Main objective of this report is to analysis Merger of Nestlé S.A. Naturally, both sides of a Merger and Acquisition deal can have different ideas about the worth of the target company: its seller will usually value the company at as high of a price as doable, while the buyer will try to obtain the lowest price that they can. At the very least in theory, mergers develop synergies and economies regarding scale, expanding operations as well as cutting costs. Investors may take comfort in the idea that a merger will provide enhanced market power.
Mergers and Acquisitions: Introduction
Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world. Every day, Wall Street investment bankers arrange M&A transactions, which bring separate companies together to form larger ones. When they’re not creating big companies from smaller ones, corporate finance deals do the reverse and break up companies through spinoffs, carve-outs or tracking stocks.
Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even billions, of dollars. They can dictate the fortunes of the companies involved for years to come. For a CEO, leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so many of these transactions; they happen all the time. Next time you flip open the newspaper’s business section, odds are good that at least one headline will announce some kind of M&A transaction.
Sure, M&A deals grab headlines, but what does this all mean to investors? To answer this question, this tutorial discusses the forces that drive companies to buy or merge with others, or to split-off or sell parts of their own businesses. Once you know the different ways in which these deals are executed, you’ll have a better idea of whether you should cheer or weep when a company you own buys another company – or is bought by one. You will also be aware of the tax consequences for companies and for investors.
Company History:
Nestlé S.A. is the largest food and beverage company in the world. With a manufacturing facility or office in nearly every country of the world, Nestlé often is referred to as “the most multinational of the multinationals.” Nestlé markets approximately 7,500 brands organized into the following categories: baby foods, breakfast cereals, chocolate and confectionery, beverages, bottled water, dairy products, ice cream, prepared foods, foodservice, and pet care.
Early History
While serving as the American consul in Zurich, Charles Page decided that Switzerland, with its abundant milk supply and easy access to the whole European market, was the perfect location for a condensed milk factory. The first canned condensed milk had been produced in the United States by Gail Borden some ten years before, and originally Page planned to produce and sell “Borden Milk” in the European market as a licensee. The plan fell through, however, so in 1866 he established the Anglo-Swiss Condensed Milk Company as a limited company in Cham, Switzerland.
The company’s name was meant to flatter the British, to whom Page hoped to sell a great deal of his condensed milk. Anglo-Swiss first expanded its operations beyond Switzerland’s borders in 1872, when it opened a factory in Chippenham, England. Condensed milk rapidly became a staple product in European cupboards–the business downturn in 1872 and the depression of 1875 did not affect the firm’s sales. Charles Page died in 1873, leaving the company in the hands of his brother George and Anglo-Swiss’s other investors. The next year, Anglo-Swiss undertook further expansion in England by purchasing the Condensed Milk Company in London. By 1876 sales were almost four times their 1872 level.
Meanwhile, in Vevey, Switzerland, in 1867 Henri Nestlé began selling his newly developed cow’s-milk food for infants who could not be breastfed. Demand for his Farine Lactée Nestlé soared. Between 1871 and 1873, daily production more than doubled, from fewer than 1,000 tins a day to 2,000. Nestlé’s goal was to bring his baby food within everyone’s reach, and he spared no effort in trying to convince doctors and mothers of its benefits. But while his energy and good intentions were nearly endless, his financial resources were not. By 1873, demand for Nestlé’s product exceeded his production capabilities, resulting in missed delivery dates. At 61, Nestlé was running out of energy, and his thoughts turned to retirement. Jules Monnerat, a former member of parliament who lived in Vevey, had long eyed the business, and in 1874 Nestlé accepted Monnerat’s offer of CHF 1 million. Thus, in 1875, the company became Farine Lactée Henri Nestlé with Monnerat as chairman.
In 1877 Nestlé faced a new competitor when the Anglo-Swiss Condensed Milk Company–already the leading manufacturer of condensed milk in Europe–decided to broaden its product line and manufacture cheese and milk food for babies. Nestlé quickly responded by launching a condensed milk product of its own. George Page tried to buy the competing company outright, but he was firmly told that Nestlé was not for sale. Turning his attention elsewhere, he purchased the Anglo-Swiss Company’s first factory in the United States in 1881. The plant, located in Middletown, New York, was built primarily to escape import duties, and it was soon successful enough to challenge Borden’s supremacy in the U.S. condensed milk market. It also presented a drawback: George Page spent so much time there that Anglo-Swiss began to lose its hold on Europe, much to the delight of Nestlé. After George Page’s death in 1899, the Anglo-Swiss Condensed Milk Company decided to sell its American business to Borden in 1902 so that it could concentrate on regaining market share in Europe.
