Inside M&A: In the Wake of Industry Consolidation Discovery Communications Buys Scripps Networks

Cable-TV distributors buy much of their content from cable-TV content providers. With continuing consolidation among cable-TV distributors, content companies are under increasing pressure to combine. Distributors such as AT&T Inc. and Charter Communications Inc. have completed acquisitions in recent years. Smaller content providers have been under pressure from investors to merge to gain additional clout in their negotiations with the huge cable-TV distributors to improve their cut of subscriber fees paid to the cable-TV companies.

Cable and satellite-TV providers pay fees to content owners for the right to carry their channels.¹ Cable-TV distributors make the majority of their revenue from subscriber fees.² The amount each content provider receives depends on the attractiveness of their content and their negotiating leverage. Cable and satellite-TV providers’ subscriber revenues drive content provider revenues. With subscriber revenues under pressure from so-called “cord cutting,”³ smaller media content providers are competing for a shrinking subscriber revenue pool. The trend among cable-TV distributors is to offer a more select lineup of channels known as “skinny bundles” making it increasingly difficult for content providers to be included in such offerings.

Cord cutting has accelerated largely as a result of the attractiveness of such online streaming services as Netflix and Amazon’s Prime. In mid-2017, Netflix subscribers exceeded 50 million, more than the 48.5 million subscribers to the major cable-TV providers. Services like Alphabet’s (Google) YouTube enable users to provide short videos online for free. Moreover, the number of potential customers for the smaller media company’s content has been shrinking as video streaming sites such as Hulu and YouTube have excluded the content of such providers as Discovery and Scripps from their offering.

The larger cable-TV providers have attempted to adjust to the changing industry dynamics through mergers or by developing targeted services. In 2016, Time Warner Inc. agreed to be acquired by AT&T in a deal valued at $85.4 billion. This followed AT&T’s acquisition of DirecTV in mid-2015 for $48.5 billion. Walt Disney Co., which owns ESPN, is developing an online service to reach sports fans that have chosen not to use traditional cable-TV providers.

Increasing concentration among cable-TV distributors spurred greater concentration among content providers. On July 31, 2017, Discovery Communications Inc. (Discovery) agreed to buy Scripps Networks Interactive (Scripps) for $11.9 billion in a bet that a larger footprint in “lifestyle programming” will help it weather cable TV industry upheaval. Including Scripps’ debt, the deal is valued at $14.6 billion.

Together, these two firms will collect 20% of the fees paid for content by the cable-TV distributors. They will also have a strong international presence as a result Discovery’s international distribution network. With a limited global presence, Scripps can now bring programming such as Home and Garden TV (HGTV), the Food Network, and the Travel Channel to millions of viewers outside the U.S. Discovery can benefit from Scripps’ success in creating short videos similar to YouTube’s content that it could utilize with its own Group Nine Media. The two firms expect that their short videos will be streamed 7 billion times monthly. Finally, the combined firms expect to pare costs by $350 million annually be eliminating redundant overhead.

A bigger portfolio of channels specializing in “lifestyle television” would give the combined firms an edge in talks with advertisers who covet female and younger audiences. A critical mass of programs about home renovations, cooking contests, and similar programming have put Discovery and Scripps in a position to offer a web-TV bundle directly to consumers who are cutting the cord to cable and turning to offerings from Netflix, Hulu and other competitors.

This was not Discovery’s first attempt to acquire Scripps. Three years ago, talks between the two companies broke down, in part because the Scripps family, which owned a controlling interest, was not ready to sell. With the CEOs of both firms having been friends for three decades, preliminary discussions were reignited informally in November 2016 at a media conference. This time the Scripps family was on board. The family, which collectively controls 91.8% of Scripps voting shares, entered into an agreement to vote in favor of the deal.

While the tie-up between the two firms helps them cut costs, gain negotiating leverage with distributors, and expand internationally, challenges remain. Cable-TV distributors are buying fewer channels rather than more as they move toward slimmer bundles to compete with Netflix on price. The continued popularity of video streaming companies, which thus far have excluded Discovery and Scripps content from their offering, will continue to dampen the demand for combined Discovery/Scripps programming. Longer-term, the newly combined firm may have to offer its content directly to consumers by offering its own broadband service.

