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Chapter 5
Implementation: Search through Closing—Phases 3 to 10
Examination Questions and Answers
True/False Questions: Answer true or false to the following:
1. The first step in establishing a search plan for potential acquisition or merger targets is to identify the primary screening or selection criteria. True or False
Answer: True
The number of selection criteria should be as extensive as possible to ensure that all factors relevant to the firm’s decision-making process are considered. True or False
Answer: False
Only acquiring firms perform due diligence. True or False
Answer: False
Banks are commonly used to provide bridge or temporary financing to pay all or a portion of the purchase price and meet possible working capital requirements until permanent financing can be found. True or False
Answer: True
The targeted industry and the maximum size of the potential transaction are often the most important selection criteria used in the search process. True or False
Answer: True
Advertising in the business or trade press is generally a very efficient way to locate attractive acquisition target candidates. True or False
Answer: False
An excessively long list of screening criteria used to develop a list of potential acquisition targets can severely limit the number of potential candidates. True or False
Answer: True
The appropriate approach for initiating contact with a target firm is essentially the same for large or small, public or private companies. True or False
Answer: False
In contacting large, publicly traded firms, it is usually preferable to make initial contact through an intermediary and at the highest level of the company possible. True or False
Answer: True
Rumors of impending acquisition can have a substantial deleterious impact on the target firm. True or False
Answer: True
So-called permanent financing for an acquisition usually consists of long-term unsecured debt. True or False
Answer: True
Confidentiality agreements are usually signed before any information is exchanged to protect the buyer and the seller from loss of competitive information. True or False
Answer: True
Confidentiality agreements often cover both the buyer and the seller, since both are likely to be exchanging confidential information, although for different reasons. True or False
Answer: True
Confidentiality agreements usually also cover publicly available information on the potential acquirer and target firms. True or False
Answer: False
A letter of intent formally stipulates the reason for the agreement, major terms and conditions, the responsibilities of both parties while the agreement is in force, a reasonable expiration date, and how all fees associated with the transaction will be paid. True or False
Answer: True
The signing of a letter of intent usually precludes the target firm from suing the potential acquiring company if the acquirer eventually withdraws its initial offer. True or False
Answer: False
“No shop” provisions are seldom found in letters of intent. True or False
Answer: False
The letter of intent often specifies the type of information to be exchanged as well as the scope and duration of the potential buyer’s due diligence. True or False
Answer: True
Letters of intent are usually legally binding on the potential buyer but rarely on the target firm. True or False
Answer: False
The actual price paid for a target firm is unaffected by the buyer’s due diligence. True or False
Answer: False
Total consideration refers to what is to be paid for the target firm and usually only consists of cash or stock, exclusively. True or False
Answer: False
The total purchase price paid by the buyer should also reflect the assumption of liabilities stated on the target’s balance sheet, but it should exclude all off balance sheet liabilities. True or False
Answer: False
Discretionary assets are undervalued or redundant assets not required to run the acquired business and which can be used by the buyer to recover a portion of the purchase price. True or False
Answer: True
The actual purchase price paid for a target firm is determined doing the negotiation process and is often quite different from the initial offer price stipulated in a letter of intent. True or False
Answer: True
Buyers routinely perform due diligence on sellers, but sellers rarely perform due diligence on buying firms. True or False
Answer: False
Due diligence is the process of validating assumptions underlying the initial valuation of the target firm as well as the uncovering of factors that had not previously been considered that could enhance or detract from the value of the target firm. True or False
Answer: True
It is usually in the best interests of the seller to allow the buyer unrestricted access to all seller employees and records doing due diligence in order to create an atmosphere of cooperation and goodwill. True or False
Answer: False
Buyers should not be concerned about performing an exhaustive due diligence since in doing so they could degrade the value of the target firm because of the disruptive nature of a rigorous due diligence. The buyer can be assured that all significant risks can be handled through the standard representations and warranties commonly found in agreements of purchase and sale. True or False
Answer: False
Bridge financing refers to the temporary financing obtained by the buyer to pay all or a portion of the purchase price until so-called permanent financing can be arranged. True or False
Answer: True
Seller financing represents a very important source of financing for buyers. True or False
Answer: True
Elaborate multimedia presentations made to potential lenders in an effort to “shop” for the best financing are often referred to as the “road show.” True or False
Answer: True
The buyer’s ability to obtain adequate financing is a closing condition common to most agreements of purchase and sale. True or False
Answer: True
Closing is a phase of the acquisition process that usually occurs shortly after the target has been fully integrated into the acquiring firm. True or False
Answer: False
Shrewd sellers often negotiate a break-up clause in an agreement of purchase and sale requiring the buyer to pay the seller an amount at least equal to the seller’s cost associated with the transaction. True or False
Answer: True
The purchase price for a target firm may be fixed at the time of closing, subject to future adjustment, or be contingent on future performance. True or False
Answer: True
36. Brokers or finders should never be used in the search process. True or False.
Answer: False
37. More and more firms are identifying potential target companies on their own without the use of investment bankers. True or False
Answer: True
38. Fees charged by investment bankers are never negotiable. True or False
Answer: False
39. Debt-to-equity ratios may be used to measure a firm’s degree of leverage and are frequently used as a search criterion in looking for potential takeover candidates. True or False
True
40. Even though time is critical, it is always critical to build a relationship with the CEO of the target firm before approaching her with an acquisition proposal. True or False
Answer: False
41. There is no substitute for performing a complete due diligence on the target firm. True or False
Answer: True
42. Confidentiality agreements are rarely required when target and acquiring firms exchange information. True or False
Answer: False
43. The financing plan may be affected by the discovery during due diligence of assets that can be sold to pay off debt accumulated to finance the transaction. True or False
Answer: True
44. There is no need for the seller to perform due diligence on its own operations to ensure that its representations and warranties in the definitive agreement are accurate. True or False
Answer: False
45. The closing often involves getting all the necessary third-party consents and regulatory and shareholder approvals. True or False
Answer: True
46. The purchase price may be fixed at the time of closing, subject to future adjustment, or it may be contingent on future performance of the target business. True or False
Answer: True
47. Earnouts are generally very poor ways to create trust and often represent major impediments to the integration process. True or False
Answer: True
48. Loan covenants are promises made by the borrower that certain acts will be performed and others will be avoided. True or False
Answer: True
49. Buyers generally want to complete due diligence on the seller as quickly as possible. True or False
Answer: False
50. A data room is a method commonly used by sellers to limit buyer due diligence. True or False
Answer: True
Multiple Choice Questions.
1. Each of the following is true about the acquisition search process except for
A candidate search should start with identifying the primary selection criteria.
The number of selection criteria should be as lengthy as possible.
At a minimum, the primary criteria should include the industry and desired size of transaction.
The size of the transaction may be defined in terms of the maximum purchase price the acquirer is willing to pay.
A search strategy entails the use of electronic databases, trade publications, and querying the acquirer’s law, banking, and accounting firms for qualified candidates.
