Last month we introduced the concept of selecting a target operating model, or TOM, based on the parameters of the deal. In this month’s post we’ll take a deeper dive into how this would apply to a vertical transaction, such as AT&T’s proposed purchase of Time Warner, Inc.
Recall that we previously stipulated most acquirers will lack the knowledge, tools, and relationships to effectively manage a vertical acquisition. As such, most vertical deals will require lower levels of integration until enough internal expertise can be developed to make effective choices about how (or whether) to combine the companies. This means the acquirer is likely to have both an interim and an end-state TOM. The interim TOM describes a stable point in the integration where the companies will “pause” integration, operating in that TOM state until such time as additional integration becomes appropriate.
Of course, if the businesses are different enough, it may never be practical or appropriate to integrate fully, in which case the end-state TOM becomes minimal integration, and an interim model is not required; however, in this case the overall return on the deal is at risk. The valuations of most vertical deals rely on either extensive cost or extra-accretive revenue synergies to justify the purchase price, and these synergies can be very difficult to achieve when companies continue to operate as separate entities.
In the case of AT&T’s proposed purchase of Time Warner, Inc. it seems unlikely that AT&T’s internal organization design, systems configuration, and capital allocation cycle are ideal for media content production. AT&T has no content production expertise. Nor do they have any of the valuable relationships on which media producers rely. Some integration will be required to meet the minimum compliance requirements, such as being able to file SEC reports. And there may be some low-hanging fruit, i.e. standardizing on a common payroll provider and/or employee benefits platform, laying off some administrative employees, squeezing a few common suppliers for lower costs, but largely I would anticipate the companies continuing to operating independently should the deal come to fruition. What then will that mean in regards to AT&T realizing the synergies from the acquisition?
Let’s first consider a simplified example with two imaginary companies. Cones, Inc. manufactures cones which it sells to its only customer Cream, Inc. an ice cream manufacturer and retailer. Prior to combining their business results are as follows:
Cream, Inc. decides to buy Cones, Inc. to reduce input cost for cones in their ice cream parlors. Comparable companies are selling for 10x revenue, so the purchase price of Cones, Inc. would be (200 x 10=2000). Since Cream, Inc. lacks the knowledge and equipment to make cones, they decide to let Cones, Inc. stand alone. After the acquisition operating results would be:
Cream, Inc. gets a boost in operating profit from $300 prior to the acquisition to $350 ($500-$150) after the acquisition. The combined results do not change since the operations are the same as before the combination; furthermore, Cream, Inc. must recover their cost of acquiring. If they wish to recover that cost over 5 years, they would need ($2000/5=$400) in benefits per year. This of course assumes that attorney fees, bankers, auditors, and other transaction costs were zero, and also ignores the time value of money. Even if Cones, Inc. had additional profitable customers, we would still have only accretive synergies if we persisted with maintaining separate operations, and the valuation would have been proportionately higher.
Now consider this example in light of AT&T’s proposed valuation for Time Warner, Inc. of 3.7 times revenue, and 27.8 times earnings, and it should become apparent that my bias against vertical deals is not merely the result of irrational prejudice. The bottom line is that unless a profitable business is being very inefficient in its operations or has a high cost of capital it is very difficult to realize extra-accretive synergies at all. Such synergies come from combining either cost structures or market offers, and often this is just not practical. Vertical deals will still take place, and AT&T’s consideration of Time Warner as a defensive move against Comcast’s acquisition of Universal is an example, but for most business vertical deals should be approached with a high degree of skepticism. The difficulty of combining non-overlapping businesses will likely delay synergy realization, and the purchase price, combined with costs to achieve extra-accretive synergies, make these very tricky indeed.
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