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. 

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.

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

Introduction
Last time we reviewed some basic strategy frameworks, and stated that the best M&A deals are those that address challenges identified via strategic analysis.  This post expands on that point, with a discussion of the “why” of M&A deals.
 
Deal Rationales
Every successful deal starts with the identification of the deal rationale, or the “why” of the deal.  This rationale should drive all subsequent decisions regarding the best approach to the transaction.  While there are numerous non-operational deal rationales- i.e. acquiring a company to change its capital structure and thus benefit from some financial arbitrage- most acquisitions are done to improve results of operations.  As such, it is critical to identify what type of acquisition will best address the acquirer’s operational gaps. This is where the strategic analysis comes in:

• What risks is the business facing, and will acquisition activity amplify those risks?
• Can we raise prices? 
• How much additional TAM is available, and how much of that can we realistically capture if we proceed with a deal?
• Are we better off selling more to existing customers, or expanding our portfolio?
  
• What are our competitors, suppliers, customers up to, and how shall we respond?

Before we get into the discussion of basic operational deal rationales, I am inserting a disclaimer.  I make some generalizations below, and have simplified some concepts to make them more easily digestible.  Nevertheless, I think the main points hold water, so I will ask all my banker and consultant friends to be indulgent.
 

Rational #1: Economies of scale
Acquiring an overlapping company to:

1. Acquire revenue accretion
2. Eliminate duplicate administrative costs
3. Enjoy greater pricing leverage
4. Enjoy greater purchasing leverage
5. Increase capacity

Real-world example: Miller-Coors

Rationale #2: Economies of scope- geographic
Acquiring a complementary company to gain access and expertise in geographies not previously served.
Real-world example: Yahoo!- Alibaba

Rationale #3: Economies of scope-market offers
Acquiring a complementary company to:

1. Add new products and/or create combined product offers
2. Gain access to customer base for cross-selling

Real-world example: Symantec-LifeLock

Rationale #4: Vertical Integration
Acquiring a company above or below in the value chain:

1. Acquire a supplier to ensure adequate supply of inputs and control over costs
2. Acquire a customer to realize additional margin, and/or control points of distribution

Real-world example: Comcast- Universal

Rationale #5: Defense
Acquiring either a complementary or overlapping company to:

1. Prevent competitors from acquiring highly prized assets
2. Respond to a competitor’s growth in scope or scale
3. Prevent value erosion, i.e. acquiring a new market entrant to control the timing and distribution of their disrupting product while legacy offers complete their value cycle

Real-world example: PepsiCo- Quaker

Rationale #6: Innovation
Acquiring a complementary company to:

1. Purchase research and development (often the case with serial acquirers in technology and pharmaceuticals)
2. Gain access to the company’s proven talent, so as to benefit from their future creative efforts

Real-world example: Warner Bros.- Shed Media

Note that it is common for a deal to provide multiple synergy benefits; however, there will still be a primary value driver that ultimately defines the rationale of the deal.  For example, when PepsiCo acquired Quaker, the primary value driver was the addition of the Gatorade brand sports drink, so as to compete with Coca-Cola’s Powerade product.  Naturally, there was enough overlap that PepsiCo could also benefit from more scale in the purchase of ingredients, from the elimination of duplications in distribution, etc.  These were real, albeit ancillary, synergy benefits.  The actual deal rationale was defense, i.e. the matching of a competitor’s offer in a highly rivalrous industry.

Determining Which Type of Deal to Pursue

Overlapping deals
Overlapping deals address various elasticity constraints.  That is a nerdy way of say that overlapping deals are appropriate for acquirers that need to:

1. Raise prices, but cannot due to a lack of market leverage or declining demand
2. Lower prices to discourage new entrants and/or substitutes, to address falling demand, or to compete in a rivalrous industry, but cannot due to margin constraints
3. Reduce the costs of inputs, but cannot due to a lack of market leverage or constrictions in supply (usually accompanies #2 above)
4. Produce more in the face of sticky prices with high demand, but cannot due to a lack of capacity

Overlapping deals provide scale and market leverage.  Extra-accretive revenue synergies will be realized if the deal allows an increase in pricing; however, the primary value driver of an overlapping deal is most often cost synergies.  This means that substantial integration activities are likely to be required to realize the projected synergies, and corresponding costs to achieve must therefore be considered in the deal valuations.

Complementary deals
Complementary deals add products, geographies, innovation, and/or expertise.  If cost synergies exist, often they are ancillary benefits.  The primary value driver will usually be extra-accretive revenue synergies.  Synergy realization risk is higher in a complementary deal than an overlapping deal, and we will discuss the reasons for this in more detail in future posts.  For now, just understand that careful attention will need to be paid to diligence, valuation, and integration, in order to ensure synergy realization on complementary deals.

Vertical deals
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.
 
Conclusion
Hopefully this discussion of deal rationales illustrates why it was critical to begin the process with a good understanding of our strategic foundation.  We’ll continue to expand on this in future posts, and I’ll throw in some fun, real-world examples that should provide even more insight on how these basics come into play.
 
I look forward to hearing your thoughts,
K

Introduction

Admittedly, I struggled when creating the schedule of blog posts for 2018.  The conflict centered on what to include in this first substantive post.  Should I begin with what I believe is the beginning of the M&A process, or lead off with a flashier, more deal-centric topic?  After some hemming and hawing I have decided to begin at the beginning, and thus our first few posts will address how to decide whether to engage in M&A.