Answer: B
The screening process represents a refinement of the search process and commonly utilizes which of the following as selection criteria
Market share, product line, and profitability
Product line, profitability, and growth rate
Profitability, leverage, and growth rate
Degree of leverage, market share, and growth rate
All of the above
Answer: E
3. Initial contact should be made through an intermediary as high up in the organization for which of the following firms
Companies with annual revenue of less than $25 million
Medium sized companies between $25 and $100 million in annual revenue
Large, publicly traded firms
Small, privately owned firms
Small, privately owned competitors
Answer: C
4. All of the following statements are true about letters of intent except for
Are always legally binding
Spells out the initial areas of agreement between the buyer and seller
Defines the responsibilities and rights of the buyer and seller while the letter of intent is in force
Includes an expiration date
Includes a “no shop” provision
Answer: A
5. All of the following are true about a confidentiality agreement except for
Often applies to both the buyer and the seller
Stipulates the type of seller information available to the buyer and how the information can be used
Limits the use of information about the seller that is publicly available
Includes a termination date
Limits the ability of either party to disclose publicly the nature of discussion between the buyer and seller
Answer: C
6. The actual price paid by the buyer for the target firm is determined when
The initial offer is made
As a result of the negotiation process
When the letter of intent is signed
Following the completion of due diligence
Once a financing plan has been approved
Answer: B
7. Total consideration is a legal term referring to the composition of the purchase price paid by the buyer for the target firm. It may consist of which of the following:
Cash
Cash and stock
Cash, stock, and debt
A, B, and C
A and B only
Answer: D
8. In a merger, the acquiring firm assumes all liabilities of the target firm. Assumed liabilities include all but which of the following?
Current liabilities
Long-term debt
Warranty claims
Fully depreciated operating equipment
Off-balance sheet liabilities
Answer: D
9. The negotiation process consists of all of the following concurrent activities except for
Refining valuation
Deal structuring
Integration planning
Due Diligence
Developing the financing plan
Answer: C
10. All of the following are true of buyer due diligence except for
Due diligence is the process of validating assumptions underlying valuation.
Can be replaced by appropriate representations and warranties in the agreement of purchase and sale.
Primary objectives are to identify and to confirm sources and destroyers of value
Consists of operational, financial, and legal reviews.
Endeavors to identify the “fatal flaw” that could destroy the deal
Answer: B
11. Which of the following are commonly used sources of financing for M&A transactions?
Asset based lending
Cash flow based lending
Seller financing
A and B only
All of the above
Answer: E
12. Which of the following is generally not true of a financing contingency?
It is a condition of closing in the agreement of purchase and sale
Trigger the payment of break-up fees if not satisfied.
Protects both the lender and seller
Primarily protects the buyer
Primarily protects the seller
Answer: C
13. Which of the following is generally not true of integration planning?
Is of secondary importance in the acquisition process.
Is crucial to the ultimate success of the merger or acquisition
Represents an opportunity to earn trust among all parties to the transaction
Involves developing effective communication strategies for employees, customers, and suppliers.
Is often neglected in the heat of negotiation.
Answer: A
14. All of the following are true of closing except for
Consists of obtaining all necessary shareholder, regulatory, and third party consents
Requires significant upfront planning
Is rarely subject to last minute disagreements
Involves the final review and signing of such documents as the agreement of purchase and sale, loan agreements (if borrowing is involved), security agreements, etc.
Fulfillment of the so-called closing conditions
Answer: C
15. Which of the following do not represent typical closing documents in an asset purchase?
Letter of intent
Listing of any liabilities to be assumed by the buyer
Loan and security agreements if the transaction is to be financed with debt
Complete descriptions of all patents, facilities, and investments
Listing of assets to be acquired
Answer: A
16. Which of the following is not typically true of post-closing evaluation of an acquisition?
It is important not to change the performance benchmarks against which the acquisition is measured
It is critical to ask the tough questions
It is an opportunity to learn from mistakes
It is commonly done
It is frequently avoided by acquiring firms because of the potential for embarrassment.
Answer: D
17. Which of the following is true about integration planning? Without integration planning, integration is not likely to
a.Provide anticipated synergies
b.Proceed without significant disruption to the target business’ operations
c.Proceed without significant disruption to the acquirer’s operations
d.Be completed without experiencing substantial customer attrition
e.All of the above
Answer: E
18. Which of the following statements are true about due diligence?
a.The seller should perform due diligence on its own operations.
b.The seller should perform due diligence on the buyer.
c.The seller should perform due diligence on the lender used by the buyer to finance the transaction.
d.A & B
e.A, B, & C
Answer: D
19. Which of the following is not true of the financing plan?
a. It is rarely affected by the discovery during due diligence of target assets not required to operate the business.
b. It may include both stock and debt.
c. It may include a combination of stock, debt, and cash.
d. It serves as a reality check on the buyer.
e. None of the above.
Answer: A
20. Refining the target valuation based on new information uncovered during due diligence is most likely to affect which of the following
a.Total consideration
b.The search process
c.The business plan
d.The acquisition plan
e.The target’s business plan
Answer: A
21. The negotiation process consists of all of the following except for
a.Refining valuation
b.Due diligence
c.Closing
d.Developing a financing plan
e.Deal structuring
Answer: C
22. Closing is included in which of the following activities?
a.Development of a business plan
b.Development of an acquisition plan
c.The search process
d.The negotiation process
e.None of the above
Answer: E
23. Integration planning is included in which of the following activities?
a.Development of a business plan
b.The search process
c.Development of a financing plan
d.Post-closing integration
e.None of the above
Answer: E
24. The development of search criteria is included in which of the following activities?
a.Development of a business plan
b.Development of the acquisition plan
c.Post-closing integration
d.Post-closing evaluation of the acquisition process
e.None of the above
Answer: B
25. The financing plan is included in which phase of the acquisition process?
a.The development of the business plan
b.The negotiation phase
c.The integration planning phase
d.The development of the acquisition plan
e.None of the above
Answer: B
26. Which of the following is not true of the acquisition process?
It always follows a predictable sequence of steps.
It sometimes deviates from the sequence outlined in this chapter.
It involves a negotiation phase
It involves the development of a business plan
None of the above
Answer: A
Case Study Short Essay Examination Questions:
Oracle’s Efforts to Consolidate the Software Industry
Key Points:
Industry-wide trends, coupled with the recognition of its own limitations, compelled Oracle to alter radically its business strategy.
A rapid series of acquisitions of varying sizes enabled the firm to respond rapidly to the dynamically changing business environment.
Increasingly, the major software competitors seem to be pursuing very similar strategies.
The long-term winner often is the firm most successfully executing its chosen strategy.
_____________________________________________________________________________________________
Oracle ‘s completion of its $7.4 billion takeover of Sun Microsystems on January 28, 2010 illustrated how in somewhat more than five years the firm has been able to dramatically realign its focus. Once viewed as the premier provider of proprietary database and middleware services (accounting for about three-fourths of the firm’s revenue), Oracle is now seen as a leader in enterprise resource planning, customer relationship management, and supply chain management software applications. What spawned this rapid and dramatic transformation?
The industry in which Oracle competes has undergone profound and lasting changes. In the past, the corporate computing market was characterized by IBM selling customers systems that included most of the hardware and software in a single package. Later, minicomputer manufacturers pursued a similar strategy in which they would build all of the crucial pieces of a large system, including its chips, main software, and networking technology. The traditional model was upended by the rise of more powerful and standardized computers based on readily available chips from Intel and an innovative software market. Customers could choose the technology they preferred (i.e., “best of breed”) and assemble those products in their own data centers networks to support growth in the number of users and the growing complexity of user requirements. Such enterprise-wide software (e.g., human resource and customer relationship management systems) became less expensive as prices of hardware and software declined under intensifying competitive pressure as more and more software firms entered the fray.
Although the enterprise software market grew rapidly in the 1990s, by the early 2000s, market growth showed signs of slowing. This market consists primarily of large Fortune 500 firms with multiple operations across many countries. Such computing environments tend to be highly complex and require multiple software applications that must work together on multiple hardware systems. In recent years, users of information technology have sought ways to reduce the complexity of getting the disparate software applications to work together. Although some buyers still prefer to purchase the “best of breed” software, many are moving to purchase suites of applications that are compatible.
