Lowering Total Costs Arising From Inefficient Market Transactions

The value driver. Total input costs decline due to reduction of market inefficiencies. If it were possible to bring down the total input costs by reducing market transaction costs through vertical M&A, gross margins-the difference between total revenues and total costs-would improve.

The strategy. There may be many cases where reducing technical/transaction/uncertainty costs through vertical integration is possible. For, such integration enables better coordination and planning, reduces technical costs, assures supply, and lowers transaction costs, bargaining time and other market fractions. The assumption: internal exchanges are more efficient than market exchanges. Vertical integration also increases control over the production process, an important parameter in capacity-constrained economies where there are supply bottlenecks or there is asset-specificity. This strategy is aimed at reducing total costs. If revenues are fixed, gross margins should improve. Therefore, M&As that reduce the inefficiencies of market exchange can result in positive synergies for the combination.

The problems. Vertical integration is limited in its ability to ensure regular supply or reduce transaction costs. The inefficiency of markets can sometimes be over-estimated, making the resultant reductions in costs minimal. And there are several factors that actually make vertical M&A a more costly proposition:

• The added capital costs can become an extra burden even as they reduce flexibility and bargaining power of the combined entity.
• Using the Porterian Value Chain Analysis, a company might discover that only part of its production chain is profitable, making it better to focus on that sub-section. This will contradict the benefits of vertical integration.
• Sometimes, suppliers subsidise the forward segment by selling products to its captive buyer at lower-than-market prices, thereby denying themselves the profits they could make by selling in the open market. This makes vertical integration less profitable.

Reducing Marginal Cost Through Operating Synergy

The value driver. Marginal costs decline due to economies of scale, achieved through improvements in operating efficiency arising from horizontal or related M&A. Since marginal cost is difficult to ascertain, average cost-which moves in tandem with the marginal cost-is used as a proxy.

The strategy. The implicit assumption here is that the long-run marginal cost curve declines as the quantity produced increases, forcing down the average cost per unit. This is possible for several reasons. First, the rationalisation of productive resources allows a company to spread its fixed costs over a larger base of customers and units produced. Second, achieving critical mass allows certain cost advantages both as a buyer and a seller, as intangible costs like marketing and overheads can be distributed over a larger production base. In industries where these principles hold, it makes economic sense to acquire large production capacities through M&A. Thus, horizontal or related M&A, which increases the size of the operations, might result in cost-reductions, and improve the competitive position of the combined company.

The problems. Although there are numerous examples of economies of scale being reached through M&A, it is questionable whether it is the best way of achieving this. The reasons:

• The Experience Curve theory is dubious. In several industries, smaller and nimbler companies are more profitable than their larger counterparts. Even in utilities, new technology has made unbundling economically feasible.
• Central services are sometimes difficult to transfer to the specialised needs of a subsidiary. The complicated structure of large corporations may actually increase administrative costs.
• Joint ventures, sub-contracting excess capacity, and other forms of market agreements may improve performance in the same way that economies of scale do, while adding the flexibility to operations that large capacities do not permit.

Reducing Company-Specific Risk To Lower The Discount Rate
The value driver. M&A strategies that reduce unsystematic (company-specific risk) will lower the discount rate (beta) of the company. Specialised diversification can stabilise cash-flows in relation to market fluctuations.

The strategy. Using the dcf method of calculating the present value of future earnings, it is clear that to increase valuation, one can either increase earnings or reduce risk. There are two kinds of risk that a company is exposed to: systemic (common to the universe of investible assets), and unsystematic (company-specific). Most forms of reducing systematic risk are equally available to the individual investor. However, company-specific risk-reduction is a function of diversification strategy, and, hence, cannot be achieved by individual investors. It needs to dampen the company-specific fluctuations of earning streams in relation to market fluctuations.

There is some evidence to suggest that a company-specific risk can be reduced by diversifying into related areas. This strategy hinges on extending reputational capital-through brand extensions, for instance-developing critical mass in buying and selling, reducing technological and marketing risks, and reinforcing managerial skills. Moreover, mutual forebearance reduces competition as it leads to tacit collusion. Companies buy into their rivals' industries in order to threaten a retaliatory strike on their competitors' main markets.

The problems. Investors can reduce risk by diversifying within the market basket more cheaply than a company can through M&A. That's not all.

• There may be cases of over-extension into unrelated product areas or product-lines that dilute the original brand image.
• Often, the motivation to merge is to protect cash-flows by investing in counter-cyclical businesses. This risk-pooling concept is weak since several counter-cyclical industries have been known to nose-dive in unison. Further, companies may have no competency for managing such unrelated business.

Improving Imperfect Market Valuation Through M&A

The value driver. Imperfect market valuation can be corrected. M&A might force an upward revaluation of a target's valuation. And this is reflected in an improvement in its Price to Earnings (P-E) ratio.

