Although many feel that we are on the cusp of a new wave of merger and acquisition (M&A) deal-flow, history suggests that M&A has not been nor ever will be a good option for the shareholder. A great majority of past deals have diminished shareholder value. Yet, the premise of this article is that corporate growth by acquisitions will continue and can harvest significant advantages.
Chief executive officers (CEOs) and top executives today must be mindful, however, that the game has changed. Increased scrutiny from the board and stakeholders should force leaders to be much more cognizant of the acquisition process and its impact on the intrinsic value of the corporation.
A New Game
CEOs and company boards have always had a primary responsibility to compete for shareholder investment in the market. To do so, they must focus on driving up the intrinsic value (discounted cash flows) of the company to create demand for the stock. Empirical evidence from both the stock market and cash flow analysis show that returns on invested capital (ROIC), combined with revenue growth, drive the intrinsic value and, in turn, the demand-driven stock prices.
The highest valued companies are those that drive the spread between ROIC and the weighted average cost of capital (WACC), while concurrently maintaining revenue growth above 10% year-on-year. Revenue growth is critical, for it allows companies to reinvest earnings in the spread between ROIC and WACC at rates greater those available from alternative investments, creating more demand for the stock. Growth or profits alone no longer attract smart shareholders. The investment community now demands both.
The Game Plan
Revenue growth is and will continue to be a requirement of corporate value. A good senior-level team must find a way to grow the business by 10% or more every year. If a weak global economy marginalises the demand for products and services, there will be a need to cut operating costs to optimise ROIC. What about revenue growth? Given that revenue growth is a major component of intrinsic value, and that significant organic growth is nearly impossible in the current economy, isn’t M&A the best option for revenue growth? It may well be the only option.
In this economy, M&A is a company’s best option for growth. However, growth will only bear fruit if acquisitions maintain or increase ROIC. Capturing a weak competitor to increase market share or buying undervalued assets may be a good strategic decision, but the senior-level team must anticipate its crucial impact on intrinsic value.
It is no longer an acceptable practice to qualify a target acquisition by assessing only the current strategic and financial fit. Most often acquisitions fail to meet expectations due to incomplete knowledge of the entity being acquired and the critical first steps to take when the deal is inked. Companies blessed with deep pockets and an urge to deploy capital for revenue growth must perform deeper levels of due diligence and subsequent detailed pre-close planning.
Important cponsiderations are:
- Strategic fit: The mission and strategy of the buyer has to match with the internal structures and external environment of the target organisation. It must be the core responsibility of executives to make investment and resource allocation decisions that upgrade ROIC and revenue growth.
- Financial fit: The buyer has to validate the accuracy and completeness of information about the target, to prevent avoidable harm to either party. It has to perform a detailed assessment of assets, liabilities and solvency, regulatory and licensing, liens and judgments, conflicts of interest and pending litigation. It has also to initiate capital allocation and decide how best to reinvest cash flows.
Once the target qualifies as both a strategic and financial fit, a buyer must go further and plan meticulously how the two entities will effectively blend operations:
- Culture fit: Differences in culture are often cited as the prime barrier to successful M&A. Due diligence in culture must be intensive and go far beyond congenial mutual visits or casual discussions over dinner.
- Integration strategy: Executives need to quit tossing acquisitions to their managers after an acquisition commitment has been made. A clear integration strategy along with pre-deal training and planning can overcome strategic, financial and cultural missteps.
As many M&A’s fail to meet expectations and actually destroy value, management needs to do a far better job of assessing the ‘business fit’ of a target company. They need to understand the real barriers to increasing the ROIC of the enterprise, while growing the top line and penetrating markets.
To eliminate M&A as a primary strategy for shareholder value would be like throwing the baby out with the bath water. Just because most companies tend to focus on the deal, not the deal dynamics and subsequent consequences, does not mean that M&A has ceased to be a potent tool for a dramatic impact on intrinsic value. Done right, acquisitions can be beneficial to stockholders and stakeholders on both sides of the deal and create a positive legacy for the senior-level corporate team.
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