In response to these industry changes and the maturing of its database product line, which accounted for three-fourths of its revenue, Oracle moved into enterprise applications with its 2004 $10.3 billion purchase of PeopleSoft. From there, Oracle proceeded to acquire 55 firms, with more than one-half focused on strengthening the firm’s software applications business. Revenues almost doubled by 2009 to $23 billion, growing through the 2008–2009 recession.
Oracle, like most successful software firms, generates substantial and sustainable cash flow as a result of the way in which business software is sold. Customers buy licenses to obtain the right to utilize a vendor’s software and periodically renew the license in order to receive upgrades. Healthy cash flow minimized the need for Oracle to borrow. Consequently, it was able to sustain its acquisitions by borrowing and paying cash for companies rather than having to issue stock and potentially diluting existing shareholders.
In helping to satisfy its customers’ challenges, Oracle has had substantial experience in streamlining other firms’ supply chains and in reducing costs. For most software firms, the largest single cost is the cost of sales. Consequently, in acquiring other software firms, Oracle has been able to apply this experience to achieve substantial cost reduction by pruning unprofitable products and redundant overhead during the integration of the acquired firms. Oracle’s existing overhead structure would then be used to support the additional revenue gained through acquisitions. Consequently, most of the additional revenue would fall to the bottom line.
For example, since acquiring Sun, Oracle has rationalized and consolidated Sun’s manufacturing operations and substantially reduced the number of products the firm offers. Fewer products results in less administrative and support overhead. Furthermore, Oracle has introduced a “build to order” mentality rather than a “build to inventory” marketing approach. With a focus on “build to order,” hardware is manufactured only when orders are received rather than for inventory in anticipation of future orders. By aligning production with actual orders, Oracle is able to reduce substantially the cost of carrying inventory; however, it does run the risk of lost sales from customers who need their orders satisfied immediately. Oracle has also pared down the number of suppliers in order to realize savings from volume purchase discounts. While lowering its cost position in this manner, Oracle has sought to distinguish itself from its competitors by being known as a full-service provider of integrated software solutions.
Prior to the Sun acquisition, Oracle’s primary competitor in the enterprise software market was the German software giant SAP. However, the acquisition of Sun’s vast hardware business pits Oracle for the first time against Hewlett-Packard, IBM, Dell Computer, and Cisco Systems, all of which have made acquisitions of software services companies in recent years, moving well beyond their traditional specialties in computers or networking equipment. In 2009, Cisco Systems diversified from its networking roots and began selling computer servers. Traditionally, Cisco had teamed with hardware vendors HP, Dell, and IBM. HP countered Cisco by investing more in its existing networking products and by acquiring the networking company 3Com for $2.7 billion in November 2009. HP had purchased EDS in 2008 for $13.8 billion in an effort to sell more equipment and services to customers often served by IBM. Each firm seems to be pursuing a “me too” strategy in which they can claim to their customers that they and they alone have all the capabilities to be an end-to-end service provider. Which firm is most successful in the long run may well be the one that successfully integrates their acquisitions the best.
Investors’ concern about Oracle’s strategy is that the frequent acquisitions make it difficult to measure how well the company is growing. With many of the acquisitions falling in the $5 million to $100 million range, relatively few of Oracle’s acquisitions have been viewed as material for financial reporting purposes. Consequently, Oracle is not obligated to provide pro forma financial data about these acquisitions, and investors have found it difficult to ascertain the extent to which Oracle has grown organically (i.e., grown the revenue resulting from prior acquisitions) versus simply by acquiring new revenue streams. Ironically, in the short run, Oracle’s acquisition binge has resulted in increased complexity as each new acquisition means more products must be integrated. The rapid revenue growth from acquisitions may indeed simply be masking underlying problems brought about by this growing complexity.
Discussion Questions and Answers:
How would you characterize the Oracle business strategy (i.e., cost leadership, differentiation, niche, or some combination of all three)? Explain your answer.
Answer: The business strategy can best be described as a cost leadership strategy focused on business application software in which Oracle seeks to add the revenue from acquired companies without taking on much additional cost and to achieve revenue growth for its existing product lines by cross-selling its current products to the customers of the newly acquired businesses. This requires that the existing Oracle infrastructure to support the sales, marketing, and customer service functions formerly supported by the acquired firm’s infrastructure. Moreover, The Oracle strategy is characterized by substantial economies of scale to the extent that it can achieve better utilization of its operations and economies of scope to the extent it can have existing departments support additional product lines or customer groups. Substantial cost savings are achieved by terminating redundant employees and by spreading fixed costs over a larger revenue stream. The strategy could also be viewed as a niche strategy to the extent it is focused on increasing the firm’s share of the business application software market by targeting customers seeking vendors capable of supplying a range of business software that works well together. The strategy also has elements of a differentiation strategy in that Oracle is attempting to distinguish itself from single product vendors by developing the capability to provide suites of integrated business software applications. However, this latter strategy is increasingly common among major software companies.
Conduct an external and internal analysis of Oracle. Briefly describe those factors that influenced the development of Oracle’s business strategy. Be specific.
Answer: From an external point of view, Oracle’s core product offering, database software, is maturing. Since the product historically represented three-fourths of the firm’s revenue, Oracle recognized that it was unlikely to achieve rapid growth as long as it remained focused on this market segment. Moreover, customers have made it clear that they are looking for vendors capable of providing a full range of integrated software products. From an internal point of view, Oracle’s core competency is in developing and marketing database software, essentially a niche product. Moreover, their database systems are based on proprietary software that does not easily integrate into a customer’s existing software infrastructure. These external and internal considerations necessitated a change in business strategy to broaden both the firm’s product offering and skill set to support such an offering.
In what way do you think the Oracle strategy was targeting key competitors? Be specific.
Answer: The strategy targets competitors by eliminating partners with whom competitors had worked to augment their product offering to customers.
What other benefits for Oracle, and for the remaining competitors such as SAP, do you see from further industry consolidation? Be specific.
Answer: Industry consolidation could provide Oracle and the remaining competitors with additional pricing power by narrowing the range of choices available to customers.
Cingular Acquires AT&T Wireless in a Record-Setting Cash Transaction
Cingular outbid Vodafone to acquire AT&T Wireless, the nation’s third largest cellular telephone company, for $41 billion in cash plus $6 billion in assumed debt in February 2004. This represented the largest all-cash transaction in history. The combined companies, which surpass Verizon Wireless as the largest U.S. provider, have a network that covers the top 100 U.S. markets and span 49 of the 50 U.S. states. While Cingular’s management seemed elated with their victory, investors soon began questioning the wisdom of the acquisition.
By entering the bidding at the last moment, Vodafone, an investor in Verizon Wireless, forced Cingular’s parents, SBC Communications and BellSouth, to pay a 37 percent premium over their initial bid. By possibly paying too much, Cingular put itself at a major disadvantage in the U.S. cellular phone market. The merger did not close until October 26, 2004, due to the need to get regulatory and shareholder approvals. This gave Verizon, the industry leader in terms of operating margins, time to woo away customers from AT&T Wireless, which was already hemorrhaging a loss of subscribers because of poor customer service. By paying $11 billion more than its initial bid, Cingular would have to execute the integration, expected to take at least 18 months, flawlessly to make the merger pay for its shareholders.
