Merger motives

By David C. Lam & Michael Chiu

In a consolidating marketplace, companies should understand that offence may win the game, but defence will win the championship

After several years of inactivity, the mergers and acquisition market came alive in mid-2003. Since that time, there have been numerous significant transactions. In early 2004, we saw such acquisitions as Allstream by Manitoba Telecom for $1.56 billion, Slocan Forest by Canfor for $630 million, and Atrix Laboratories by QLT Inc. for $855 million. Their objectives were diverse, in cluding filling critical capability gaps, achieving synergies and economies of scale, acquisition of tax losses and fending off an income trust structure and replacement of management. As sectors continue to consolidate, we will likely see another strategic motive — the acquisition of assets to protect existing revenue base (protection value).

But let’s look at protection value performed in industry, the related implications and impact on pricing.

High-growth targets require companies not only to drive revenue growth and capitalize on op-portunities made possible by new technologies but also to defend market position with unprecedented intensity. It is in this competitive context that the concept of protection value is emerging with greater frequency.

From both a theoretical and practical perspective, the acquisition of an asset that can effectively obstruct the entry of a major competitor and prevent the erosion of its market share has significant value. This is particularly true in mature sectors dominated by a handful of players and where top-line growth is constantly challenged and competitors look for a catalyst to break through into each other’s geographies to steal business from one another.

In most transactions, price paid over and above the intrinsic value is generally deemed to be a form of strategic premium. This premium represents qualitative advantages such as defensive value offered by business retention tactics. A further reason to pay a premium is to obtain protection value. The question is only how to quantify the benefit and how much of the benefit needs to be paid for or reflected in price?

Despite public commentaries made by CEOs on the nonquantifiable, strategic rationales behind their deals, at the board level, quantifiable financial return on investment is a mandatory prerequisite to any deal approval, not only to legitimize the initial offer price but to determine the walk away price.

The following illustrates the concept of protection benefit and how it can be analyzed. While it is based on an actual transaction, certain information (including names) in the example has been changed to protect the confidentiality of the parties involved.

The players
Prince Co. An information technology services company specializing in core IT services such as desktop support and network maintenance. It holds a majority market share in Ontario, with established customer relationships.

Teck Co.  A small, but reputable IT consulting company, focusing on high-end consulting in Ontario. It does not compete with Prince as it offers different services. In fact, Prince and Teck share the same client base and often subcontract with each other to provide end-to-end solutions to clients.

Cain Co. A major player in BC, Cain provides a full range of IT services to its business clients (i.e. high-end consulting to core IT outsourcing services — covers the range of services of both Teck and Prince). Cain, already monopolizing its geographic market, is looking to expand into Ontario, a much larger and more lucrative market, in order to reach its revenue growth targets.

The situation
Due to the legacy relationships that Prince has with the large enterprise clients, Cain has not been able to attract large customer accounts away from Prince and successfully enter the Ontario marketplace. To gain access to Prince’s accounts, Cain is looking to acquire Teck.
Prince pre-emptively purchased Teck in light of the threat to existing market share in Ontario if Cain purchased Teck. Although Teck has a current market value (intrinsic only) of $75 million, how much is Teck worth to Prince assuming there are no synergies other than protection value?

The valuation
Through extensive review of business, Prince executives identified eight major accounts that were at risk if Cain acquired Teck and subsequently entered the market. As set out in Exhibit I (see p. 41), if Cain were to own Teck, based on this detailed account analysis, $340 million of re-venue would be at risk over the forecasted period, as well as an estimated terminal annual run rate of $55 million.

The present value of the revenue retained as a result of this acquisition is assessed using the discounted cash flow approach. Traditionally, the DCF technique sums the present value of expected future cash flows resulting from an investment. In this case however, not unlike the valuation of a noncompete agreement, the DCF determines the present worth of cash flows preserved or saved by preventing a competitor from stealing market share, discounted at an appropriate rate to provide a risk-adjusted return to Prince.

Based on the above calculation, the net present protection value to Prince is estimated at $40 million. If Teck’s stand-alone value is $75 million, the price range that Prince may be willing to pay is $75 million to $115 million.

Other considerations
A pre-emptive acquisition of Teck would permit Prince to defend against Cain entering Prince’s backyard. However, Prince management must carefully consider the following factors:

• Protection versus deceleration of a competitor’s entrance — by purchasing Teck, is Prince merely slowing Cain’s eventual pres-ence in Ontario versus the true protection of market on an absolute basis? Are there other assets for sale that can prove to be equally effective for Cain to springboard into Prince’s market space? If so, is the value really the $40 million calculated or something less? Perhaps the terminal value should not be included or the discount rate (reflecting the risk of the loss of customers) should be higher.
• Opportunity cost analysis — to a certain extent, the at-risk revenue estimates implicitly presuppose that Prince will not react to signs of market erosion or counter Cain’s advances in a timely manner after the acquisition. Is this reasonable? What would the risk-adjusted cost of such reaction be in comparison to the acquisition of Teck?
  Can Prince use the same $75 million to $115 million in other marketing or service delivery improvement efforts to drive similar, or more important, greater business retention benefits over the same forecast period? What organic growth would be generated by spending the same funds?
• Measurement problems — although the at-risk revenue was rigorously determined, in the end, there is no objective way of separating the subsequent protected revenue from that of the rest of Prince’s business (employing a risk-adjusted discount rate will partially offset this uncertainty).
• Pyrrhic victory — victories that ultimately lead to defeat have often been seen in the marketplace. Take as example Canadian Airlines and Air Canada. The willingness to erode profitability to gain market share and be the last man standing blinded or incapacitated Air Canada. By the time it starved out Canadian, Air Canada itself was in such a spiral that other discount carriers were successfully able to enter the market. Will the acquisition of Teck only lead to a Pyrrhic victory for Prince in time?
• Prevarication strategy — Prince can step up to the auction in an ostensible effort to protect, with the view to bidding up the price then walking away — sometimes dangerous if Prince ends up with Teck at too high a price.

Protection value deserves genuine consideration and related implications must be carefully explored. Risk-adjusted DCF valuation techniques are the most appropriate method to determine the right price for protection benefits. Similar to many companies in a consolidating marketplace with products nearing saturation levels, the Prince executives understand that, as in basketball, offence wins games, but defence wins championships.