Merger Consequences
This analysis assesses the effects of a merger and acquisition (M&A) transaction
What Are Merger Consequences?
Merger consequences analysis assesses the effects of a merger and acquisition (M&A) transaction. Before carrying out a merger or an acquisition, the leaders of the acquiring company must carefully consider the potential financial impacts of the transaction.
Before discussing the consequences, let’s first discuss mergers and acquisitions and why companies carry out these transactions.
M&A is the consolidation of two firms or their assets through financial transactions. The goal of an M&A transaction is to achieve synergies. Synergies occur when two companies can increase operational efficiency, optimize revenue, or cut expenses through consolidation.
The terms mergers and acquisitions are often used interchangeably. However, they differ in meaning.
- A merger occurs when two companies combine into one entity
- An acquisition is one company’s purchase of a majority stake in another company
M&A transactions require a lot of analysis and preparation. Therefore, valuation is an integral part of the M&A deal process. A company can be valued using various metrics, like:
- Price-to-earnings ratio (P/E ratio)
- Enterprise-value-to-sales (EV/sales)
- Using discounted cash flow (DCF)
Key Takeaways
- A merger is a mutual agreement between two firms to combine to achieve synergies and economies of scale.
- Although the terms are often used interchangeably, mergers and acquisitions differ in their actual meanings.
- To make the distinction, an acquisition occurs when one company purchases a majority stake of another company, and a merger is a combination or consolidation of two firms.
- Merger consequence analysis is the process of determining whether an M&A transaction will be accretive or dilutive.
- An accretive transaction occurs when the deal raises the acquirer's earnings per share. Conversely, a dilutive agreement occurs when the opposite happens, and the acquirer's EPS falls.
- Merger consequence analysis can be carried out using per-share metrics and pro forma analysis to assess the impact of a potential merger.
- A merger can fail due to a myriad of reasons, some of which include integration risk and clashing corporate cultures.
- A merger has several effects, including changes in capital structure, share prices, and projected growth estimates.
How Mergers Affect a Company
Mergers can fundamentally transform a company's operational structure, financial standing, market positioning, and overall strategic direction.
While they may promise potential synergies, increased market share, and enhanced competitiveness, they can also pose challenges related to integration, cultural alignment, and customer retention.
1. How Can A Firm Analyze the Effects Of A Potential Merger?
One of the most common ways of carrying out merger consequence analysis is by determining whether the M&A transaction will be accretive or dilutive.
An M&A deal is considered accretive if the acquiring company's earnings per share (EPS) increases due to the transaction. Conversely, the transaction is considered dilutive if the deal causes the acquiring company's EPS to decrease.
It is important to note that not every accretive deal is good, and not every dilutive deal is bad.
2. Using Earnings-Per-Share Analysis
Measuring the effects of an M&A transaction using EPS is a method of analyzing the acquiring company's welfare with the newly combined business. EPS analysis will reveal whether carrying out the deal will increase or decrease the post-transaction EPS of the acquiring company.
EPS analysis has shortcomings, so it must be performed alongside other valuation methods. Comparing only EPS does not reveal the additional transactional effects that can artificially increase the acquiring company's EPS (but not the value).
When the transaction neither increases nor decreases the buyer's EPS, the company "breaks even." This is because pre-tax synergies are required, and the transaction is neither accretive nor dilutive.
3. Projection Analysis
Pro forma calculations are hypothetical estimates of potential future earnings for the newly combined firm. Pro forma statements record the future financial position of the acquiring firm.
The buyer must decide on a price it is willing and able to pay for the acquisition.
Additionally, the buyer must decide how it will pay for the transaction (whether it be in cash, stock, other securities, or some combination). All these considerations determine the M&A deal structure.
Incentives for Mergers
There are many different reasons why companies decide to carry out M&A transactions.
Most of the time, acquiring companies look for strategic ways to grow their business.
1. Synergies
When companies merge, they can take advantage of synergies, which increase the value of the combined company to be greater than the values of the individual companies.
A few examples of how a merger can achieve synergies are the removal of redundant resources, reduction in operating costs, and boost in revenue.
Companies can also achieve economies of scale by producing more goods with lower input costs because of synergies.
2. Competition
Competition among firms is a powerful motivator for M&A activity. Companies want to combine with other businesses with appealing portfolios before their competitors.
One of the main goals of an investment banker in charge of helping businesses with their M&A deals is to create a bidding war for the acquisition of a company. A bidding war occurs when two or more acquirers are interested in the same target firm.
Bidding wars typically result in the target firm being sold for a higher price; thus, investment bankers in charge of the deal can usually take home a larger commission for the sale.
3. Growth
Mergers are typically a much quicker and more efficient way for a company to increase its size than organic growth. As a result, companies often look to M&A to grow and potentially surpass rival businesses.