With AT&T Wireless, Cingular would have a combined subscriber base of 46 million, as compared to Verizon Wireless’s 37.5 million subscribers. Together, Cingular and Verizon control almost one half of the nation’s 170 million wireless customers. The transaction gives SBC and BellSouth the opportunity to have a greater stake in the rapidly expanding wireless industry. Cingular was assuming it would be able to achieve substantial operating synergies and a reduction in capital outlays by melding AT&T Wireless’s network into its own. Cingular expected to trim combined capital costs by $600 to $900 million in 2005 and $800 million to $1.2 billion annually thereafter. However, Cingular might feel pressure from Verizon Wireless, which was investing heavily in new mobile wireless services. If Cingular were forced to offer such services quickly, it might not be able to realize the reduction in projected capital outlays. Operational savings might be even more difficult to realize. Cingular expected to save $100 to $400 million in 2005, $500 to $800 million in 2006, and $1.2 billion in each successive year. However, in view of AT&T Wireless’s continued loss of customers, Cingular might have to increase spending to improve customer service. To gain regulatory approval, Cingular agreed to sell assets in 13 markets in 11 states. The firm would have six months to sell the assets before a trustee appointed by the FCC would become responsible for disposing of the assets.
SBC and BellSouth, Cingular’s parents, would have limited flexibility in financing new spending if it were required by Cingular. SBC and BellSouth each borrowed $10 billion to finance the transaction. With the added debt, S&P put SBC, BellSouth, and Cingular on credit watch, which often is a prelude in a downgrade of a firm’s credit rating.
Discussion Questions:
What is the total purchase price of the merger?
Answer: The total purchase price is $47 billion, consisting of $41 billion in cash and $6 billion in assumed debt.
What are some of the reasons Cingular used cash rather than stock or some combination to acquire AT&T Wireless? Explain your answer.
Answer: Cingular may have used cash rather than stock or some combination to acquire AT&T Wireless because of the limited growth prospects of its stock as perceived by AT&T Wireless shareholders.
How might the amount and composition of the purchase price affect Cingular’s, SBC’s, and BellSouth’s cost of capital?
Answer: The all-cash offer required the parents of Cingular, SBC and BellSouth, to each borrow $10 billion. All three were subsequently put on the credit watch list of the major credit rating agencies. Since this is often a prelude to a downgrade of their credit rating, all three were likely to experience an increase in their cost of capital to reflect the higher perceived risk.
With substantially higher operating margins than Cingular, what strategies would you expect Verizon Wireless to pursue? Explain your answer.
Answer: Verizon Wireless is in a position to lure Cingular customers with potentially lower prices and better service, because it is in a better position to price its products aggressively and to spend on improved customer service.
Bank of America Acquires Merrill Lynch
Against the backdrop of the Lehman Brothers’ Chapter 11 bankruptcy filing, Bank of America (BofA) CEO Kenneth Lewis announced on September 15, 2008, that the bank had reached agreement to acquire mega–retail broker and investment bank Merrill Lynch. Hammered out in a few days, investors expressed concern that the BofA’s swift action on the all-stock $50 billion transaction would saddle the firm with billions of dollars in problem assets by pushing BofA’s share price down by 21 percent.
BofA saw the takeover of Merrill as an important step toward achieving its long-held vision of becoming the number 1 provider of financial services in its domestic market. The firm’s business strategy was to focus its efforts on the U.S. market by expanding its product offering and geographic coverage. The firm implemented its business strategy by acquiring selected financial services companies to fill gaps in its product offering and geographic coverage. The existence of a clear and measurable vision for the future enabled BofA to make acquisitions as the opportunity arose.
Since 2001, the firm completed a series of acquisitions valued at more than $150 billion. The firm acquired FleetBoston Financial, greatly expanding its network of branches on the East Coast, and LaSalle Bank to improve its coverage in the Midwest. The acquisitions of credit card–issuing powerhouse MBNA, U.S. Trust (a major private wealth manager), and Countrywide (the nation’s largest residential mortgage loan company) were made to broaden the firm’s financial services offering.
The acquisition of Merrill makes BofA the country’s largest provider of wealth management services to go with its current status as the nation’s largest branch banking network and the largest issuer of small business, home equity, credit card, and residential mortgage loans. The deal creates the largest domestic retail brokerage and puts the bank among the top five largest global investment banks. Merrill also owns 45 percent of the profitable asset manager BlackRock Inc., worth an estimated $10 billion. BofA expects its retail network to help sell Merrill and BlackRock’s investment products to BofA customers.
The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not allow for proper due diligence. The extent of the troubled assets on Merrill’s books was largely unknown. While the losses at Merrill proved to be stunning in the short run—$15 billion alone in the fourth quarter of 2008—the acquisition by Bank of America averted the possible demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S. government had injected $45 billion in loans and capital into BofA in an effort to offset some of the asset write-offs associated with the acquisition. Later that year, Lewis announced his retirement from the bank.
Mortgage loan losses and foreclosures continued to mount throughout 2010, with a disproportionately large amount of such losses attributable to the acquisition of the Countrywide mortgage loan portfolio. While BofA’s vision and strategy may still prove to be sound, the rushed execution of the Merrill acquisition, coupled with problems surfacing from other acquisitions, could hobble the financial performance of BofA for years to come.
When Companies Overpay—Mattel Acquires The Learning Company
Mattel, Inc. is the world’s largest designer, manufacturer, and marketer of a broad variety of children’s products selling directly to retailers and consumers. Most people recognize Mattel as the maker of the famous Barbie, the best-selling fashion doll in the world, generating sales of $1.7 billion annually. The company also manufactures a variety of other well-known toys and owns the primary toy license for the most popular kids’ educational program “Sesame Street.” In 1988, Mattel revived its previous association with The Walt Disney Company and signed a multiyear deal with them for the worldwide toy rights for all of Disney’s television and film properties
Business Plan
Mission Statement and Strategy
Mattel’s mission is to maintain its position in the toy market as the largest and most profitable family products marketer and manufacturer in the world. Mattel will continue to create new products and innovate in their existing toy lines to satisfy the constant changes of the family-products market. Its business strategy is to diversify Mattel beyond the market for traditional toys at a time when the toy industry is changing rapidly. This will be achieved by pursuing the high-growth and highly profitable children’s technology market, while continuing to enhance Mattel’s popular toys to gain market share and increase earnings in the toy market. Mattel believes that its current software division, Mattel Interactive, lacks the technical expertise and resources to penetrate the software market as quickly as the company desires. Consequently, Mattel seeks to acquire a software business that will be able to manufacture and market children’s software that Mattel will distribute through its existing channels and through its Website (Mattel.com).
Defining the Marketplace
The toy market is a major segment within the leisure time industry. Included in this segment are many diverse companies, ranging from amusement parks to yacht manufacturers. Mattel is one of the largest manufacturers within the toy segment of the leisure time industry. Other leading toy companies are Hasbro, Nintendo, and Lego. Annual toy industry sales in recent years have exceeded $21 billion. Approximately one-half of all sales are made in the fourth quarter, reflecting the Christmas holiday.
Customers. Mattel’s major customers are the large retail and e-commerce stores that distribute their products. These retailers and e-commerce stores in 1999 included Toys “R” Us Inc., Wal-Mart Stores Inc., Kmart Corp., Target, Consolidated Stores Corp., E-toys, ToyTime.com, Toysmart.com, and Toystore.com. The retailers are Mattel’s direct customers; however, the ultimate buyers are the parents, grandparents, and children who purchase the toys from these retailers.
Competitors. The two largest toy manufacturers are Mattel and Hasbro, which together account for almost one-half of industry sales. In the past few years, Hasbro has acquired several companies whose primary products include electronic or interactive toys and games. On December 8, 1999, Hasbro announced that it would shift its focus to software and other electronic toys. Traditional games, such as Monopoly, would be converted into software.
Potential Entrants. Potential entrants face substantial barriers to entry in the toy business. Current competitors, such as Mattel and Hasbro, already have secured distribution channels for their products based on longstanding relationships with key customers such as Wal-Mart and Toys “R” Us. It would be costly for new entrants to replicate these relationships. Moreover, brand recognition of such toys as Barbie, Nintendo, and Lego makes it difficult for new entrants to penetrate certain product segments within the toy market. Proprietary knowledge and patent protection provide additional barriers to entering these product lines. The large toymakers have licensing agreements that grant them the right to market toys based on the products of the major entertainment companies.