Until 1898 Nestlé remained determined to manufacture only in Switzerland and export to its markets around the world. But that year the company finally decided to venture outside Switzerland with the purchase of a Norwegian condensed milk company. Two years later, in 1900, Nestlé opened a factory in the United States, and quickly followed this by entering Britain, Germany, and Spain. Early in the 1900s, Nestlé also became involved in chocolate, a logical step for a company based in Vevey, the center of the Swiss chocolate industry. Nestlé became a partner in the Swiss General Chocolate Company, the maker of the Peter and Kohler brands. Under their agreement, the chocolate company produced the first Nestlé brand milk chocolate, while Nestlé concentrated on selling the Peter, Kohler, and Nestlé brands around the world.
Merger of Nestlé and Anglo-Swiss in 1905
In 1905 Nestlé and the Anglo-Swiss Condensed Milk Company finally quelled their fierce competition by merging to create the Nestlé and Anglo-Swiss Milk Company. The new firm would be run by two registered offices, one in Vevey and one in Cham. With Emile-Louis Roussy as chairman, the company now included seven factories in Switzerland, six in Great Britain, three in Norway, and one each in the United States, Germany, and Spain.
In response to an increase in import duties in Australia–Nestlé’s second largest export market–the company decided to begin manufacturing there in 1906 by buying a major condensed milk company, the Cressbrook Dairy Company, in Brisbane. In the next few years production and sales continued to increase as the company began to replace sales agents with subsidiary companies, particularly in the rapidly growing Asian markets.
Most of its factories were located in Europe, however, and when World War I broke out in 1914, Nestlé’s operations, particularly in such warring countries as Britain and Germany, were seriously affected. Although production continued in full force during the early months of the war, business soon grew more difficult. By 1916 fresh milk shortages, especially in Switzerland, meant that Nestlé’s factories often sold almost all of their milk supplies to meet the needs of local towns. Shipping obstacles, increased manufacturing and operating costs, and restrictions on the use of production facilities added to Nestlé’s wartime difficulties, as did a further decrease in fresh milk supplies due to shortages of cattle.
To deal with these problems and meet the increased demand for its products from governments supplying their troops, Nestlé decided to expand in countries less affected by the war and began purchasing existing factories, particularly in the United States, where it established links with several existing firms. By 1917 Nestlé had 40 factories, and in 1918, its world production was more than double what it was in 1914. Nestlé pursued the same strategy in Australia; by 1920 it had acquired a controlling interest in three companies there. That same year, Nestlé began production in Latin America when it established a factory in Araras, Brazil, the first in a series of Latin American factories. By 1921, the firm had 80 factories and 12 subsidiaries and affiliates. It also introduced a new product that year–powdered milk called Lactogen.
It did not take long for the effects of such rapid expansion to catch up with the company, however. Nestlé and Anglo-Swiss reported its first loss in 1921, to which the stock market reacted with panic, making matters worse. The company explained that the CHF 100 million loss was due to the rising prices of raw materials such as sugar and coal, and a trade depression that had caused a steady fall in consumer purchasing power, coupled with falling exchange rates after the war, which forced the company to raise prices.
To battle the storm, the company decided to reorganize both management and production. In 1922 it brought production in line with actual sales by closing some of its factories in the United States, Britain, Australia, Norway, and Switzerland. It also hired Louis Dapples, a banking expert, to put the company back in order. Dapples directed Nestlé with an iron fist, introducing stringent financial controls and reorganizing its administration. By 1923, signs of improvement were already evident, as Nestlé’s outstanding bank loans had dropped from CHF 293 million in 1921 to CHF 54.5 million in 1923. Meanwhile in France, Belgium, Italy, Germany, and South Africa, production facilities were expanded. By consolidating certain operations and expanding others, Nestlé was also able to widen its traditional range of products.
Overall, the late 1920s were profitable, progressive times. In addition to adding some new products of its own–including malted milk, a powdered beverage called Milo, and Eledon, a powdered buttermilk for babies with digestive disorders–the company bought interests in several manufacturing firms. Among them were butter and cheese companies, as well as Sarotti A.G., a Berlin-based chocolate business that began manufacturing Nestlé, Peter, Cailler, and Kohler chocolate. In 1928, under the direction of Chairman Louis Dapples, Nestlé finally merged with Peter, Cailler, Kohler, Chocolats Suisses S.A.–the resulting company of a 1911 merger between the Swiss General Chocolate Company and Cailler, another leading firm–adding 13 chocolate plants in Europe, South America, and Australia to the growing firm.
Expansion During the Great Depression
Nestlé was becoming so strong that it seemed even the Great Depression would have little effect on its progress. In fact, its U.S. subsidiary, Nestlé’s Food Company Inc. of New York, barely felt the stock market crash of 1929. In 1930 Nestlé created new subsidiaries in Argentina and Cuba. Despite the Depression, Nestlé added more production centers around the world, including a chocolate manufacturer in Copenhagen and a small factory in Moravia, Czechoslovakia, to manufacture milk food, Nescao, and evaporated milk. Factories were also opened in Chile and Mexico in the mid-1930s.