Chapter Overview

What constitutes a successful acquirer? A lot can be learned by looking at the characteristics of those with a successful track record in meeting the strategic and tactical objectives established for their M&As. As such, the chapter begins with a discussion of the characteristics of high performing acquirers to provide a context for the subsequent discussion of Phases 3–10 of the acquisition process: search, screening, first contact, negotiation, integration planning, closing, postmerger integration, and evaluation.

Once a firm has a viable business plan (Phase 1), it must determine the appropriate implementation strategy (Phase 2). This chapter assumes the firm requires an acquisition to execute its business plan. A review of this chapter (including practice questions and answers) is contained in the file folder entitled Student Study Guide on the companion site to this book (https://www.elsevier.com/books-and-journals/book-companion/9780128150757). The companion site also contains an updated comprehensive due diligence question list.

Characteristics of High Performing Acquirers

McKinsey & Company’s 2015 Global Survey of M&A practices and capabilities defines “high performing acquirers” (HPAs) as respondents who describe themselves as having met or surpassed targets for both cost and revenue synergies in their transactions of the past five years. Typically, HPAs more frequently review their portfolio of new opportunities, move more quickly through deal negotiation and due diligence, and better manage cultural differences across organizations and the realization of synergy. However, most respondents feel they could do a better job in balancing incentives among different stakeholders in the process.⁴

While many firms report reviewing their investment opportunities for acquisitions, joint ventures, and divestitures at least once annually, HPAs tend to do so more often. More frequent reviews enable HPAs to stay abreast of changing market dynamics and to seize opportunities on a timelier basis. For example, with the pace of M&As reaching record levels in recent years, the attractiveness of firms cited previously as potential targets may change as their market valuations increase. If the opportunity arises, it is important to move quickly rather than to simply react after a competitor has already made an offer for the firm.

HPAs also differentiate themselves from their peers in how they manage deal negotiation and due diligence. Deal negotiation includes the elapsed time from a nondisclosure agreement to a binding offer. HPAs tend to move through these activities in less than six months while low performers tend to take longer. The longer it takes to get a binding offer the greater the likelihood of an information leak and for uncertainty to grow among investors, employees, customers, and suppliers.

Finally, HPAs tend to be more effective in managing cultural differences across the organizations and in setting and realizing synergy targets. Improperly handing cultural differences can result in a mass exodus of key employees, slumping productivity of those that remain, and a decline in customer service. The net effect of these impacts is to increase operating costs, contribute to customer attrition, and erode profits. Setting unrealistic synergy targets can result in the need to take corrective actions at a later date due to excessive layoffs or a too rapid integration of information technology and customer service functions, leading to growing customer dissatisfaction. Moreover, employees may become demotivated and leave if they feel they cannot perform to the expectations of the new owner. While this may contribute to realizing cost synergies in the short term, it can also increase costs longer term due to hiring and training costs associated with new employees.

Most survey respondents felt they could do a better job in balancing stakeholder incentives between the need to complete the deal in a timely basis and the desire to smoothly and efficiently integrate the businesses following closing. Those having a stake in the closing of the deal often are different from those who have to integrate the firms postclosing. Highly acquisitive firms often have extremely professional “in-house” M&A teams whose primary incentive is to get a deal done, albeit within the terms demanded by senior management and the board. In contrast, the “deal owners” (or the team expected to manage the business following closing) have an incentive to build relationships with employees in the acquired firm to gain cooperation and information sharing. The two incentives can be at odds. The M&A team may seek to uncover as many “synergy opportunities” as possible to justify paying a higher price to close the deal. However, a higher purchase price makes realizing the desired financial return on invested assets that much more difficult for the postmerger management team. Why? They must realize even greater revenue gains and cost reductions to recover the premium paid. This may involve wholesale layoffs and, if possible, renegotiation of supplier and customer contracts to get better terms. While this may help profits in the short-run, it hurts longer term performance by alienating employees, customers, and suppliers.