Product Substitutes. One of the major substitutes for traditional toys such as dolls and cars are video games and computer software. Other product substitutes include virtually all kinds of entertainment including books, athletic wear, tapes, and TV. However, these entertainment products are less of a concern for toy companies than the Internet or electronic games because they are not direct substitutes for traditional toys.
Suppliers. An estimated 80% of toy production is manufactured abroad. Both Mattel and Hasbro own factories in the Far East and Mexico to take advantage of low labor costs. Parts, such as software and microchips, often are outsourced to non-Mattel manufacturing plants in other countries and then imported for the assembly of such products as Barbie within Mattel-owned factories. Although outsourcing has resulted in labor cost savings, it also has resulted in inconsistent quality.
Opportunities and Threats
Opportunities
New Distribution Channels. Mattel.com represents 80 separate toy and software offerings. Mattel hopes to spin this operation off as a separate company when it becomes profitable. Mattel.com lost about $70 million in 1999. The other new channel for distributing toys is directly to consumers through catalogs. The so-called direct channels offered by the internet and catalog sales help Mattel reduce its dependence on a few mass retailers.
Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The number of grandparents is expected to grow from 58 million in 1999 to 76 million in 2005.
Interactive Media. As children have increasing access to computers, the demand for interactive computer games is expected to accelerate. The “high-tech” toy market segment is growing 20% annually, compared with the modest 5% growth in the traditional toy business.
International Growth. In 1999, 44% of Mattel’s sales came from its international operations. Mattel already has redesigned its Barbie doll for the Asian and the South American market by changing Barbie’s face and clothes.
Threats
Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items are now more likely to include athletic clothes and children’s software and video games rather than more traditional items such as dolls and stuffed animals.
Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A quality problem with the Cabbage Patch Doll could cost Mattel more than $10 million in returns and in settling lawsuits.
Shrinking Target Market. Historically, the toy industry has considered their prime market to be children from birth to age 14. Today, the top toy-purchasing years for a child range from birth to age 10.
Just-In-Time Inventory Management. Changing customer inventory practices make it difficult to accurately forecast reorders, which has resulted in lost sales as unanticipated increases in orders could not be filled from current manufacturer inventories.
Internal Assessment
Strengths
Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of its toys manufactured in low-labor-cost countries like China and Indonesia, and its established distribution channels. Moreover, licensing agreements with Disney enable Mattel to add popular new characters to its product lines.
Weaknesses
Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been slow to reposition these core brands. The lack of technical expertise to create software-based products limits Mattel’s ability to exploit the shift away from traditional toys to video or interactive games.
Acquisition Plan
Objectives and Strategy
Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys segment into high-growth segments. Mattel believed that it had to acquire a recognized brand identity in the children’s software and entertainment segment of the toy industry, sometimes called the “edutainment” segment, to participate in the rapid shift to interactive, software-based toys that are both entertaining and educational. Mattel believed that such an acquisition would remove some of the seasonality from sales and broaden their global revenue base. Key acquisition objectives included building a global brand strategy, doubling international sales, and creating a $1 billion software business by January 2001.
Defining the Target Industry
The “edutainment” segment has been experiencing strong growth predominantly in the entertainment segment. Parents are seeing the importance of technology in the workplace and want to familiarize their children with the technology as early as possible. In 1998, more than 40% of households had computers and, of those households with children, 70% had educational software. As the number of homes with PCs continues to increase worldwide and with the proliferation of video games, the demand for educational and entertainment software is expected to accelerate.
Management Preferences
Mattel was looking for an independent children’s software company with a strong brand identity and more than $400 million in annual sales. Mattel preferred not to acquire a business that was part of another competitor (e.g., Hasbro Interactive). Mattel’s management stated that the target must have brands that complement Mattel’s business strategy and the technology to support their existing brands, as well as to develop new brands. Mattel preferred to engage in a stock-for-stock exchange in any transaction to maintain manageable debt levels and to ensure that it preserved the rights to all software patents and licenses. Moreover, Mattel reasoned that such a transaction would be more attractive to potential targets because it would enable target shareholders to defer the payment of taxes.
Potential Targets
Game and edutainment development divisions are often part of software conglomerates, such as Cendant, Electronic Arts, and GT Interactive, which produce software for diverse markets including games, systems platforms, business management, home improvement, and pure educational applications. Other firms may be subsidiaries of large book, CD-ROM, or game publishers. The parent firms showed little inclination to sell these businesses at what Mattel believed were reasonable prices. Therefore, Mattel focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc., Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two Interactive Software. Of these, only Acclaim, Activision, and The Learning Company had their own established brands in the games and edutainment sectors and the size sufficient to meet Mattel’s revenue criterion.
In 1999, TLC was the second largest consumer software company in the world, behind Microsoft. TLC was the leader in educational software, with a 42% market share, and in-home productivity software (i.e., home improvement software), with a 44% market share. The company has been following an aggressive expansion strategy, having completed 14 acquisitions since 1994. At 68%, TLC also had the highest gross profit margin of the target companies reviewed. TLC owned the most recognized titles and appeared to have the management and technical skills in place to handle the kind of volume that Mattel desired. Their sales were almost $1 billion, which would enable Mattel to achieve its objective in this “high-tech” market. Thus, TLC seemed the best suited to satisfy Mattel’s acquisition objectives.
Completing the Acquisition
Despite disturbing discoveries during due diligence, Mattel acquired TLC in a stock-for-stock transaction valued at $3.8 billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 billion licensing deal also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.
Epilogue
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August, just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad, was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of any future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands, and repaired relationships with distributors. Gores also has sold the entertainment division and is seeking buyers for the remainder of TLC.
Discussion Questions:
Why was Mattel interested in diversification?
Answer: With more than one-third of its revenue coming from a mature product like Barbie, Mattel was
hoping to take advantage of the children’s software market that was growing at 20 percent per year,
about four times the growth rate of the traditional toy market.
What alternatives to acquisition could Mattel have considered? Discuss the pros and cons of each
alternative?
Answer: Mattel could have considered building the capability internally by leveraging its small, but growing software division. Alternatively, Mattel could have considered creating a joint venture corporation with a leading “edutainment” software company. Both parties would contribute certain assets. Mattel could contribute certain of its most recognized brand name products and the software company could contribute its technical expertise. Mattel could also have considered licensing certain software products from other companies for distribution under its own brand or taking minority positions in software companies that would develop products for distribution by Mattel. Developing the capability internally may be a high-risk proposition, since given its limited technical resources Mattel may have missed the opportunity to participate in the accelerating market for interactive children’s toys. A joint venture or partnering arrangement may not provide the control Mattel may want in order to market globally and to produce only products that would not compete directly with Mattel’s current products. Licenses and minority investments both suffer from limited control and may be difficult to manage.
How might the internet affect the toy industry? What potential conflicts with customers might be
created?
As illustrated by eToys success at that time, the Internet poses an interesting new distribution channel for Mattel. However, efforts to exploit this new technology put Mattel in direct competition with its customers, which are already online.
What are the primary barriers to entering the toy industry?
Answer: Barriers to entry include the well-established distribution channels of the major manufacturers, based on long-standing relationships with retailers such as Wal-Mart and Toys “R” Us. Companies like Mattel and Hasbro have substantial brand recognition created over the years by spending tens of millions of advertising dollars. Furthermore, patents and proprietary knowledge protect brand names. Finally, the top manufacturers have licensing arrangements granting them the exclusive right to market toys based on products provided by the major entertainment companies.