While profits were down 13 percent in 1930 over the year before, Nestlé faced no major financial problems during the Depression, as its factories generally maintained their output and sales were steady. Although Nestlé’s New York-based subsidiary, renamed Nestlé’s Milk Products Company, was more affected than those in other countries, U.S. sales of milk products were steady until 1931 and 1932, when a growing public frugality began to cause trouble for more expensive but established brands such as Nestlé’s. Profit margins narrowed, prices dropped, and cutthroat competition continued until 1933, when new legislation set minimum prices and conditions of sales.
The markets, such as the United States, that were among the first to feel the effects of the Depression were also the first to recover from it. The Depression continued in Switzerland, however. Nestlé products manufactured there could no longer compete on international markets since Swiss currency exchanges were made especially difficult from the early 1930s, when many major countries devalued their currencies, until 1936, when Switzerland finally did likewise. The company decided to streamline production and close several factories, including its two oldest, in Cham and Vevey.
Decentralization efforts begun during the Depression continued to modify the company’s structure gradually. By 1936, the industrial and commercial activity of the Nestlé and Anglo-Swiss Condensed Milk Company itself was quite limited in comparison with the considerable interests it had in companies manufacturing and selling its products. More than 20 such companies existed on five continents. In effect, the firm had become a holding company. Consequently, the Nestlé and Anglo-Swiss Condensed Milk Company Limited was established to handle production and marketing on the Swiss market; the parent company officially became a holding firm, called the Nestlé and Anglo-Swiss Holding Company Ltd.; and a second holding company, Unilac Inc., was created in Panama by a number of Nestlé’s overseas affiliates.
Nescafé Instant Coffee Debuting in 1938
In 1937 Louis Dapples died, and a new management team, whose members had grown up with the organization, took over. The team included Chairman Edouard Muller, formerly managing director; Carl J. Abegg, vice-chairman of the board; and Maurice Paternot, managing director. In 1938 Nestlé introduced its first nonmilk product: Nescafé. The revolutionary instant coffee was the result of eight years of research, which had begun when a representative of the Brazilian Coffee Institute asked Louis Dapples if Nestlé could manufacture “coffee cubes” to help Brazil use its large coffee surplus. Although coffee crystals and liquid extracts had been tried before, none had satisfactorily preserved a coffee taste.
Nestlé’s product took the form of a soluble powder rather than cubes, allowing users to control the amount of coffee they used. Although Nestlé originally intended to manufacture Nescafé in Brazil, administrative barriers were too great, so Nescafé was first manufactured in Switzerland. Limited production capacity meant that it was launched without the elaborate marketing tactics usually used for products with such potential.
Nescafé quickly acquired a worldwide reputation, however, after it was launched in 1939 in the United States, where it did exceptionally well. Nestea, a soluble powdered tea, also made a successful debut in the early 1940s.
World War II had a dire effect on Nestlé. In 1939 profits plummeted to $6 million, compared to $20 million the year before. As in the last war, the company was plagued by food shortages and insufficient supplies of raw materials. To wage its own battle against the war, the company decided to split its headquarters at Vevey and transfer part of the management and executive team to an office in Stamford, Connecticut, where it could better supervise distant markets. Nestlé continued under control of dual managements until 1945.
But the war was not all bad for Nestlé. When the United States became involved in 1941, Nescafé and evaporated and powdered milk were in heavy demand from American armed forces. Nestlé’s total sales jumped from $100 million before the war to $225 million in 1945, with the greatest increase occurring in North America, where sales went from $14 million to $60 million. With the end of the war, Nestlé’s European and American branches were able to discuss future plans without fear of censorship, and the company could begin to face the challenge of rebuilding its war-torn subsidiaries. Nestlé also relaunched Nescafé and baby foods and began to research new products extensively. Researchers focused on the three areas Nestlé considered most likely to affect the food industry’s future: an increase in world population, rising standards of living in industrialized countries, and the changing social and economic conditions of raw-material-producing countries.
Postwar Growth Through Merger and Acquisition
In 1947 Nestlé merged with Alimentana S.A., the manufacturer of Maggi seasonings, bouillon, and dehydrated soups, and the holding company changed its name to Nestlé Alimentana Company. Edouard Muller became the first chairman of Nestlé Alimentana, but he died in 1948, before the policies he helped formulate put the company on the road to a new future. Carl Abegg assumed leadership of the board.
