any significant administrative cost synergies could be realized; however, they were convinced that the revenue synergies from the new combined market offer would be sufficient to turn this into a fantastic investment.  After all the target- Company B- had similar customer demographics, so fantastic cross-selling opportunities seemed likely, correct?

 Company A paid a significant EBITDA premium to acquire Company B, and post-deal integration consultants were hired to evaluate Company B in preparation for integration planning.  These consultants soon discovered that Company B's biggest challenge had been…wait for it… adjacent companies had developed similar products and were giving away subscriptions as gifts to their customers! To make matters worse, Company B had gathered most of the addressable market share by promising customers a lifetime subscription with no increase in price.  And for the icing on the cake, more than 80% of Company B customers were existing customers of Company A.  This meant that the only way to increase revenue would be to raise the price of the combined offer to be higher than the price customers were paying to buy each separately, with the added wrinkle that the price of Company B’s products could not legally be increased for existing subscribers, and of course the original problem of readily available free substitutes for both.  Woops.

If Company A had taken the time to use the strategic frameworks some significant red flags should have been obvious.  Porter’s Five Forces would have highlighted the availability of substitutes for both Companies A and B as a significant strategic hurdle, along with high customer bargaining power, and a competitive business environment.  SWOT analysis would have shown similar concerns, while an elasticity study would have pointed out the inability to raise prices.  Finally, a proper TAM and share study might have uncovered the pre-existing customer overlap, indicating that cross-selling would not be a profitable effort in an environment of price inelasticity.

What both Company A and Company B missed was the opportunity to engage in strategic arrangements that would have precluded the need to do this deal.  A licensing arrangement could have been very lucrative in both cases- allowing the acquirer of the license to include a branded product in their offer set, instead of incurring the cost of developing the free giveaway alternative.  And Companies A and B could have realized benefits both from the licensing revenue, and potentially from a strategic alliance or joint marketing arrangement with the license holder for access to their customer base for upselling complementary products and services, getting access to the “net new” customer base that both craved.

Conclusion
We hope you have enjoyed these first two Tales from the Trenches.  In our next post we’ll consider how to determine the integration scope and approach based on deal rationales, an elaboration of February’s topic.
 
We look forward to hearing your thoughts,
K