5, What could Mattel have done to protect itself against risks uncovered during due diligence?
Answer: Mattel could have protected itself by shifting some of the risk to The Learning Company (TLC). This could have been achieved by making part of the purchase price contingent on TLC hitting certain future performance targets defined in terms of profits or revenue. Alternatively, Mattel could have insisted that a portion of the purchase price be put into an escrow account until the full extent of the problems uncovered during due diligence were understood.
First Union Buys Wachovia Bank: A Merger of Equals?
First Union announced on April 17, 2001, that an agreement had been reached to acquire Wachovia Corporation for about $13 billion in stock, thus uniting two fiercely independent rivals. With total assets of about $324 billion, the combination created the fourth largest bank in the United States behind Citigroup, Bank of America, and J.P. Morgan Chase. The merger also represents the joining of two banks with vastly different corporate cultures. Because both banks have substantial overlapping operations and branches in many southeastern U.S. cities, the combined banks are expected to be able to add to earnings in the first 2 years following closing. Wachovia, which is much smaller than First Union, agreed to the merger for only a small 6% premium.
The deal is being structured as a merger of equals. That is a rare step given that the merger of equals’ framework usually is used when two companies are similar in size and market capitalization. L. M. Baker, chair and CEO of Wachovia, will be chair of the new bank and G. Kennedy Thompson, First Union’s chair and CEO, will be CEO and president. The name Wachovia will survive. Of the other top executives, six will be from First Union and four from Wachovia. The board of directors will be evenly split, with nine coming form each bank. Wachovia shareholders own about 27% of the combined companies and received a special one-time dividend of $.48 per share because First Union recently had slashed its dividend.
To discourage a breakup, First Union and Wachovia used a fairly common mechanism called a “cross option,” which gives each bank the right to buy a 19.9% stake in the other using cash, stock, and other property including such assets as distressed loans, real estate, or less appealing assets. (At less than 20% ownership, neither bank would have to show the investment on its balance sheet for financial reporting purposes.) Thus, the bank exercising the option would not only be able to get a stake in the merged bank but also would be able to unload its least attractive assets. A hostile bidder would have to deal with the idea that another big bank owned a chunk of the stock and that it might be saddled with unattractive assets.
The deal structure also involved an unusual fee if First Union and Wachovia parted ways. Each bank is entitled to 6% of the $13 billion merger value, or about $780 million in cash and stock. The 6% is about twice the standard breakup fee. The cross-option and 6% fee were intended to discourage other last-minute suitors from making a bid for Wachovia.
According to a First Union filing with the Securities and Exchange Commission, Wachovia rebuffed an overture from an unidentified bank just 24 hours before accepting First Union’s offer. Analysts identified the bank as SunTrust Bank. SunTrust had been long considered a likely buyer of Wachovia after having pursued Wachovia unsuccessfully in late 2000. Wachovia’s board dismissed the offer as not being in the best interests of the Wachovia’s shareholders.
The transaction brings together two regional banking franchises. In the mid-1980s, First Union was much smaller than Wachovia. That was to change quickly, however. In the late 1980s and early 1990s, First Union went on an acquisition spree that made it much larger and better known than Wachovia. Under the direction of now-retired CEO Edward Crutchfield, First Union bought 90 banks. Mr. Crutchfield became known in banking circles as “fast Eddie.” However, acquisitions of the Money Store and CoreStates Financial Corporation hurt bank earnings in late 1990s, causing First Union’s stock to fall from $60 to less than $30 in 1999. First Union had paid $19.8 billion for CoreStates Financial in 1998 and then had trouble integrating the acquisition. Customers left in droves. Ill, Mr. Crutchfield resigned in 2000 and was replaced by G. Kennedy Thompson. He immediately took action to close the Money Store operation and exited the credit card business, resulting in a charge to earnings of $2.8 billion and the layoff of 2300 in 2000.
In contrast, Wachovia assiduously avoided buying up its competitors and its top executives frequently expressed shock at the premiums that were being paid for rival banks. Wachovia had a reputation as a cautious lender.
Whereas big banks like First Union did stumble mightily from acquisitions, Wachovia also suffered during the 1990s. Although Wachovia did acquire several small banks in Virginia and Florida in the mid-1990s, it remained a mid-tier player at a time when the size and scope of its bigger competitors put it at a sharp cost disadvantage. This was especially true with respect to credit cards and mortgages, which require the economies of scale associated with large operations. Moreover, Wachovia remained locked in the Southeast. Consequently, it was unable to diversify its portfolio geographically to minimize the effects of different regional growth rates across the United States.
In the past, big bank deals prompted a rash of buying of bank stocks, as investors bet on the next takeover in the banking sector. Banks such as First Union, Bank of America (formerly NationsBank), and Bank One acquired midsize regional banks at lofty premiums, expanding their franchises. They rationalized these premiums by noting the need for economies of scale and bigger branch networks. Many midsize banks that were obvious targets refused to sell themselves without receiving premiums bigger than previous transactions. However, things have changed.
Back in 1995 buyers of banks paid 1.94 times book value and 13.1 times after-tax earnings. By 1997, these multiples rose to 3.4 times book value and 22.2 times after-tax earnings. However, by 2000, buyers paid far less, averaging 2.3 times book value and 16.3 times earnings. First Union paid 2.47 times book value and 15.7 times after-tax earnings. The declining bank premiums reflect the declining demand for banks. Most of the big acquirers of the 1990s (e.g., Wells Fargo, Bank of America, and Bank One) now feel that they have reached an appropriate size.
Banking went through a wave of consolidation in the late 1990s, but many of the deals did not turn out well for the acquirers’ shareholders. Consequently, most buyers were unwilling to pay much of a premium for regional banks unless they had some unique characteristics. The First Union–Wachovia deal is remarkable in that it showed how banks that were considered prized entities in the late 1990s could barely command any premium at all by early 2001.
Discussion Questions:
In your judgment, was this merger a true merger of equals? Why might this framework have been used in this instance? Do you think it was a fair deal for Wachovia stockholders? Explain your answer.
Answer: In a true merger of equals, the synergy created by combining the firms is about equally attributable to each firm and the size and market capitalization of the two firms involved are usually comparable. Consequently, the resulting combination of the firms is such that the target firm’s shareholders do not receive a significant premium for their stock. Moreover, governance in terms of board representation is usually equally shared between the boards of the acquiring and target firms. Often, a Co-CEO arrangement is established for the new firm consisting of the CEOs of the acquiring and target firms.
In this instance, Wachovia was a much smaller bank than First Union. While board representation was equally divided and 40% of top management of the new firm came from Wachovia, Wachovia’s shareholders ended up with only about 27% of the combined firms’ market capitalization. It is likely that the application of the “mergers of equal” concept was only a tactic used to convince Wachovia’s senior management to support the transaction. The power sharing arrangement with Wachovia’s CEO becoming CEO of the new bank and First Union’s CEO becoming CEO and President was probably a necessary condition for the transaction to happen. Finally, the name Wachovia would survive. Wachovia shareholders may well fare much better in the long-term as part of the new bank than they would have had they remained independent due to their weak overall competitive position as a large regional bank.
Do you believe the cross option and unusual fee structure in this transaction were in the best interests of the Wachovia shareholders? Explain your answer.
Answer: The use of the cross-option was a particularly onerous defensive tactic designed to ensure the combination of First Union and Wachovia and to discourage the arrival of a third party bidder. The tactic was unfair to Wachovia shareholders to the extent it prevented the creation of an auction environment. It is unclear whether such an environment would have developed even without the use of the cross-option because of the waning interest in bank mergers during the 2000-2001 period.