In 1950 Nestlé acquired Crosse and Blackwell, a British manufacturer of preserves and canned foods. Nestlé hoped its $24 million investment would serve as a marketing outlet for Maggi products, but the plan was less than successful, primarily because Crosse and Blackwell could not compete in the United Kingdom with H.J. Heinz Company. Similar setbacks occurred in 1963, when Nestlé acquired Findus frozen foods in Scandinavia for $32 million. Although the company performed well in Sweden, it encountered difficulties in other markets, where the British-Dutch giant Unilever reigned. While parts of the Findus operation eventually became profitable, Nestlé merged its German, Italian, and Australian Findus branches with Unilever. The development of freeze-drying in 1966 led to Taster’s Choice, the first freeze-dried coffee, as well as other instant drinks.
In 1971 Nestlé acquired Libby, a maker of fruit juices, in the United States, and in 1973 it bought Stouffer’s, which took Nestlé into the hotel and restaurant field and led to the development of Lean Cuisine, a successful line of low-calorie frozen entrees. Nestlé entered the nonfood business for the first time in 1974 by becoming a major shareholder in the French company L’Oréal, a leading cosmetics company. Nestlé diversified further in 1977 with the acquisition of Alcon Laboratories, a Fort Worth, Texas, pharmaceutical company that specialized in ophthalmic products. Then, two years later, Nestlé purchased Burton, Parsons and Company Inc., an American manufacturer of contact lens products. The company adopted its present name–Nestlé S.A.–in 1979.
Facing Boycott in Late 1970s and Early 1980s
The 1970s saw Nestlé’s operations in developing countries increase considerably. Of Nestlé’s 303 manufacturing facilities, the 81 factories in developing nations contributed 21 percent of Nestlé’s total production. In the mid-1970s, however, the firm faced a new problem as a result of its marketing efforts in these countries, when a boycott against all Nestlé products was started in the United States in 1977. Activists claimed that Nestlé’s aggressive baby food promotions made mothers in developing countries so eager to use Nestlé’s formula that they used it any way they could. The poverty-stricken areas had high rates of illiteracy, and mothers, unable to read and follow the directions, often mixed the product with local polluted water or used an insufficient amount of the expensive formula, unwittingly starving their infants. Estimates of Nestlé’s losses as a result of the boycott, which lasted until the early 1980s, ranged as high as $40 million.
In 1981 Helmut Maucher became managing director of Nestlé and made this controversy one of his top priorities. He met with boycott supporters and complied with the World Health Organization’s demands that Nestlé stop promoting the product through advertising and free samples. His direct confrontation of the issue contrasted with Nestlé’s earlier low-profile approach and was quite successful in allaying its critics’ fears.
Series of Major Acquisitions in the Later 1980s
Maucher also reduced overhead by turning over more authority to operating units and reducing headquarters staff. In addition, he spearheaded a series of major acquisitions. In 1985 Nestlé acquired Carnation, a U.S. manufacturer of milk, pet, and culinary products, for $3 billion, at the time one of the largest acquisitions in the history of the food industry. This was followed in 1985 by the acquisition of Hills Brothers Inc., the third largest U.S. coffee firm, which added ground roast coffee to Nestlé’s product line. In the late 1980s, as food companies around the world prepared for the integration of the European Community in 1992, Nestlé continued to make major acquisitions. In 1988 the company paid £2.55 billion ($4.4 billion) for Rowntree Mackintosh PLC–a leading British chocolate manufacturer–marking the largest takeover of a British company by a foreign one to date. That same year Nestlé also purchased the Italian pasta maker Buitoni SpA.
Capital expenditures reached CHF 2.8 billion in 1991. Half was devoted to installation improvements, including data processing and automation, particularly in North America and Europe. The other half was spent expanding plants, primarily in Latin America and the Far East, areas where products were often based on local raw materials, tastes, and habits. That year Nestlé made 31 acquisitions, also adding a new factory in the People’s Republic of China. Among the companies purchased were Alco Drumstick, a U.S. ice cream manufacturer with many European activities; Indra, a Swedish frozen-food maker; La Campiña, a Mexican evaporated milk producer; and 97 percent of Intercsokolàdé, a Hungarian chocolate maker. The latter was Nestlé’s first venture into the newly opened markets of Eastern Europe.
In September 1991 Nestlé and The Coca-Cola Company formed a 50-50 joint-venture, Coca-Cola Nestlé Refreshment Company, to produce and distribute concentrates and bases for the production of ready-to-drink coffee and tea beverages. With an initial capitalization of $100 million the products, to be sold under the Nescafé and Nestea brand names, would be marketed worldwide save for Japan, primarily through Coca-Cola’s international network of businesses.
Nescafé, sold in more than 100 countries by 1991, was launched in the Republic of Korea–Coca-Cola and Nestlé’s first joint endeavor–as was Nescafé Cappuccino in Europe. Hills Bros. “Perfect Balance,” a 50 percent-decaffeinated coffee, began selling in the United States, as did Nestea in cans at the beginning of 1992. By early 1992, a joint venture allowed the company to obtain a majority interest in Cokoladovny, a Czechoslovakian chocolate and biscuit producer. In addition, Nestlé in 1992 battled for and won, with a bid of $2.3 billion in cash, the French mineral water producer Source Perrier, though European regulators forced Nestlé to sell off some Perrier brands. That same year Nestlé took nearly full control of another mineral water concern, Vittel. Nestlé had acquired a 30 percent stake in Vittel in 1969, a move marking the company’s first foray into mineral water.