Phase 3: The Search Process

The first step in searching for acquisition candidates is to establish a small number of primary selection criteria, including the industry and the size of the transaction. Deal size is best defined in terms of the maximum purchase price a firm is willing to pay, expressed as a maximum price-to-earnings, book, cash flow, or revenue ratio, or a maximum purchase price stated in terms of dollars. It also may be appropriate to limit the search to a specific geographic area.

Consider a private acute care hospital holding company that wants to buy a skilled nursing facility within 50 miles of its largest hospital in Allegheny County, PA. Management believes it cannot afford to pay more than $45 million for the facility. Its primary selection criteria could include an industry (skilled nursing), a location (Allegheny County, PA), and a maximum price (five times cash flow, not to exceed $45 million). Similarly, a Texas-based manufacturer of patio furniture with manufacturing operations in the southwestern United States seeks to expand its sales in California. The company decides to try to find a patio furniture manufacturer that it can purchase for no more than $100 million. Its primary selection criteria could include an industry (outdoor furniture), a geographic location (California, Arizona, and Nevada), and a maximum purchase price (10 times operating earnings, not to exceed $100 million).

The next step is to search available computerized databases using the selection criteria. Common databases and directory services include Disclosure, Dun & Bradstreet, Standard & Poor’s Corporate Register, and Capital IQ. Firms also may query their law, banking, and accounting firms to identify other candidates. Investment banks, brokers, and leveraged buyout firms are also fertile sources of potential candidates, although they are likely to require an advisory or finder’s fee. Yahoo! Finance, Hoover’s, and EDGAR Online enable analysts to obtain data quickly about competitors and customers. These sites provide easy access to a variety of documents filed with the Securities and Exchange Commission. Exhibit 5.1 provides a comprehensive listing of alternative information sources.

If confidentiality is not an issue, a firm may advertise its interest in acquiring a particular type of firm in the Wall Street Journal or the trade press. While likely to generate interest, it is less likely to produce good prospects. Rather, it often results in many responses from those interested in getting a free valuation of their own company or from brokers claiming that their clients fit the buyer’s criteria, as a ruse to convince you that you need the broker’s services.⁵

Finding reliable information about privately owned firms is a major problem. Sources such as Dun & Bradstreet and Experian may only provide fragmentary data. Publicly available information may offer additional details. For example, surveys by trade associations or the U.S. Census Bureau often include industry-specific average sales per employee. A private firm’s sales can be estimated by multiplying this figure by an estimate of the firm’s workforce, which may be obtained by searching the firm’s product literature, website, or trade show speeches or even by counting the number of cars in the parking lot during each shift.

Credit rating agencies, independent firms that assign a rating to a firm’s ability to repay its debt, provide an independent assessment of the viability of both publicly traded and privately owned firms. Information about rated firms may be available on the rating agency’s website or through a paid subscription. Studies show that acquirers of target firms are less likely to overpay because of access to financial information used by the rating agencies. Rated targets receive lower premiums and generate higher acquirer postmerger returns than nonrated firms.⁶

The IPO market can expedite the search process by providing information about private firms, especially in the absence of any significant publicly available information. By scouring the prospectus accompanying an IPO, it is possible to gain insights into how other private firms similar to the one that had “gone public” operate as well as their potential growth prospects. Also, the resulting price to sales, profit, or cash flow multiples associated with the IPO can be applied to similar private firms in order to estimate their fair market value.⁷

Failed takeover bids can also be a source of information for selecting potential target firms. Theoretically, if a target’s share price jumps on the announcement date of a bid, the share price should return to preannouncement levels if the bid is later withdrawn. If it does not return to earlier levels, investors could perceive the target as undervalued and likely to attract other bidders. Strategic buyers (versus financial buyers) appear to be more adept at identifying undervalued firms as target share prices following failed bids tend to remain elevated longer when the bidder is a strategic rather than a financial buyer.⁸

There is some evidence that publicly traded firms with the greatest analyst coverage may tend to be undervalued because investment analysts are under pressure to cover those firms exhibiting the greatest appreciation potential. Consequently, the number of analysts covering a firm and the frequency of their reports can be a proxy for undervalued firms. However, the usefulness of this factor in selecting potential target firms is limited to publicly traded companies.