How did big banks during the 1990s justify paying lofty premiums for smaller, regional banks? Why do you think their subsequent financial performance was hurt by these acquisitions?
Answer: Big banks typically justified the payment of huge premiums by touting the anticipated huge cost savings that could be realized by eliminating overlapping operations. While this is true in theory, there is little evidence that this happened in practice. This loss of confidence in being able to realize economies of scale and scope contributed to the decline in the larger banks’ willingness to pay large premiums. The large premiums that had been paid prevented the acquiring banks from realizing their cost of capital, as they were unable to generate sufficient savings to boost income in order to generate measurably higher returns on the greatly enlarged asset base.
What integration challenges do you believe these two banks will encounter as they attempt to consolidate operations?
Answer: Both banks had different cultures. Consequently, getting cooperation between management teams is likely to prove daunting. Moreover, the power sharing arrangement at the CEO level is likely to slow the decision-making process and to contribute to disarray at middle and lower management levels. These factors will retard the development of a new corporate culture in which the employees of both banks will share common values and behaviors. Finally, neither bank has shown any particular skill at integrating effectively their historical acquisitions. Therefore, it is uncertain that this combination will be any more effective in streamlining operations. The use of the mergers of equals’ concept will also retard the realization of cost savings in that the employees will expect that under such an arrangement the burden of layoffs will be equally shared between the two banks.
Speculate on why Wachovia’s management rebuffed the offer from SunTrust Banks with the ambiguous statement that it was not in the best interests of Wachovia’s shareholders?
Answer: This may be a classic example of the management entrenchment hypothesis at work. Wachovia‘s management may have felt that they would be more likely to retain positions of power with First Union than with Sun Trust Banks.
McKesson HBOC Restates Revenue
McKesson Corporation, the nation’s largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1 billion stock deal in early 1999. The transaction was touted as having created the country’s largest comprehensive health care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998 revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice, and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the new chair of McKesson HBOC.
As one of the decade’s hottest stocks, it had soared 38-fold since early 1992. McKesson’s first attempt to acquire HBO in mid-1998 collapsed following a news leak. However, McKesson’s persistence culminated in a completed transaction in January 1999. In its haste, McKesson closed the deal even before an in-depth audit of HBO’s books had been completed. In fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm, Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to surface.
By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This evidence underscored HBO’s efforts to deliberately accelerate revenues by backdating contracts that were not final. Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing so, they were able to boost reported earnings, the company’s share price, and ultimately the purchase price paid by McKesson.
In mid-July, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the past 3 fiscal years to correct for accounting irregularities. The company’s stock had fallen by 48% since late April when it first announced that it would have to restate earnings. McKesson’s senior management had to contend with rebuilding McKesson’s reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not having adequate access to HBO’s records, McKesson decided to close the transaction anyway.
Discussion Questions:
Why do you think McKesson may have been in such a hurry to acquire HBO without completing an appropriate
due diligence?
Answer: In a word, hubris. Lawyers often rely on the reps and warranties in the contract to protect their clients.
If the contract is breeched, the buyer has the right to receive damages from the seller as defined in the
indemnification section of the contract.
Assume an audit had been conducted and HBO’s financial statements had been declared to be in accordance with
GAAP. Would McKesson have been justified in believing that HBO’s revenue and profit figures were 100% accurate?
Answer: Even though financial statements are declared by auditors to be in accordance with GAAP, there is no guarantee that they are wholly accurate, e.g., Enron, WorldCom.
McKesson, a drug wholesaler, acquired HBO, a software firm. How do you think the fact that the two firms were
in different businesses may have contributed to what happened?
Answer: McKesson did not really understand the software business. Consequently, HBO’s management would have had the upper hand in negotiating the contract, because McKesson’s management’s did not realize the extent of the risks they were assuming.
Describe the measurable and non-measurable damages to McKesson’s shareholders resulting from HBO’s
fraudulent accounting activities.
Answer: The 48% decline in the firm’s share price resulted in a $9.5 billion loss in market value and triggered numerous lawsuits. Non-measurable costs included the company’s image and confidence in management.
The Cash Impact of Product Warranties
Reliable Appliances, a leading manufacturer of washing machines and dryers, acquired a marginal competitor, Quality-Built, which had been losing money during the last several years. To help minimize losses, Quality-Built reduced its quality-control expenditures and began to purchase cheaper parts. Quality-Built knew that this would hurt business in the long run, but it was more focused on improving its current financial performance to increase the firm’s prospects for eventual sale. Reliable Appliances saw an acquisition of the competitor as a way of obtaining market share quickly at a time when Quality-Built’s market value was the lowest in 3 years. The sale was completed quickly at a very small premium to the current market price.
Quality-Built had been selling its appliances with a standard industry 3-year warranty. Claims for the types of appliances sold tended to increase gradually as the appliance aged. Quality-Built’s warranty claims’ history was in line with the industry experience and did not appear to be a cause for alarm. Not surprisingly, in view of Quality-Built’s cutback in quality-control practices and downgrading of purchased parts, warranty claims began to escalate sharply within 12 months of Reliable Appliances’s acquisition of Quality-Built. Over the next several years, Reliable Appliances paid out $15 million in warranty claims. The intangible damage may have been much higher because Reliable Appliances’s reputation had been damaged in the marketplace.
Discussion Questions:
1. Should Reliable Appliances have been able to anticipate this problem from its due diligence of Quality-Built? Explain how this might have been accomplished.
Answer: These types of issues should surface during due diligence when financial analysts have an opportunity to analyze in detail the target firm’s financials and to review historical trends in the data. Anomalies in the data would be highlighted in this manner.
2. How could Reliable have protected itself from the outstanding warranty claims in the definitive agreement of purchase and sale?
Answer: A portion of the purchase price could have been held in escrow until the normal period of warranty claims had expired.
The Downside of Earnouts
In the mid-1980s, a well-known aerospace conglomerate acquired a high-growth systems integration company by paying a huge multiple of earnings. The purchase price ultimately could become much larger if certain earnout objectives, including both sales and earnings targets, were achieved during the 4 years following closing. However, the buyer’s business plan assumed close cooperation between the two firms, despite holding the system integrator as a wholly owned but largely autonomous subsidiary. The dramatic difference in the cultures of the two firms was a major impediment to building trust and achieving the cooperation necessary to make the acquisition successful. Years of squabbling over policies and practices tended to delay the development and implementation of new systems. The absence of new systems made it difficult to gain market share. Moreover, because the earnout objectives were partially defined in terms of revenue growth, many of the new customer contracts added substantial amounts of revenue but could not be completed profitably under the terms of these contracts. The buyer was slow to introduce new management into its wholly owned subsidiary for fear of violating the earnout agreement. Finally, market conditions changed, and what had been the acquired company’s unique set of skills became commonplace. Eventually, the aerospace company wrote off most of the purchase price and merged the remaining assets of the acquired company into one of its other product lines after the earnout agreement expired.
Discussion Questions:
Describe conditions under which an earnout might be most appropriate.
Answer: Earnouts are applicable when the parties are far apart on price, the seller’s shareholders are few in
number, and when the buyer anticipates being to keep the target business separate from its primary operations.
Earnouts also represent a way for the buyer to shift some of the risk to the seller.
In your opinion, are earnouts more appropriate for firms in certain types of industries than for others? If so, give examples. Explain your answer.
Answer: Earnouts are most appropriate in high technology businesses where the potential pay-off is in the
distant future.