Reemphasis on Core Food Area in Later 1990s
As the 1990s continued, Nestlé recommitted itself to its core food products area, never having been able to grow its healthcare and cosmetics sectors into significant parts of the overall business. The company sold off some of its health and beauty interests, retaining Alcon and the minority holding in L’Oréal–it still hoped to gain full control of the latter, which was privately controlled. Nestlé made other divestments as well, including Wine World Estates, a group of northern California wineries (sold in 1995); canned beans and pasta operations in Canada, a fresh meat business in Germany, and cold meat operations in Sweden (1996); Contadina canned tomato products in the United States, Sarotti chocolate and Dany sandwiches in Germany, and Locatelli brand cheeses in Italy (1997); and Libby’s canned meat products, which were sold to International Home Foods for $126 million in 1998.
Acquisitions in the mid-to-late 1990s centered around mineral water, ice cream, and pet foods. In 1993 Nestlé purchased mineral water brands in the United States (Deer Park and Utopia) and Italy (Vera and San Bernardo), as well as ice cream brands in Italy, the Philippines, and South Africa. Added in 1994 were the Alpo pet food company in the United States and Warnke ice creams in Germany; the company also gained a majority stake in chocolate maker Goplana S.A. in Poland. Still further expansion of the ice cream sector came in 1995 with the purchase of Conelsa, the leader in the Spanish market; the chilled dairy products division of Pacific Dunlop in Australia; and Dolce S.A.E., the leading maker of ice cream in Egypt. That year Nestlé also acquired Ortega, a leading brand of Mexican food products in the United States. In 1997 Nestlé entered the Canadian ice cream market through the purchase of Ault and Dairy World, giving the company a 40 percent market share. In early 1998 Nestlé took full control of the San Pellegrino mineral water group and acquired Klim milk powders and Cremora coffee creamers from Borden Brands International. Also in 1998 the company secured the number two position in the European pet food market, trailing only Mars, through the £715 million ($1.2 billion) purchase of the Spillers pet food business of Dalgety PLC.
Despite all of this activity, Nestlé’s acquisition pace slowed during the late 1990s as the company shifted toward organic growth starting in 1996. The numerous acquisitions had enabled Nestlé to gain a presence in various product areas in various countries. The company now had fewer countries and products that it wished to add to its portfolio. Other reasons for the shift to organic growth included the increasing price of acquisitions and antitrust concerns. Meanwhile, in June 1997 Peter Brabeck-Letmathe was named chief executive, taking over the day-to-day management of Nestlé from Maucher. In September 1998 Nestlé announced that Maucher would retire as chairman by the spring of 2000, being replaced by Rainer Gut, then chairman of the Credit Suisse Group.
Nestlé’s aggressive marketing of infant formula once again became an issue in 1997 when a report called Cracking the Code was issued by the Interagency Group on Breastfeeding Monitoring (IGBM), which had conducted research in Bangladesh, Poland, South Africa, and Thailand. The IGBM concluded that several companies, including Nestlé, were in violation of the World Health Organization’s International Code of Marketing of Breastmilk Substitutes, which had been adopted in 1981. According to the report Nestlé’s code violations included supplying pregnant women and health workers with materials that promoted formula feeding but did not emphasize the superiority of breastfeeding over formula, and distributing free samples. Nestlé countered by calling the report biased and flawed, and by eliciting a response critical of Cracking the Code from an independent marketing research consultant.
At the dawn of the 21st century, Nestlé had about 500 factories in more than 78 countries, boasted sales exceeding CHF 70 billion, and was the undisputed leader in the food industry worldwide. Its portfolio included more than 8,500 brands. The company had set a goal of achieving 4 percent underlying sales growth each year, but failed to meet this target for 1998, largely because of economic downturns in southeast Asia, Latin America, and Eastern Europe.
Consolidation and Expansion in the Early 21st Century
It took several years before the character of the Brabeck-Letmathe era of leadership revealed itself. Initially, Brabeck-Letmathe managed the company in a fashion similar to his predecessor, Maucher. The pair, in fact, had agreed on a list of characteristics to remain unaltered during the two reigns of command, but after several years at the helm, Brabeck-Letmathe realized he needed to break the covenant, making one sweeping change in particular. Maucher had insisted that Nestlé retain its decentralized structure as a way to cater to local markets and tastes (Nestlé, for example, produced 200 different formulations of Nescafé), but Brabeck-Letmathe saw the company becoming uncompetitive so he began to consolidate its operations. The management of factories, which historically had been divided country by country, was broken into regional divisions. Further, products that were similar were organized into strategic business units, adding more cohesion to the operation of Nestlé’s global business.
