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STRATEGIC INTENT OF M &A

BY Bhagirat B. Merchant Past President BSE IIM Kozhikode, 5th September, 2009

Reasons for strategic planning for inorganic growth through M & A Globalization, Dispersion of Technology, Importance of Fixed Costs Learning by customers and reduction of uncertainty coupled with diffusion of technology, product life cycles are shortening causing intensification of competition

Growth Synergy - simply put elimination of inefficient management by installing more capable management of the acquiring firm Two types of Synergies : {a} operational & {b} financial synergy

Real intent is to improve the shareholders wealth through M & A Two ways to improve shareholders wealth :- Value capture and Value creation Value capture involves shifting value from target companys stakeholders to the acquiring firms shareholders.

Value capture tends to be a one-time event, largely related to the transaction itself; While Value creation is a long-term phenomenon that results from the synergy arising from the transaction. Synergy occurs when capabilities transferred between firms improve a firms competitive position and consequently its performance.

Value is captured by a one time transaction oriented means like acquiring undervalued assets, tax benefits, asset stripping etc. to mention a few. However, the goal in acquisition is to capture and create value simultaneously. This will require both quick decision making of the financial entrepreneur and the strategic view of the patient organization builder.

Lets look at the two synergies that we talked about earlier : Operational Synergy : two forms of this :{a} revenue enhancements; and {b} cost reductions Revenue enhancements will include sharing of marketing opportunities by cross marketing each merger partners products :

{A} lending a major brand name reputation to an upcoming new product line of merger partner OR {B} using an effective distribution network for a product of great potential of other merger partner.

Cost Reduction Synergy : This is the main source of operating synergies acquirer tend to look. This comes on account of economies of scale decreases in the per unit costs that result from an increase in the size or scale of firms operations e.g.

A] spreading overheads output levels rise, thus fixed costs get reduced B] increased specialization of labour & management and more efficient use of capital equipment, which might not be possible at low output levels. Lets look at one example that would simplify the understanding of this point :

Cruise Industry in 1989 Princess Cruises, an American company acquired Sitman Cruises and the 1994 merger between Radison Diamond Cruises & Seven Seas Cruises enabled the combined cruise lines to offer an expanded product line in the form of more ships, beds and itineraries while lowering per bed costs.

This industry quickly learned that a sales force of given size can service a greater number of ships and itineraries. The merged cruise firms found out that there was no need to maintain the same size of administrative & sales forces. . For example, each cruise line has its own network of district sales managers who call on travel agencies within one area.

The acquiring firms sales force was good enough for servicing combined itineraries of both firms ships. Thus enabling the acquiring firm to purchase the targets projected revenues with less than the targets historical cost structure. Normally the marketing expenses of a cruise company involves advertising through visual media television.

In 1989 Princess Cruise Co. had developed an interesting marketing theme Love Theme - targeting the youngsters. This campaign became very popular resulting in unexpected higher bookings for various itineraries, requiring higher fleet of cruise ships. Timely acquisition of Sitman Cruise Co. proved very profitable.

By the time new ships ordered by Princess came, the Co. had already taken advantage of higher bookings and as such after the busy season sold off old fleet of Sitman Cruise.

Lets look at the example of value capture and creation simultaneously by a multinational company operating in India through the acquisition of an Indian company. Hindustan Lever Ltd. Acquiring Tata Oil Mills Co. Ltd. {TOMCO}.

Lets look at the position of Tomco before merger : It was loosing Rs. 1 crore a week Its business volume had gone down by 30% It was least equipped player in the soaps & detergents business without any competitive weapon, while HLL & P&G-Godrej had technology, brands & reach. Even Nirma and others had price as their weapon. Spic Fine Chemicals had technology, Henkels brand names and ecofriendly products.

Tomco had 7,500 employees producing 1,30,000 tons volume, whereas HLL had 7,000 employees for one million tons of volume.

Tomcos Hamam, Moti and Super 501 detergent cake helped HLL to plug the gaps in its product portfolio. It also acquired world famous O.K. brand. HLL had 17 manufacturing facilities but a week base in South and Tomcos two plants in Kerala & Tamilnadu helped HLL to strengthen its base in South.

After merger HLL did few things : Closed down all sales offices of Tomco Closed down 65% of manufacturing facilities Retrenched 3,500 employees; and Spent Rs. 150 crore on restructuring costs

The result :- Tomcos business started growing at 15% p.a. Its market share of relevant product profile started going up; and Its started earning profits A shareholder holding 100 shares of Tomco who got HLL shares with a market value of Rs. 22,000/- against what it would have been at the peek of Tomco price of not more than Rs. 7,000/-

Lets also look at the value creation through restructuring of a company. Restructuring of ICI Ltd. Before 1993 ICI in India was in the business of fibres, fertilizers, seeds, explosives, rubber, chemicals, catalysts and pharmaceuticals.

In 1993 all these activities resulted in a loss. ICI took three steps : Sold its fibre business Sold its fertilizers business; and Added additional capacities in Paints & Explosives businesses, identified as core competencies.