Case Study: Sleepless in Philadelphia
Closings can take on a somewhat surreal atmosphere. In one transaction valued at $20 million, the buyer intended to finance the transaction with $10 million in secured bank loans, a $5 million loan from the seller, and $5 million in equity. However, the equity was to be provided by wealthy individual investors (i.e., “angel” investors) in amounts of $100,000 each. The closing took place in Philadelphia around a long conference room table in the law offices of the firm hired by the buyer, with lawyers and business people representing the buyer, the seller, and several banks reviewing the final documents. Throughout the day and late into the evening, wealthy investors (some in chauffeur-driven limousines) and their attorneys would stop by to provide cashiers’ checks, mostly in $100,000 amounts, and to sign the appropriate legal documents. The sheer number of people involved created an almost circus-like environment. Because of the lateness of the hour, it was not possible to deposit the checks on the same day. The next morning a briefcase full of cashiers’ checks was taken to the local bank.
Discussion Question:
1. What do you think are the major challenges faced by the buyer in financing small transactions transaction in this
manner?
Answer: Frequently, small transactions are more difficult to finance because the relative lack of sophistication of
the participants, lack of unencumbered assets, or sustainable and predictable cash flows. Consequently, buyers
must utilize less traditional sources of financing such as angel investors who often demand equity participation in
the form of direct ownership or warrants.
Case Study: Mattel Overpays for the Learning Company
Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of software for toys, in a stock-for-stock transaction valued at $3.5 billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 million licensing deal also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated.
For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August, just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad, was leaving the company.
On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an affiliate of Gores Technology Group (GTG) for rights to a share of future profits. Essentially, the deal consisted of no cash upfront and only a share of potential future revenues. In lieu of cash, GTG agreed to give Mattel 50 percent of any profits and part of any future sale of TLC. In a matter of weeks, GTG was able to do what Mattel could not do in a year. GTG restructured TLC’s seven units into three, put strong controls on spending, sifted through 467 software titles to focus on the key brands, and repaired relationships with distributors. GTG also sold the entertainment division.
Discussion Questions:
Despite being aware of extensive problems, Mattel proceeded to acquire The Learning Company. Why? What could Mattel to better protect its interests? Be specific.
Answer: Mattel was more focused on the trend toward software-based toys, Mattel that the additional revenue and profit generated by the acquisition would more than offset the potential drains on cash flow. Mattel could have protected itself by withholding portion of the purchase price in escrow, negotiating an earn-out or contingent payout, or negotiating a lower overall purchase price.
Why was Gore Technology Group able to do what Mattel could not do in a year.?
Answer: Gore specialized in turnarounds and restructuring and had skills not readily available inside Mattel. Moreover, as a smaller, more specialized firm without public shareholders, Gore was able to make decisions more rapidly.
The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA
Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company’s diversified mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost competitiveness but also potentially subjects the company to a variety of global uncertainties.
K2’s success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The company’s external analysis at the time showed that the most successful sporting goods suppliers will be those with the greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands. Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them manage the supply of products and the allocation of shelf space.
The firm’s primary customers are sporting goods retailers. Many of K2’s smaller retailers and some larger retailers were not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals.
The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand recognition and financial resources with whom K2 did not compete. However, they could easily enter K2’s currently served markets. In the company’s secondary business, sports apparel, it did face stiff competition from some of these same suppliers, including Nike and Reebok.
K2’s internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2 was its relatively small size in comparison to major competitors.
As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent within five years; and reduce its debt-to-equity ratio to the industry average of 25 percent in the same period. The business strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2 planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than China.
All this required an implementation strategy. K2 decided to avoid product or market extension through partnering because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy would build on the firm’s great success, in recent years, acquiring and integrating smaller sporting goods companies with well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams. Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment.
In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings.
K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm against the business plan.
In its acquisition plan, K2’s overarching financial objective was to earn at least its cost of capital. The plan’s primary non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and promotional products that could be easily integrated into K2’s current operations.
The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a merger, the target’s sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain management, key employees, customers, distributors, vendors and other business partners of both companies. An evaluation of financial risk showed that borrowing under K2’s existing $205 million revolving credit facility and under its $20 million term loan, as well as potential future financings, could substantially increase current leverage, which could – among other things – adversely affect the cost and availability of funds from commercial lenders and K2’s ability to expand its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital.
Ultimately, management set some specific preferences: the target should be smaller than $100 million in market capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The initial search, by K2’s experienced acquisition team, would involve analyzing current competitors. The acquisition would be made through a stock purchase – and K2 chose to consider only friendly takeovers involving 100 percent of the target’s stock – and the form of payment would be new K2 non-voting common stock. The target firm’s current year P/E should not exceed 20.
After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash flows, complementary product offering, and many licenses with most of the major sports leagues and college teams. Fotoball USA represented a premier platform for expansion of K2’s marketing capabilities because of its expertise in the industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2 believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high earning growth rate of the combined firms.
Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is a very young company and many of its investors were looking to make their profits through the growth of the stock. The offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet deadlines in a timely order.
Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely, reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated at $909 million – an increase of $82.7 million over the sum of the standalone values of the two firms.
Based on Fotoball’s outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious dilution of earnings. To determine the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion of the combined firms revenues would be contributed by each of the players and then applied that proportion to the synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2, only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8 million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball’s stock at the time.
The synergies and the Fotoball’s relatively small size compared to K2 made it unlikely that the merger would endanger K2’s credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the addition of Fotoball would help diversify and smooth K2’s revenue stream, which had been subject to seasonality in the past.
Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best practices of both firms.
On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after, senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any immediate concerns.
Discussion Questions:
1. How did K2’s acquisition plan objective support the realization of its corporate mission and strategic objectives?
Answer: K2’s overarching financial objective for an acquisition was to earn at least its cost of capital. This financial objective dovetails directly with the overarching business objective of meeting or exceeding its corporate cost of capital of 15%. Its primary non-financial objectives are to acquire a firm with well-established brands and complementary distribution channels. K2 was specifically seeking a firm with a successful franchise in the marketing and manufacturing of souvenir and promotional products that could be easily integrated into K2’s current operations. These non-financial acquisition plan objectives would allow K2 to cross-sell its existing products into the acquired firm’s markets and the acquired firm’s products into K2’s markets. The resulting synergy could accelerate overall revenue and profit growth enabling the firm to realize more readily its business plan financial goals.
What alternatives to M&As could K2 have employed to pursue its growth strategy? Why were the
alternatives rejected?
Answer: K2 could have achieved some improvement in revenue by entering into a series of strategic cross-marketing alliances in which each party to the alliance would be able to sell its products into the other firm’s markets. K2 had decided to avoid product or market extension through collaborating because of the potential loss of control and for creating competitors once the cross-marketing alliance agreements lapsed.
What was the role of “strategic controls” in implementing the K2 business plan?
Answer: K2 employed a series of incentive plans and performance monitoring systems to increase the likelihood that their business strategy would be implemented successfully. The incentive plans were designed to motivate employees to work towards implementing its business strategy. Employees were awarded annual bonuses based on their performance throughout the year. Moreover, managers were given bonuses based on how well their departments performed against the plan. The firm’s monitoring systems were in place to give advance warning of underperformance against the business plan. The performance variables the firm tracked included customer retention, average revenue per customer, and average revenue per dealer.
How did the K2 negotiating strategy seek to meet the primary needs of the Fotoball shareholders
and employees?
Answer: K2 employed a share for share exchange such that the transaction would qualify as a tax-free transaction that would enable the Fotoball shareholders to defer the payment of taxes until they sold their K2 stock. Moreover, most Fotoball employees were retained and management was allowed to continue to run the company. K2 also paid a healthy premium over the Fotoball share price at the time of the announcement of the transaction and made use of earn-outs to give management incentives to improve the overall profitability of the firm.
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