Maucher was remembered as a wheeler and dealer, executing an ambitious acquisition campaign during his decade-and-a-half in charge. Brabeck-Letmathe, in contrast, waited several years before making a major acquisition, preaching growth through internal means during his first years in office. When he did strike out on the acquisition trail, he gravitated toward companies involved in pet care, health, and nutritional products, steering Nestlé toward the higher, value-added market in which the company added basic ingredients to products. Nestlé acquired PowerBar in 2000, but Brabeck-Letmathe’s master stroke occurred two years later when he spent $10.3 billion to acquire Ralston-Purina. The acquisition made Nestlé the joint world leader in the pet food business, putting the company alongside Mars, Incorporated, which owned the Pedigree, Sheba, and Whiskas brands. Next, Brabeck-Letmathe turned his attention to Nestlé’s ice cream business, completing the acquisition of a German ice cream manufacturer named Schoeller in 2002. The following year, the company spent $2.8 billion to acquire majority control of Dreyer’s Grand Ice Cream.
As Nestlé pressed forward under the leadership of Brabeck-Letmathe, the company plotted a future course that distinguished it from its rivals. Rival food conglomerates such as Unilever and Danone focused on narrowing their strategic focus, shedding businesses in an effort to increase their profit margins. Unilever, for example, shuttered more than 100 of its factories and reduced the number of its brands from 1,600 to 400 during the first three years of the decade. Nestlé chose a different path for its future, promising to get bigger as the years passed, emphasizing growth in areas designed to transform it from a food company into a food, health, and wellness company with a deeper involvement in nutritional products. Growth in this direction promised to be the legacy of Brabeck-Letmathe’s tenure. The influence of his leadership was expected to increase as he completed his first decade of stewardship. In early 2005, Brabeck-Letmathe was named chairman of Nestlé, giving him the two most powerful positions at one of the largest companies in the world.
Mergers and Acquisitions: Definition
The Main Idea
One plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies – at least, that’s the reasoning behind M&A.
This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone.
Distinction between Mergers and Acquisitions
Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition mean slightly different things.
When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer “swallows” the business and the buyer’s stock continues to be traded.
In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a “merger of equals.” Both companies’ stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, DaimlerChrysler, was created.
In practice, however, actual mergers of equals don’t happen very often. Usually, one company will buy another and, as part of the deal’s terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it’s technically an acquisition. Being bought out often carries negative connotations, therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable.
A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly – that is, when the target company does not want to be purchased – it is always regarded as an acquisition.
Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company’s board of directors, employees and shareholders.
Synergy
Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following:
- Staff reductions – As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package.
- Economies of scale – Yes, size matters. Whether it’s purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies – when placing larger orders, companies have a greater ability to negotiate prices with their suppliers.
- Acquiring new technology – To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge.
- Improved market reach and industry visibility – Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies’ marketing and distribution, giving them new sales opportunities. A merger can also improve a company’s standing in the investment community: bigger firms often have an easier time raising capital than smaller ones.
That said, achieving synergy is easier said than done – it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two.
Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers – who have much to gain from a successful M&A deal – will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price. We’ll talk more about why M&A may fail in a later section of this tutorial.
Varieties of Mergers
From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging:
- Horizontal merger – Two companies that are in direct competition and share the same product lines and markets.
- Vertical merger – A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker.
- Market-extension merger – Two companies that sell the same products in different markets.
- Product-extension merger – Two companies selling different but related products in the same market.
- Conglomeration – Two companies that have no common business areas.
There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors:
- Purchase Mergers – As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial.
- Consolidation Mergers – With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger.
Acquisitions
As you can see, an acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another – there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile.
In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y’s assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business.
Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares.
Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved.
Mergers and Acquisitions: Valuation Matters
Investors in a company that are aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth.
Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.
There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:
Comparative Ratios – The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio (P/E Ratio) – With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target’s P/E multiple should be.
- Enterprise-Value-to-Sales Ratio (EV/Sales) – With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
- Replacement Cost – In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity’s sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn’t make much sense in a service industry where the key assets – people and ideas – are hard to value and develop.
- Discounted Cash Flow (DCF) – A key valuation tool in M&A, discounted cash flow analysis determines a company’s current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization – capital expenditures – change in working capital) are discounted to a present value using the company’s weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
Synergy: The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company’s post-merger share price increases by the value of potential synergy.
Let’s face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company’s future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:
In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.
What to Look For
It’s hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:
- A reasonable purchase price – A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests.
- Cash transactions – Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside.
- Sensible appetite – An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers.
Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.