This action yielded Rs. 85 crores. After this divestment turnover came down to Rs. 607 crores {31.3.97} from Rs. 888 crores {31.3.93} But the bottom line changed from Rs. 2 crore loss to a profit of Rs. 27 crores. In other words, though sales dropped by 36% profit went up by 13.5 times

The productivity gain as measured by value added per employee went up from Rs. 2.48 lacs in 1993-94 to Rs. 4.45 lacs in 1996-97

FUNDING OPTIONS Pricing is also one of the key factors driving an M & A decision. M & A Currencies : Cash, Stock Swaps, Combination of cash & stocks Sources of Financing : global commercial banks, global investment banks, venture capitalists, private equity investors, turnaround venture capital specialists, raising money through the follow on issuances of equity/quasi equity/debt instruments/preferred stock or convertible preferred stocks etc.

Lets look at how the acquiring company can take positive advantage of the booming financial markets or even fail to do so when the management fail to appreciate the timing factor for such a strategy. I will give three different case studies here of three professionally well managed Indian companies who, in my opinion, failed to read the market correctly while the markets were really booming, for the reasons best known to them!

Tata Motors acquisition of Jaguar & Land Rover {JLR} : The detail of the case: Takeover announcement 26th March, 2008 Price US$ 2.3 billion {Rs. 9,200 crores} Market Price of Tata Motors shares on the date of deal announcement Rs. 680/{about US$ 17/- per share at the time}

Financing option chosen by Tata Motors : Rights issue of shares around November, 2008 at an issue price of Rs. 340/- per share, almost after 7 months of the date they announced the deal to takeover JLR from Ford Motors. The issue failed to excite the shareholders, it tanked and devolved on the underwriters.

Apparently Tata Sons had to invest its own funds to bridge the gap by investing money meant for other purposes and also by selling additional shares of TCS. In this act, this professionally managed company displayed complete lack of rational planning and by this time, its market price had fallen to Rs. 170/- per share, substantially lower than its rights offer price.

What the company could have done, if they had read the booming market conditions correctly to their advantage. At the time of announcement of the deal company could have also firmed up its financing plan through either : a] issue of 13.52 crore equity shares at a discount to market price or at a market price of Rs. 680/- to Ford Motors as a complete share swaps OR

B} could have decided to make Rights Issue in April, 2009 immediately after the deal announcement, at a discount to market price and utilised its proceeds to pay off Ford Motor as an all cash deal. With a small dilution of equity and insignificant cost of funds share premium is free of cost Tata Motors could have had a win-win situation.

This could have been the most ideal method to use its own over priced shares as a currency to fund the JLR acquisition. Lets look what Tata Motors have suffered because of its bad financial planning or no planning at all.

The company management rushed into close the deal first and to tie up funds much later. In the last week of November, 2008 Ford Motors market price of shares fell to US$ 1.01 and as a result, Tata Motors could have for the same consideration paid for mere two units Jaguar & Land Rover acquired the entire Ford Motors.

Tata Motors decided to raise long term funds through Rights Issue, which failed and devolved on underwriters and Tat Sons had to bail out the underwriters by putting in the entire shortfall. This strategy, if at all, showed lack of sound financial planning. By December, 2008 its market price fell to Rs. 170/- per share completely leaving any investor appetite.{Though as on 3.9.09 it closed at Rs. 518/-}

Another Case Study : Hindalcos takeover of Novellis : Purchase consideration US$ 3.6 billion all cash transaction Hindalco took a loan of US$ 2.8 billion to pay off shareholders of Novellis Hindalco was also assigned US$ 2.4 billion debt by Novellis

Therefore, effective total debt of US$ 5.2 billion on books of Hindalco post takeover At the time of this deal Hindalcos market price was Rs. 147/- which could have been utilised positively by the company to offer all stock deal OR Company could have made Rights offer to its shareholders to raise the money to pay off Noveliis as all cash deal.

However, by the time company chose to make a Rights issue at Rs. 90/- per share, the issue completely failed and the market price crashed to Rs. 54/ The correct way to go about it was to first come out with a rights issue at around Rs. 140/- and then plan the payment schedule for the acquisition

The counter argument put forward was that the target company would not have waited for so long. In reality that would have been a more suitable or rather desirable situation rather than rushing into a deal for which the had no funds.

The third case study : Suzlons takeover of RE Power Purchase consideration Euro 1.35 billion all cash transaction This company also failed to encash the bullish sentiment which had pushed it share price to Rs. 1,380/- in May, 2007 when the deal was going through.

Either they could have offered their own shares to RE Powers shareholders as all stock deal OR Raised money through rights offer at a huge premium. In fact its market price touched Rs. 2,300/in January, 2008 but it failed to wake up and pay heed to financial prudence.

In November, 2008 company realised its cash flow statements have become weak and it needed to raise funds through rights offer. On this announcement of its rights offer the market price of its share started plunging from Rs. 210/- to Rs. 160/- {pre split Rs. 1,050/-} and touched a low of Rs. 50/- in first week of December, 2008.

One can see how such well managed and successful company managements did not utilise the booming market conditions to their advantage in order to create value for their shareholders. Rather they eroded their balance sheets which in turn would take a longer time to restore it meaningfully.

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