Mergers and Acquisitions

Chapter Ten

Mergers and Acquisitions

1. Under the purchase accounting method, a firm that pays more than fair value for an acquirer amortizes the difference over time on its income statement. In the 1990s, mergers between equally sized firms qualified for treatment as a pooling-of-interests, in which case no amortization was required. John McCormack, a senior vice president at the consulting firm Stern Stewart, is quoted as follows: "The accounting model, in brief, says that the value of a company is its current earnings per share multiplied by a standard, industry-wide P/E ratio...Take the case of Bernie Ebbers of WorldCom. I used to think he was brilliant until I heard him explain in a public forum why it was really important to have acquisitions created under the pooling-of-interests accounting method rather than the purchase method. These accounting effects have absolutely no effect on future cash flows, but they will definitely affect EPS. And if you had been persuaded by your investment bankers, as Bernie apparently was, that the value of MCI-WorldCom shares was your earnings per share multiplied by your industry P/E ratio, then you might have believed pooling accounting was important."

Discuss John McCormack's statements in the context of heuristics and biases, and relate the discussion to the market valuations of AOL and Time Warner.

Answer: John McCormack points out that instead of relying on DCF for valuation, investors rely on the P/E valuation heuristic that takes P/E as given and overfocuses on E. He points out that Bernie Ebbers appears to have relied on this heuristic in making acquisitions.

Reliance on heuristics can cause market prices to deviate from intrinsic values. This appears to have been the case with AOL, whose market value was much larger than that of Time Warner. Subsequent events showed that Time Warner was intrinsically more valuable than AOL.

2. In the chapter discussion of the merger between H-P and Compaq, H-P director Sam Ginn initially voiced doubts about the deal. However, the McKinsey experts retorted that even a slim profit in PCs would mean a decent return on invested capital. Do you detect any agency conflicts in this exchange?

Answer: The acquisition of Compaq by H-P might have resulted in higher fees for McKinsey consultants, even if carrying out such an acquisition would have destroyed value for H-P shareholders.

3. H-P director Patricia Dunn works in the banking industry, where consolidation mergers have worked out well in the long run, but are vulnerable in the first two years. She responded positively to the McKinsey consultants' statements that a merger between H-P and Compaq would produce significant cost savings. Discuss her perspective.

Answer: For Patricia Dunn, the "representative" successful acquisition overcomes key challenges in the first two years. The cost savings mentioned by McKinsey would provide confirming evidence in support of H-P's acquisition of Compaq.

4. H-P executives indicate that they use traditional discounted cash flow analysis (DCF) to evaluate investment projects, and that the firm's cost of capital is about 12 percent. Consider exhibit 10-2 that shows how McKinsey consultants proposed that H-P value the cost savings stream stemming from its merger with Compaq. On October 15, 2003, H-P's forward P/E ratio was 16.1, less than its historical value that stood around 20. H-P executives suggest that the lower P/E ratio reflected continued investor uncertainty about whether or not the merger would be successful. Discuss the manner in which H-P's executives valued the expected cost savings stream, when evaluating the merger. In particular address the following questions: Was the technique H-P executives used the same, or comparable, to traditional DCF? Do you believe that H-P paid a reasonable premium for Compaq? Are there any valuation implications attached to H-P's P/E ratio being at 16 rather than 20?

Answer: Is the technique H-P executives used the same, or comparable, to traditional DCF? Suppose that beginning two years from now, H-P expects to save $1.5 billion after tax every year into perpetuity. If H-P discounted those savings at 5 percent, then the present value of those savings would be $30 billion in Year 1 dollars, and $28.57 in current dollars (still discounting at 5 percent). H-P executives valued the $1.5 billion in after-tax cost savings as incremental earnings that extend into perpetuity. Since H-P's P/E ratio at the time was about 20, they valued the incremental earnings stream by multiplying the $1.5 billion by 20. Because the incremental earnings would occur in the future (two years out, one to complete the merger and a second to generate the cost savings), H-P discounted the associated $29.4 billion by about 15 percent per year.

Notice that there is no attempt to ascertain what value of P/E makes fundamental sense. In addition, was the expected cost savings stream as risky as the other components of earnings? The implicit answer by H-P managers would have had to have been yes, if they valued the incremental expected earnings by multiplying by P/E.

Did H-P pay a reasonable premium for Compaq? There are several ways to look at this question. First, if H-P used a discount rate of 15 percent, why are they implicitly discounting future cost savings at 5 percent, that being the implication of multiplying by 20 above? If they discounted the cost savings at 15 percent, the synergy value would only be about $8 billion, not $21.2 billion.

Second, the original $2.1 billion premium that H-P perceives that it paid for Compaq stems from the nature of the sharing rule. Effectively, the sharing rule provided H-P shareholders with 64.4 percent of the combined entity. At the time the deal was agreed, H-P's value was 66.7 percent of the combined market values of the two firms (in August 2001). The difference, 2.3 percent (= 66.7-64.4), actually correponded to $1.2 billion. However, during the prior month, the corresponding amounts fluctuated considerably, and averaged $2.1 billion.

Third, H-P does appear to have generated the cost savings they anticipated, and those savings exceeded the perceived premium.

Are there any valuation implications attached to H-P's P/E ratio being at 16 rather than 20? In the eyes of H-P managers, it means that the market's judgment of the value of the synergies is only $17.3 billion rather than $21.2 billion. Of course, multiplying by P/E is not the appropriate way to compute the fundamental value of the cost saving. The lower P/E may indeed represent the market's