Mergers and Acquisitions: Doing The Deal
Start with an Offer
When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company, or building a position. Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the company must formally declare how many shares it owns and whether it intends to buy the company or keep the shares purely as an investment.
Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it’s willing to pay for its target in cash, shares or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it.
The Target’s Response
Once the tender offer has been made, the target company can do one of several things:
- Accept the Terms of the Offer – If the target firm’s top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal.
- Attempt to Negotiate – The tender offer price may not be high enough for the target company’s shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target – their jobs, in particular. If they’re not satisfied with the terms laid out in the tender offer, the target’s management may try to work out more agreeable terms that let them keep their jobs or, even better, send them off with a nice, big compensation package. Not surprisingly, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger’s future success.
- Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be triggered by a target company when a hostile suitor acquires a predetermined percentage of company stock. To execute its defense, the target company grants all shareholders – except the acquiring company – options to buy additional stock at a dramatic discount. This dilutes the acquiring company’s share and intercepts its control of the company.
- Find a White Knight – As an alternative, the target company’s management may seek out a friendlier potential acquiring company, or white knight. If a white knight is found, it will offer an equal or higher price for the shares than the hostile bidder.
Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry.
Closing the Deal
Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company’s shares with cash, stock or both.
A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company.
If the transaction is made with stock instead of cash, then it’s not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions.
When a company is purchased with stock, new shares from the acquiring company’s stock are issued directly to the target company’s shareholders, or the new shares are sent to a broker who manages them for target company shareholders. The shareholders of the target company are only taxed when they sell their new shares.
When the deal is closed, investors usually receive a new stock in their portfolios – the acquiring company’s expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal.
Mergers and Acquisitions: Break Ups
As mergers capture the imagination of many investors and companies, the idea of getting smaller might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders.
Advantages
The rationale behind a spinoff, tracking stock or carve-out is that “the parts are greater than the whole.” These corporate restructuring techniques, which involve the separation of a business unit or subsidiary from the parent, can help a company raise additional equity funds. A break-up can also boost a company’s valuation by providing powerful incentives to the people who work in the separating unit, and help the parent’s management to focus on core operations.
Most importantly, shareholders get better information about the business unit because it issues separate financial statements. This is particularly useful when a company’s traditional line of business differs from the separated business unit. With separate financial disclosure, investors are better equipped to gauge the value of the parent corporation. The parent company might attract more investors and, ultimately, more capital.
Also, separating a subsidiary from its parent can reduce internal competition for corporate funds. For investors, that’s great news: it curbs the kind of negative internal wrangling that can compromise the unity and productivity of a company.
For employees of the new separate entity, there is a publicly traded stock to motivate and reward them. Stock options in the parent often provide little incentive to subsidiary managers, especially because their efforts are buried in the firm’s overall performance.
Disadvantages
That said, de-merged firms are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies. And the smaller size of the firm may mean it has less representation on major indexes, making it more difficult to attract interest from institutional investors.
Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm divides itself into smaller units, it may be losing the synergy that it had as a larger entity. For instance, the division of expenses such as marketing, administration and research and development (R&D) into different business units may cause redundant costs without increasing overall revenues.
Restructuring Methods
There are several restructuring methods: doing an outright sell-off, doing an equity carve-out, spinning off a unit to existing shareholders or issuing tracking stock. Each has advantages and disadvantages for companies and investors. All of these deals are quite complex.
Sell-Offs
A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn’t fit into the parent company’s core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership.
Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate raiders would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders’ method certainly makes sense if the sum of the parts is greater than the whole. When it isn’t, deals are unsuccessful.
Equity Carve-Outs
More and more companies are using equity carve-outs to boost shareholder value. A parent firm makes a subsidiary public through an initial public offering (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent’s shareholder value.
The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In these cases, some portion of the parent firm’s board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong.
That said, sometimes companies carve-out a subsidiary not because it’s doing well, but because it is a burden. Such an intention won’t lead to a successful result, especially if a carved-out subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits.
Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties.
Spinoffs
A spinoff occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of the subsidiary to its shareholders through a stock dividend. Since this transaction is a dividend distribution, no cash is generated. Thus, spinoffs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out, the subsidiary becomes a separate legal entity with a distinct management and board.
Like carve-outs, spinoffs are usually about separating a healthy operation. In most cases, spinoffs unlock hidden shareholder value. For the parent company, it sharpens management focus. For the spinoff company, management doesn’t have to compete for the parent’s attention and capital. Once they are set free, managers can explore new opportunities.
Investors, however, should beware of throw-away subsidiaries the parent created to separate legal liability or to off-load debt. Once spinoff shares are issued to parent company shareholders, some shareholders may be tempted to quickly dump these shares on the market, depressing the share valuation.
Tracking Stock
A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. The stock allows the different segments of the company to be valued differently by investors.