To assess whether acquisitions are appropriate, you must first address the basic strategy building blocks.  Since many of us haven’t been to B-school in a while (or perhaps at all) we’ll begin with a review of 5 common strategy evaluation tools.  This will provide a framework for future posts on how to address strategy challenges using M&A.  It isn’t flashy, but as Stephen R. Covey suggests, let’s begin with the end in mind.

Tool #1: Porter’s 5 Forces
Michael Porter of Harvard Business School created this classic strategy evaluation tool.  The “5 Forces” are as follows:

1. Competitive rivalry
2. Bargaining power of suppliers
3. Bargaining power of customers
4. Barriers to entry
5. Availability of substitutes

The relevance of each of these varies tremendously from company to company.  I had the privilege of working with PepsiCo on their acquisition of Quaker Oats, and I can attest that PepsiCo’s culture has ben highly influenced by being in an industry dominated by 2 large players- a duopoly.  The 5 forces also work in concert with one another.  Notice that if there are 2 significant industry participants, the barriers to entry are often high, and thus the availability of substitutes low.  Bargaining power for suppliers is likely to be low as well, since both will be significant customers.  Interestingly, the bargaining power of customers will hinge on the competitive posturing of the companies in the duopoly.  If they are more focused on one another than on the bottom line, customers may have more power.  If each adopts a “you are only as smart as your dumbest competitor” mindset, customer bargaining power will be lower.

Tool #2: SWOT Analysis
Albert Humphrey of the Stanford Research Institute developed the SWOT- or strengths, weaknesses, opportunities, and threats- model.  This is also sometimes called the “mirrors and windows” model, since the first two items require an internal examination, while the following two address external factors. 
Interestingly, while most executives seem to be able to execute a Porter’s 5 Forces exercise fairly easily, it has been my experience that many need external help to get thru a useful SWOT analysis.  The more internally focused the company, the more this holds true, although most seem to struggle with an honest assessment of both weaknesses and competitive threats.  Regardless, having this knowledge is a critical input to understanding whether acquisitions are a good investment, so I recommend either engaging consultants or volunteering for a business school case study to get a thorough, objective analysis.

Tool #3: PESTLE Analysis
Harvard Business School created the PEST framework, which was later modified to include the remaining 2 factors.  This model is used to assess the following macro-level risks:

1. Political
2. Economic
3. Socio-cultural
4. Technological
5. Legal
6. Environmental

As with Porter’s 5 Forces, the significance of each of these will vary.  For example, healthcare is an industry that currently experiences an almost extreme level of political risk at the macro level.  Commodities business are particularly sensitive to economic risks, and extractive and chemical companies deal with environmental risks as a matter of course. 
A good PESTLE analysis will provide the macro-level backdrop for your SWOT analysis, so it is key to ensure that the teams working on each are coordinating. You want to get complementary outputs, reflecting a consistent perspective.  Bear in mind that the goal isn’t to eliminate these risks, that is usually not possible, but rather to understand the impact they have on the variability of investment outcomes.  Higher risk companies may want to include more “stress testing” on the valuations of deals, for instance.

Tool #4: Elasticity and Tool #5 TAM/Share Capture
Our final 2 tools are not so much strategy frameworks as just basic business principles; however, both are often neglected when evaluating M&A.  Elasticity measures the sensitivity of demand to price.  TAM, or Total Addressable Market, is a mathematical calculation of what total volume is likely for a given product. 
The actual formula for elasticity is as follows:
Elasticity= % change in quantity demanded/% change in price
You can go uber-geek, and hire an economist to perform the calculations if you wish; however, most companies have enough pricing and competitive data to develop at least a working assumption of how sensitive their demand curve is to pricing changes.  Of course, this will be highly correlated with the findings from the Porter’s analysis in regards to industry competitiveness and bargaining power of customers.
TAM is a bit of a “burr under the saddle” for me, as I routinely see M&A models that make wildly unrealistic assumptions using growth rates.  For example, a while back I was presented with a model where the revenue assumption would have required every American man, woman, and youth from age 15-45 to purchase 3 identical camping items from the company every year, using the provided pricing assumptions.  Obviously not realistic, but very easy to do if all one does is to project a growth rate assumption over future periods!
To calculate TAM you must first decide what your target market is (i.e. Americans between 15-45 in the previous example) identify the population of that group overall, then the population likely to be in the market for your product or service.  The next step is to calculate what percentage of those in the market will buy each year, which is usually accomplished by assuming a useful life for the product.  The resulting calculation is the total annual volume of product that we expect to be sold to our target demographic in our target region.
Share capture assumptions go hand-in-hand with TAM, and should reflect the competitive environment indicated in the Porter’s and SWOT models.  How much of the total market can you realistically expect to capture, given what you have learned from both the competitive analysis, and the effects of elasticity on price?

Conclusion
Hopefully the usefulness of these tools in providing insight into a company’s readiness for M&A is apparent, and I haven’t lost too many readers with my “unflashy” initial post.  The best investments for any company are the ones that realistically address strategic challenges, and thus optimize the overall value and return.  And to understand what strategic challenges to address, there really is no substitute for a little strategy analysis legwork.

I look forward to hearing your thoughts,
K