4. Domination
The merging of two larger companies could result in the domination of a sector. However, such transactions are usually regulated and prevented by antitrust laws and regulatory authorities who want to avoid monopolies.
5. Tax Purposes
Companies also take advantage of corporate inversion when a U.S. company merges with a foreign company to move its tax home to a lower-tax jurisdiction. This strategy can significantly decrease a company's tax bill.
These are a few reasons a company might look to merge with or acquire another firm. But many things can also go wrong during or after an M&A transaction.
Reasons Mergers Might Fail
Following are the reasons:
1. Integration Risk
A potentially accretive transaction can become dilutive if a merger cannot attain its projected cost savings through synergies and economies of scale. In reality, merging two companies is much easier said than done.
2. Overpaying
A company may offer a substantial premium for the target company if other rivals are also looking to acquire it. However, the target company may fail to fulfill the acquiring company's best case projections.
This results in an overpayment for the target firm that can be very detrimental to the acquiring company.
3. Conflicting Cultures
Sometimes the corporate cultures of the two merging companies conflict, and the M&A transaction may fail.
4. Large Necessary Capacity
If a company does not have enough excess resources, it leaves no capacity to carry out a transaction successfully. A company must ensure they are not entirely over-utilizing its resources if it wants to go through an M&A transaction.
Effects of Mergers
Some of the effects are:
A) Change in Capital Structure
If the acquiring company in an M&A transaction pays for the target firm (at least partially) in stock, then the target firm's shareholders receive a stake in the acquiring company.
As a result, the target firm's shareholders have a vested interest in the long-term success of the newly combined company.
The acquisition of a large company is much riskier than that of a smaller company. However, the acquiring firm may be able to handle the failure of a smaller acquisition. However, if a large acquisition fails, it may be detrimental to the acquirer's future success.
The acquirer's cash holdings would decrease significantly if an M&A transaction were an entire cash deal.
More often, M&A deals are financed using debt. In this case, the acquirer will tolerate a higher debt load that they're ideally compensated for with increased cash flows from the acquisition.
Other times, a transaction is paid for using the acquirer's stock. In this scenario, the shares must be priced at a premium for the deal to be accretive.
B) Market Response
Large M&A deals receive different reactions from market participants, depending on their opinion and perception of the transaction. For example, the target company's shares may trade at a higher price if market participants believe that the acquiring company low-balled the offer.
Sometimes, the target firm's shares trade below the announced offer price because the acquirer's stock drops.
For example, let's say the purchase price of $30 per share of Target X is made up of two shares of an acquirer valued at $12 each and $6 in cash.
If the acquirer's shares decrease in value and are now only worth $10, Target X would likely be trading at $26 instead of the original $30.
After the announcement of an M&A deal, an acquirer's shares might decline because the market participants deem the acquisition price tag too high.
Or, the transaction is not viewed as accretive, or investors think the acquirer is using too much debt to pay for the acquisition.
Types and Examples of Mergers
We will discuss five main types of mergers in this section. We will also discuss a few examples of real-life mergers that have occurred.
The types of mergers are:
1. Conglomerate merger: occurs when two companies merge with completely unrelated business activities.
A pure conglomerate merger involves companies that do not share anything in common. A mixed conglomerate merger involves companies that are seeking product or market extensions.
Example: The merging of eBay and PayPal in 2002 is an example of a conglomerate merger. This transaction combined eBay's product platform with PayPal's electronic payment platform.
2. Horizontal merger: a merger between companies from the same industry. Typically the two companies that merged were previously competitors.
Horizontal mergers are common in industries with only a few firms because of high competition and great synergistic opportunities.
Example: Frito-Lay is made up of two separate companies, "The Frito Company" and "H.W. Lay & Company," which merged in 1961 to form "Frito-Lay, Inc."
3. Vertical merger: occurs when companies combine their different supply chain operations to produce the same good or service.
A vertical merger combines two companies from the same industry, which previously operated at different production phases.
Example: The 2016 AT&T and Time Warner merging for $85 billion is an example of a vertical merger. This deal allowed AT&T to expand its mobile entertainment business.
Read more about this merger here.
4. Market extension merger: occurs between companies that produce the same good or service but operate in different markets. Combining the companies provides both larger market access and a customer base.
Example: One example of a market extension merger is the merger between RBC Centura and Eagle Bancshares. This deal provided RBC Centura with access to the North American market.
Learn more about this transaction here.
5. Product extension merger: occurs between two companies that operate in the same market and make products that are related to each other.
Example: In 2002, the Bluetooth company, Broadcom, merged with the chips and mobile design supplier Mobilink Telecom Inc.
The two companies had been operating in the same market but supplying different products. Through the merger, they could create new technologies to support each other's products.
Find out more about this merger here.
Researched and authored by Rachel Kim | LinkedIn
Reviewed and edited by Sara De Meyer | LinkedIn
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