Who owns the firm can represent an important source of information when key information on the firm is not publicly available. Investors often bid up acquirer shares when the takeover involves targets partially or wholly owned by private equity or venture capital investors. This is especially true when the private equity or venture capital firm have a reputation for improving the performance of firms in their portfolios.⁹

Increasingly, companies—even midsize firms—are moving investment banking “in-house.” Rather than use brokers or so-called “finders”¹⁰ as part of their acquisition process, they are identifying potential targets, doing valuation, and performing due diligence on their own. This reflects efforts to save on investment banking fees, which can easily be more than $5 million plus expenses on a $500 million transaction.¹¹

Phase 4: The Screening Process

The screening process is a refinement of the initial search process. It begins by pruning the initial list of potential candidates created using the primary criteria discussed earlier. Because relatively few primary criteria are used, the initial list may be lengthy. It can be shortened using secondary selection criteria, but care should be taken to limit the number of these criteria. An excessively long list of selection criteria will severely limit the number of candidates that pass the screening process. The following selection criteria should be quantified whenever possible.

• Market Segment: A market segment is a group of customers who share one or more common characteristics. A lengthy list of candidates can be shortened by identifying a sub-segment of a target market. For example, a manufacturer of flat rolled steel coils wishes to move up the value chain by acquiring a steel fabricated products company. While the primary search criterion could be to search for US based steel fabricating firms (i.e., the steel manufacturer’s target market), a secondary criterion could stipulate segmenting the steel fabrication products market further to include only those fabricators making steel tubing.
• Product Line: A product line is a group of products sold by one company under the same logo or brand. Assume a well-known maker of men’s sports apparel wishes to diversify into women’s sports apparel. The primary search criteria would be to search for makers of women’s sports apparel, and the secondary criterion could be a specific type of apparel.
• Profitability: Profitability should be defined in terms of the percentage return on sales, assets, or total investment. This allows a more accurate comparison among candidates of different sizes. A firm with operating earnings of $5 million on sales of $100 million may be less attractive than a firm with $3 million in operating income on sales of $50 million because the latter firm may be more efficient.
• Degree of Leverage: Debt-to-equity or debt-to-total capital ratios are used to measure the level of leverage or indebtedness. The acquiring company may not want to purchase a firm whose debt burden may cause the combined company’s leverage ratios to jeopardize its credit rating.
• Market Share: The acquiring firm may be interested only in firms that are number 1 or 2 in market share in the targeted industry or in firms whose market share is some multiple (e.g., 2 × the next-largest competitor).¹²
• Cultural Compatibility: Insights into a firm’s corporate culture can be obtained from public statements about the target’s vision for the future and its governance practices as well as its reputation as a responsible corporate citizen. Examining employee demographics reveals much about the diversity of a firm’s workforce.¹³ Finally, an acquirer needs to determine whether it can adapt to the challenges of dealing with foreign firms such as different languages and customs.
• Age of CEO or Controlling Shareholder: Like many things in life, timing often is everything. For public firms, CEOs are more inclined to support an offer to buy their firms if they are at or close to retirement age. Why? Because target firm CEOs are generally unlikely to find a position with the acquirer and have less to lose since they are about to retire.¹⁴ For privately owned firms, the age of the founder or controlling shareholder often is an important determinant of when a firm is likely to be willing to sell. If there is not a likely successor, the firm may be more receptive to an offer to buy the firm.

Simply satisfying the search/screening process does not ensure a firm will pursue an attractive candidate. The firm’s approval process may require consensus among the firm’s board members and senior managers and the decision to make contact with a potential target firm may become mired in internal politics. Board members may have different priorities. Some may feel that they will not be included in a merger in which the target and acquirer boards are merged. Disagreement among key managers also may arise if some feel that their positions may be threatened. Others may feel that they will personally benefit more from the acquisition of an alternative target firm. The determination of what takeover candidates a firm pursues may ultimately depend on the firm’s ability to resolve these internal political issues to reach consensus among key decision makers. Such consensus often is critical to the successful integration of the acquiring and target firms. Without it, organizations may reject attractive opportunities.¹⁵

Phase 5: First Contact

Using both the primary and secondary selection criteria makes it possible to bring the search to a close and to begin the next part of the acquisition planning process, first contact. For each target firm, it is necessary to develop an approach strategy in which the potential acquirer develops a profile of each firm to be contacted in order to outline the reasons the target firm should consider an acquisition proposal. Such reasons could include the need for capital, a desire by the owner to “cash out,” and succession planning issues.

