PART II: Finding and Capturing Value in Consolidating Industries
by Ken Smith
In Part I (M&A Monthly / February 2015) we outlined the reasons why industries consolidate, the drivers of consolidation and how winners can anticipate and lead consolidation. Part II examines the specific sources of value, why value so often transfers to the seller, and how to capture value as a buyer.
Sources of Value Beyond the Obvious
The sources of value creation are many in consolidating industries. The winners look across the entire value chain for opportunity beyond the obvious.
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R&D: For example, in R&D consolidation the benefits are not just about cost cutting. There may also be synergies relating to the ability to better diversify risks and optimize the development process across a broader research and development portfolio.
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Operations: In operations, everyone looks for the elimination of manufacturing, distribution, and back-office redundancies. However, close to half the costs of a typical company are in purchased goods and services – consolidation and consolidation benefits can often extend into the supply chain.
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Sales & Marketing: In sales and marketing, the cost savings potential is usually less important than the revenue potential afforded by brand and marketing scale and scope. Care in leveraging the joint product market strengths can lead to new revenue, in addition to the combined revenue of the two companies. Whereas, an exclusive focus on sales and marketing rationalization, invariably leads to customer attrition and negative revenue synergies.
The Transparent Cost Synergy Benefits Transfer to the Seller
Often the largest cost synergies available through increased scale and elimination of redundancies are also the most obvious and, ironically, the most illusive. The fundamental problem with these synergies is that, especially in a consolidating industry, the cost-synergy potential is easy to calculate and thus transparent to all possible bidders. Since the market for corporate control is competitive (i.e., multiple companies will have interest in any valuable target), the value of these clear and calculable synergies will tend to be negotiated away in the bidding process. The “winning” bidder has often been the most aggressive about what synergies can be achieved and how quickly, and has bid accordingly, thereby transferring much or all of the value of the synergies to the seller’s shareholders and simultaneously setting savings goals that are nearly impossible to achieve as quickly as estimated.
A look back at the consolidation of US banking can be used to illustrate. Starting with the branch networks, every bank has been optimizing its branch networks for decades and has sophisticated decision support algorithms for branch placement and branch network optimization. Information on the locations and sizes of all bank branches is readily available, so when Bank A considers the acquisition of Bank B, it can calculate with reasonable accuracy the potential savings achievable through branch network consolidation. The problem is, Bank B could also do this calculation and so could Bank C, another interested buyer. If the offer to purchase leaves too big a gap between the price offered and the potential savings through network consolidation, then Bank B will be talking to Bank C. As a result, the value created in US bank consolidation largely went to the sellers, with only 40% of deals creating value for the buyers.
Buy, Sell, or Get Out of the Way
So in a consolidating industry, a few companies will have the potential to achieve greater synergies than others, and fewer still will have the skills to find the value and realize it in post-deal implementation. These companies can lead consolidation and create great value for their own shareholders, as well as for the sellers’.
Companies in consolidating industries that lack such a distinct advantage will eventually be targets. Selling into a consolidating industry is not necessarily a bad strategy if the company believes that it can capture more value by selling and if the company prepares to be an attractive target.
However, standing idle is high risk. The forces that are driving consolidation will ultimately put smaller companies at a disadvantage unless they can defend some small segment of the market. For example, some paper companies so cornered retreated to niches in fine paper to play in a smaller market that would be less subject to cost-based competition. Some US banks continue to hold out based on a dominant position in a local market.
The greatest risk for a company that chooses not to play is that the company becomes subscale in the consolidated industry and thus uncompetitive and ultimately unattractive even as a target. For the company that has or can acquire the skills to be a successful acquirer, the value creation potential as a buyer in a consolidation industry is high. Alternatively, if a company can remain competitive, perhaps by making some acquisitions or by maintaining a valued market position, then eventual sale is an attractive option for shareholders.
Photo: iwillknot.com