Let’s say a slow-growth company trading at a low price-earnings ratio (P/E ratio) happens to have a fast growing business unit. The company might issue a tracking stock so the market can value the new business separately from the old one and at a significantly higher P/E rating.
Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth business for shareholders? The company retains control over the subsidiary; the two businesses can continue to enjoy synergies and share marketing, administrative support functions, a headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company can use the tracking stock it owns to make acquisitions.
Still, shareholders need to remember that tracking stocks are class B, meaning they don’t grant shareholders the same voting rights as those of the main stock. Each share of tracking stock may have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all.
Mergers and Acquisitions: Why They Can Fail
It’s no secret that plenty of mergers don’t work. Those who advocate mergers will argue that the merger will cut costs or boost revenues by more than enough to justify the price premium. It can sound so simple: just combine computer systems, merge a few departments, use sheer size to force down the price of supplies and the merged giant should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice, things can go awry.
Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases, the problems associated with trying to make merged companies work are all too concrete.
Flawed Intentions
For starters, a booming stock market encourages mergers, which can spell trouble. Deals done with highly rated stock as currency are easy and cheap, but the strategic thinking behind them may be easy and cheap too. Also, mergers are often attempt to imitate: somebody else has done a big merger, which prompts other top executives to follow suit.
A merger may often have more to do with glory-seeking than business strategy. The executive ego, which is boosted by buying the competition, is a major force in M&A, especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives get a big bonus for merger deals, no matter what happens to the share price later.
On the other side of the coin, mergers can be driven by generalized fear. Globalization, the arrival of new technological developments or a fast-changing economic landscape that makes the outlook uncertain are all factors that can create a strong incentive for defensive mergers. Sometimes the management team feels they have no choice and must acquire a rival before being acquired. The idea is that only big players will survive a more competitive world.
The Obstacles to Making it Work
Coping with a merger can make top managers spread their time too thinly and neglect their core business, spelling doom. Too often, potential difficulties seem trivial to managers caught up in the thrill of the big deal.
The chances for success are further hampered if the corporate cultures of the companies are very different. When a company is acquired, the decision is typically based on product or market synergies, but cultural differences are often ignored. It’s a mistake to assume that personnel issues are easily overcome. For example, employees at a target company might be accustomed to easy access to top management, flexible work schedules or even a relaxed dress code. These aspects of a working environment may not seem significant, but if new management removes them, the result can be resentment and shrinking productivity.
More insight into the failure of mergers is found in the highly acclaimed study from McKinsey, a global consultancy. The study concludes that companies often focus too intently on cutting costs following mergers, while revenues, and ultimately, profits, suffer. Merging companies can focus on integration and cost-cutting so much that they neglect day-to-day business, thereby prompting nervous customers to flee. This loss of revenue momentum is one reason so many mergers fail to create value for shareholders.
But remember, not all mergers fail. Size and global reach can be advantageous, and strong managers can often squeeze greater efficiency out of badly run rivals. Nevertheless, the promises made by deal makers demand the careful scrutiny of investors. The success of mergers depends on how realistic the deal makers are and how well they can integrate two companies while maintaining day-to-day operations.
Mergers and Acquisitions: Conclusion
One size doesn’t fit all. Many companies find that the best way to get ahead is to expand ownership boundaries through mergers and acquisitions. For others, separating the public ownership of a subsidiary or business segment offers more advantages. At least in theory, mergers create synergies and economies of scale, expanding operations and cutting costs. Investors can take comfort in the idea that a merger will deliver enhanced market power.
By contrast, de-merged companies often enjoy improved operating performance thanks to redesigned management incentives. Additional capital can fund growth organically or through acquisition. Meanwhile, investors benefit from the improved information flow from de-merged companies.
M&A comes in all shapes and sizes, and investors need to consider the complex issues involved in M&A. The most beneficial form of equity structure involves a complete analysis of the costs and benefits associated with the deals.
Let’s recap what we learned in this tutorial:
- A merger can happen when two companies decide to combine into one entity or when one company buys another. An acquisition always involves the purchase of one company by another.
- The functions of synergy allow for the enhanced cost efficiency of a new entity made from two smaller ones – synergy is the logic behind mergers and acquisitions.
- Acquiring companies use various methods to value their targets. Some of these methods are based on comparative ratios – such as the P/E and P/S ratios – replacement cost or discounted cash flow analysis.
- An M&A deal can be executed by means of a cash transaction, stock-for-stock transaction or a combination of both. A transaction struck with stock is not taxable.
- Break up or de-merger strategies can provide companies with opportunities to raise additional equity funds, unlock hidden shareholder value and sharpen management focus. De-mergers can occur by means of divestitures, carve-outs spinoffs or tracking stocks.
- Mergers can fail for many reasons including a lack of management foresight, the inability to overcome practical challenges and loss of revenue momentum from a neglect of day-to-day operations.