Research efforts should extend beyond publicly available information and include interviews with customers, suppliers, ex-employees, and trade associations in an effort to understand better the strengths, weaknesses, and objectives of potential target firms. Insights into management, ownership, performance, and business plans help provide a compelling rationale for the proposed acquisition and heighten the prospect of obtaining the target firm’s interest.

How initial contact is made depends on the size of the company, whether the potential acquirer has direct contacts with the target, whether the target is publicly or privately held, and the acquirer’s time frame for completing a transaction. The last factor can be extremely important. If time permits, there is no substitute for developing a personal relationship with the sellers—especially if the firm is privately held. Developing a rapport often makes it possible to acquire a company that is not thought to be for sale. Personal relationships must be formed only at the highest levels within a privately held target firm. Founders or their heirs often have a strong paternalistic view of their businesses, whether they are large or small. Such firms often have great flexibility in negotiating a deal that “feels right” rather than simply holding out for the highest possible price. In contrast, personal relationships can go only so far when negotiating with a public company that has a fiduciary responsibility to its shareholders to get the best price. If time is a critical factor, acquirers may not have the luxury of developing personal relationships with the seller. Under these circumstances, a more expeditious approach must be taken.

For small companies with which the buyer has no direct contacts, it may only be necessary to initiate contact through a vaguely worded letter expressing interest in a joint venture or marketing alliance. During the follow-up telephone call, be prepared to discuss a range of options with the seller. Preparation before the first telephone contact is essential. If possible, script your comments. Get to the point quickly but indirectly. Identify yourself, your company, and its strengths. Demonstrate your understanding of the contact’s business and how an informal partnership could make sense. Be able to explain the benefits of your proposal to the contact—quickly and succinctly. If the opportunity arises, propose a range of options, including an acquisition. Listen carefully to the contact’s reaction. If the contact is willing to entertain the notion of an acquisition, request a face-to-face meeting.¹⁶

Whenever possible, use a trusted intermediary to make contact, generally at the highest level possible in the target firm. In some instances, the appropriate contact is the most senior manager, but it could be a disaffected large shareholder. Intermediaries include members of the acquirer’s board of directors or the firm’s outside legal counsel, accounting firm, lender, broker/finder, or investment banker. Intermediaries can be less intimidating than if you take a direct approach. When firms have a common board member, empirical research suggests that the likelihood of a deal closing is greater and the duration of the negotiation is usually shorter.¹⁷ Direct or common connections enable both parties to gather information about the other party more easily which tends to promote trust. However, a high degree of familiarity between board members and senior management of the acquirer and target firms can lower announcement date acquirer financial returns if it causes cronyism resulting in less objective analysis and flawed decision making. There is evidence that in the presence of significant social ties there is a greater likelihood that the target’s CEO and a larger fraction of the target’s preacquisition board will remain on the board of the combined firms after the merger.¹⁸

For public companies, making contact at the highest level possible is extremely important. Discretion is critical because of the target’s concern about being “put into play”—that is, circumstances suggest that it may be an attractive investment opportunity for other firms. Even rumors of an acquisition can have adverse consequences for the target, as customers and suppliers express concern about a change of ownership and key employees leave concerned about an uncertain future. Such a change could imply variation in product or service quality, reliability, and the level of service provided under product warranty or maintenance contracts. Suppliers worry about possible disruptions in their production schedules as the transition to the new owner takes place. Employees worry about possible layoffs or changes in compensation.¹⁹ Shareholders may experience a dizzying ride as arbitrageurs, buying on the rumor, bid up the price of the stock, only to bail out if denial of the rumor appears credible.