The strategy. Buy low and sell high. Earlier methods of creating value through M&As have dealt with either increasing the income stream, or reducing costs. But shareholder value can also be released through M&A if the acquirer plays a lower premia for a target compared to its true value.

There are considerable opportunities here. Since there is a difference between ownership and control in many companies, management may be inefficient. The market for external control (takeovers) might work as a device to curb managerial excesses. Or, post-takeover costs could be reduced by improving the management of the company.

There are several companies that have been undervalued by the market. This could make external expansion more attractive than internal growth since the price of the target might be lower than its replacement cost. The market might revalue the acquisition on the basis of the following assumptions: improvement in management, divestment of unproductive units, and realignment of businesses.

The problems. The promise behind acquisitions is not a promise of any economic gain or elimination of waste, but a belief that market valuations were incorrect.

• Studies now show that the whole M&A wave of the 1980s has had few economic gains to boast of. Indeed, if all low p-e stocks were cheap, and high p-e stocks dear, everyone would be wealthy. Acquirers must have a clear rationale for believing that takeovers will be a sufficient reason for the market to revalue companies.
• M&A isn't the only route available to a company for improving managerial performance with a view to boosting valuation. The process of tying managerial compensation to profits and share price, using the mechanism of stock options, can provide equally effective results.

The Strategy Star

The second element of the M&A analytical framework is a methodology that enables managers to identify the specific areas they wish to target for improvement. This is a necessary tool for management since it is often not clear what type of merger will create more value. The Strategy Star helps index the company's performance against the industry's, thereby highlighting the strong and weak points. The model identifies six areas for value-creation in a star-form matrix, with a simple benchmarking technique ranking within the relevant industry. These rankings identify which areas the company dominates, and the ones that require urgent attention, thus pointing the way to an M&A strategy.

Consider, for instance, a company that seems to have strong managerial talent, translated into high marketshares, and is operating in an industry which seems to favour companies with large operating bases, translating into economies of scale. Furthermore, its earnings are steady, leading to high market-valuation. However, its gross margins and roi are weak. The grid implies that the average price for the company's products are not very high, given a fixed level of investment. Besides, the cost of its inputs are relatively high as gross margins lag behind those of the industry's. Just what are the implications of this benchmarking for the company's M&A strategy?

Alleviate weaknesses. Clearly, one of the first reactions to this form of indexation would be to initiate M&As that address the weaknesses of the Star Analysis. In this case, it implies that the company should focus on improving its gross margins and ROI. If the Value-Strategy Chain model were applied, it would lead to either vertical mergers (which lower input costs) or unrelated conglomerate takeovers (which improve average recoveries).

• Increase ROI-by channelling cash to more attractive industries. But the business should be cash-rich, and be able to identify attractive industries to funnel cash-which, in turn, will increase marginal revenue.
• Improve gross margins. The industry may have some kind of supply constraints that increase market transaction costs. These market inefficiencies can be reduced by vertical integration which, in turn, improves margins.

Focus on strengths. Alternatively, the M&A gameplan could concentrate on competencies. From the Star Analysis, it appears that the company has good management, large operating efficiencies, and stable cash-flows. So, the management may decide to seek related conglomerate mergers to improve marketshare, and increase profits by improving the target's management. Or, it may presume that its marginal cost curve will dip further by adding capacities, and opt for horizontal mergers. Else, it may focus on dampening the fluctuations of its earnings even further by diversifying into related products.

The Value Star analysis provides a potential predator with insights into its strategic strengths and weaknesses. Coupled with the Value-Strategy Chain framework, the analysis opens up the M&A process for closer inspection. It identifies the routes for value creation and assesses the viability of a particular strategy. Indeed, the analysis will help a company to match its strengths with the target's, and predict the future of the combined entity. Ultimately, the Value-Strategy Chain attempts to transform the CEO's view of the M&A process and the ways in which value is created. The linkages between specific strategy with the valuation should lead corporates to review their acquistion-related decisions, focusing corporate strategy on targeting value drivers and identifying ways in which to enhance their performance.

Precisely because opportunities for acquisitions abound in today's economy, even as the environment grows increasingly receptive to even hostile takeovers, potential predators must display the very caution that entrepreneurs in the licence raj did not while blundering into expansion sans competitiveness. The specific targeting of value drivers can vastly improve a company's ability to reap synergies from its M&A. However, the CEO must avoid the pitfalls that can dilute business strategy. As M&A becomes more ambitious, and the costs of transaction and premia start rising, failure could certainly doom the predator's future. And there's no surer route to failing with your M&A than not checking beforehand if it'll add value. In this game, two plus two had better be much greater than four.

This paper is based on the author's research for a forthcoming publication, A Guide To Value-Creating M&A.

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