Some call it "the winner's curse." When two or more parties vie for a company, one bidder sharply overestimates the value of the target — perhaps reflecting its desire to send rivals home empty-handed. But as the victor begins to assimilate its trophy, it may soon discover that its winning bid was costly indeed.
In this year's overstimulated mergers-and-acquisitions market, such one-upmanship has become common. Mining concern Rio Tinto offered $32 billion for Canada's Alcan, for example, topping U.S. aluminum giant Alcoa's rival bid by fully $10 billion. The 67 percent premium that Rupert Murdoch's News Corp. offered for Dow Jones served the same purpose, preempting others who might like to own its Wall Street Journal.
For a time, bidding high may seem like a smart move, especially when it is part of a deal with a "go-shop" clause, which gives the target board a period to attract other suitors. But "topping bids" like Rio Tinto's require some tricky decision-making — and careful calculations of synergies and intangibles — if the winner is to avoid financial difficulties later.
The main problem: market-clearing, preemptive pricing often flies in the face of valuation science, which is usually based on fundamentals tied to discounted cash flow and asset analyses. Sophisticated acquirers view valuation and pricing as two separate topics. "No one is a price maker. We're all price takers," says Justin Pettit, a partner at Booz Allen Hamilton.
Are Buyers Wiser?
In the M&A boom of 1998 to 2001, the mania for Internet franchises produced merger premiums 30 to 40 percent above public companies' market caps. The environment also helped spawn some disasters, led by the creation of AOL Time Warner Inc., which eventually had to take write-downs just under $100 billion. Now, average premiums hover near 20 percent.
But buyers are not necessarily wiser. They still pay high multiples for operating cash flow, usually measured as earnings before interest, taxes, depreciation, and amortization (EBITDA). The average purchase price in the second quarter of 2007 rose to 10.8 times the seller's EBITDA, says ratings service Standard & Poor's — the highest average since S&P began compiling such data in 1997. Cash-flow multiples vary widely by industry. While software-industry targets often sell at 20 times EBITDA or more, consumer-retail multiples rarely exceed the low single digits. Manufacturing companies on average fetch 6 to 8 times EBITDA, while pharmaceutical deals stretch multiples to the 12 to 19 range.
Letting a rival bidder determine the amount of an offer — or being swayed by the target's market price — is dangerous. "We try very hard not to get hung up on the premium; the premium reflects what someone else is paying," says James Socas, senior vice president of corporate development at Symantec Corp., a Cupertino, California-based security-software maker.
Besides various cash-flow analyses, other measurements that acquirers use to triangulate the intrinsic value of a target include studying comparable transactions and calculating return on investment, earnings accretion, and dilution.
To construct a ceiling and a floor for a bid, Robert Bruner, dean of the University of Virginia's Darden Graduate School of Business Administration, recommends this equation: the acquiree's market price plus bid premium should be less than or equal to the stand-alone value, plus any projected synergies. Still, "the threat of an interloper, the degree to which management enters the bidding, the impatience of the buyer all affect premium behavior," says Bruner, author of the cautionary tome Deals from Hell.
Beware the Synergy
Of all the variables that become part of an offer, revenue synergies are among the hardest to assess, and the riskiest to long-term success. A 2005 KPMG transaction services study found that in 43 percent of cases revenue synergies are included in a buyer's price, but that fully two-thirds of acquirers announcing such synergy targets failed to achieve them. One reason: "Sellers will try to extort a piece of it for themselves," says Booz Allen's Pettit. Moreover, few good techniques exist for evaluating the revenue boost that will result from a business combination. Cost synergies such as reducing head count or closing facilities are more easily controlled and measured.
"We would never factor revenue synergies into a purchase price," says Mike Beach, CFO of Blackboard Inc., an educational software provider. In February 2006, Blackboard acquired competitor WebCT for $178 million, five times the target's recurring yearly contracts — an important multiple for WebCT. While there was no bidding war for WebCT, the target had retained Goldman Sachs, which suggested that competition would emerge if Blackboard bid too low.
To figure WebCT's worth, Blackboard studied multiples paid in comparable transactions. A DCF valuation helped it calculate how quickly the deal would be accretive to earnings. The company's goal: accretion to earnings by Year Two.
Blackboard focused on estimating potential cost synergies. Within the first six months, it had trimmed overhead by sharing product development and eliminating duplicative marketing projects, while also combining back-office operations. Cost synergies, Beach says, are realized over time as the combined company running more efficiently creates "a business worth more than the two standalone businesses." In the second quarter, Blackboard's revenue was up 47 percent and its profits jumped to $1.9 million, and in July its shares hit an all-time high.
Symantec has developed a way to measure strategic advantages from a deal, thus allowing a higher premium to be offered with less risk of overpricing. In July, Symantec completed the acquisition of software developer Altiris for $830 million net of cash on the balance sheet — a 22 percent premium over its share price, and carrying an EBITDA multiple of 18.3. While no other bidders emerged, "software is in a consolidation phase and we always assume the process will be competitive," Symantec's Socas says.
His company was able to put a number on a major strategic advantage of the deal: a midmarket distribution channel that the company could use to push its own products. Based on the rule of thumb that software companies in its space generally have 25 percent operating margins, Socas derived the formula that Symantec must generate $4 of sales for every dollar of cash spent. "That's a sobering analysis," he says.
Deal risk escalates when a merger premium is completely detached from the seller's valuation. Microsoft's $6 billion purchase of digital marketer aQuantive "makes no sense at all if you look at the pure numbers," says Sid Parakh, an analyst at McAdams Wright Ragen. Microsoft paid 29 times aQuantive's EBITDA estimates for 2008 and 67 times the consensus estimate for 2008 earnings per share, Parakh says. (Microsoft did not respond to requests for comment.) Had it invested $6 billion in a Treasury bond, it would have earned $300 million annually.
Says Parakh: "It will be a long, long time before [the aQuantive unit] can generate those numbers."
Vincent Ryan is a senior editor at CFO.
|Paying Top Dollar|
The five highest premiums paid in U.S. deals this year*
|Bidder Company||PCT |
(in $ mill.)
|Fieldstone Investment (2/16)||Credit-Based Asset Servicing and Securitization||113%||$226|
|Analex (1/20)||Apollo Merger Sub||97||84|
|Greater Atlantic Financial (3/13)||Summit Financial Group||81||14|
|Boston Communications Group (7/11)||Tea Party Acquisition||81%||$64|
|*As of 7/31/07; includes all deals more than $5 million.|
1Based on share price one day before bid was announced.