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Diversification & Synergy

This is only a summary. Please read the text book and additional readings for details. Removal of errors and omissions, if any, in this ppt are your responsibility.

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Agenda

SynergyDiversification

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Synergy

In M&A – it is value creation for the shareholders that they would not have been able to garner on their own

For valuation of synergies, usual DCF works, often need advanced option valuation techniques

Theory offers no suggestions on the discount rate to be used

Judgment, intuition and experience

Need significant analysis to ‘justify’ approach

Analysis is company, industry and economic-condition specific

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Numerical

Firm A announced a merger proposal with Firm T. Both have an overall cost of capital of 10%. Currently Firm A generates an after-tax cash flow of 0.5 billion per year and firm T generates an after-tax cash flow of 0.3 billion per year. If the two firms merge it is expected that they will generate after tax cash flow of 1billion per year.

• Should they merge?• What is the gain from the takeover (merger)?• What is the value of firm T to firm A?

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Numerical

The acquiring firm A has two options when acquiring the target firm T. Below are some details of the two firms.

 Firm A expects to generate cost savings and other synergies equating to additional annual net profit after tax of $6 billion in the foreseeable future. Both firms have an overall cost of capital of 10.5% and are in the same marginal tax bracket.

• What is the gain to the acquirer firm A, and price per share of the merged entity when the target, firm T will accept cash of $25 billion for the merger?

• What is the gain to the acquirer firm A, and price per share of the merged entity when the target, firm T will accept shares worth $25 billion for the merger?

• What is the gain to the acquirer firm A, and price per share of the merged entity when the target, firm T will accept 0.6 shares of firm A for 1 share of firm T?

Firm A Firm TPrice per share $30 $20

# O/S shares 1.7 billion 1.1 billionMV of equity $51 billion $ 22 billion

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Diversification

Diversification• A collection of businesses under one corporate

umbrella (referred to as conglomerates)• A firm is diversified when it is in two or more lines of

business• It is through coherent overarching strategy and

actions that the corporation will create shareholder value in the long term and be sustainable as a multi-business entity

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Diversification

Peter Drucker : a company should be diversified in products, markets and end-uses and highly concentrated in its basic knowledge area orIt should be diversified in its knowledge area and highly concentrated in product, markets, end-uses

This is by no means exact but a directional approach or indicator to understanding related and unrelated diversification (and core or non-core activities of the firm) – very tenuous

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Diversification

Microsoft – tracing its history is it related or unrelated diversification?Network 18 – related or unrelated diversification?GEGoogleWiproJain IrrigationJindals

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Diversification

AdjacenciesWhen a firm moves out of core into adjacent space

Expand along the value chain (mfg and retail) Grow new products and services (IBM moved into global

services which now accounts for just over 50% of its pre tax profits)

Use new distribution channel (Dell, Landmark) New markets (Indian IT companies, Tesco from UK to

US) New Customer segment (CAF from prime to sub-prime) New space(AA sets up Sabre which led to Travelocity) Hybrid approaches (Nike customer experience)

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Diversification

Develop new core• One example - Barrick the largest gold mining firm• ITC

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Diversification

Berkshire Hathaway (BH)• One of the successful conglomerates with over 60

subsidiary operating business• Has grown by acq of firms in insurance, bricks,

furniture, jewelry…• Business model is simple: surplus cash from low

growth business is invested in high growth business, key acq or stock market investment

• Market perception is that the success of BH is due to its equity investment portfolio – the portfolio only contributes 20% of the market value of BH

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Diversification

Berkshire Hathaway (BH)Firm groupings as per 2008 annual report• Insurance group (GEICO, General Re…)

• Finance and financial products group (various)

• Marmon (130 mfg and service business)

• McLane Co (wholesale distn of grocery and non-food items)

• MidAmerican (regulated el. and gas, power gen and distn US and overseas)

• Shaw Industries (carpet and flooring)

• Mfg (Brown shoe Co, FTL, ACME building…)

• Service (Bufallo news, Business wire…)

• Retailing (Helzberg Diamonds, Nebraska furniture…)

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Diversification

Berkshire Hathaway (BH)Business model• Insurance group generated a lot of float which

helped the business• Ensure that businesses generate free cash

especially on the aggregate• Owner orientation – own diversified business, o/w

own parts of businesses, price of a business is a major factor (seek undervalued firms), choose managers astutely (not much interference in day-today tactics)

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Diversification

Berkshire Hathaway (BH)Business model• Prefer negotiated transactions• Yet, will buy shares of interested firms in the stock

market when the price is right• Since the 1990s investment has been in several

100% owned businesses• Conglomerate strategy anchored by the core

business: insurance• Very effectively and efficiently managed – low

corporate headcount