Phase 6: Negotiation

The negotiation phase often is the most complex aspect of the acquisition process. It is during this phase that the actual purchase price paid for the acquired business is determined, and often it will be quite different from the initial target company valuation. A successful outcome is usually defined as achieving a negotiator’s primary goals. Successful outcomes generally reflect the relative leverage a party has in the negotiation and their willingness to accept preclosing risk (i.e., the risk of failing to satisfy closing conditions which postpone or prevent deal completion) and postclosing risk (i.e., vulnerability to potential liabilities following closing).²² Other factors impacting the likelihood of achieving successful outcomes include competition (if any) among multiple bidders and the skill of the negotiators and their support teams.

In this section, the emphasis is on negotiation in the context of problem solving or interest-based bargaining, in which parties look at their underlying interests rather than simply stating positions and making demands. In most successful negotiations, parties to the transaction search jointly for solutions to problems. All parties must be willing to make concessions that satisfy their own needs as well as the highest priority needs of the others involved in the negotiation. The party to the negotiations with access to the most reliable information often has a definite advantage in the process. For this reason, acquirers hiring a target’s former investment bankers appear to benefit from information they possess. Such acquirers tend to pay lower premiums and receive a larger portion of merger synergies, while target shareholders are less likely to receive competing bids and often earn lower abnormal financial returns. About 10% of acquirers hire target firm ex-investment bankers as advisors despite the potential for being sued for conflicts of interest.²³

The negotiation phase consists of four iterative activities that may begin at different times but tend to overlap (Fig. 5.1). Due diligence starts as soon as the target is willing to allow it and, if permitted, runs throughout the negotiation process. Another activity is refining the preliminary valuation based on new data uncovered as part of due diligence, enabling the buyer to understand the target’s value better. A third activity is deal structuring, which involves meeting the most important needs of both parties by addressing issues of risk and reward. The final activity, the financing plan, provides a reality check for the buyer by defining the maximum amount the buyer can expect to finance and, in turn, pay for the target company. These activities are detailed next.

Phase 7: Developing the Integration Plan

Part of the premerger integration planning process involves the preclosing due diligence activity. One responsibility of the due diligence team is to identify ways in which assets, processes, and other resources can be combined to realize cost savings, productivity improvements, or other perceived synergies. This information is also essential for refining the valuation process by enabling planners to understand better the necessary sequencing of events and the resulting pace at which the expected synergies may be realized.

Phase 8: Closing

Closing entails obtaining all necessary shareholder, regulatory, and third-party consents (e.g., customer and vendor contracts) and also completing the definitive purchase agreement. These are discussed next.

Phase 9: Implementing Postclosing Integration

The postclosing integration activity is widely viewed as among the most important phases of the acquisition process and is discussed in detail in Chapter 6. What follows is a discussion of those activities required immediately following closing, which fall into five categories.

Phase 10: Conducting a Postclosing Evaluation

The primary reasons for conducting a postclosing evaluation of deals are to determine if the acquisition is meeting expectations, undertake corrective actions if necessary, and to identify what was done well and what should be done better in future deals.

The Increasing Application of Data Analytics in M&As

Often described as the identification and interpretation of meaningful patterns in data, data analytics relies on the application of statistics, computer programing, and model building to uncover insights helpful in business decision making. In an age when the cost of data storage, organization, and manipulation has been declining, senior executives often are confronted with vast amounts of data on their customers, suppliers, employees, etc. Just as executives attempt to use such data to describe, predict and improve business performance, data analytics can be applied to all phases of the M&A process described in this book.

Putting a deal together often requires access to large amounts of granular data and the ability to achieve an understanding of historical patterns which underlie predictions of future performance. While the spreadsheet models discussed in Chapters 9 and 14 of this book are examples of how analytical tools can be used to address value and risk related to M&As, they often fail to identify and explain more complex issues. So-called “structured data” such as 10K financial statements are more easily accessible and manipulated than “unstructured data”which ranges from that gleaned from social media to customer preference survey results, census data, to weather information. Thus, analytical tools which use both structured and unstructured data may provide insights into patterns not observable in the output of financial spreadsheet models.

The application of data analytics to M&A has increased in acceptance and popularity with 40% of 2016 Deloitte & Touche survey respondents viewing data analytics as critical to M&A analysis. Larger firms are more inclined to use data analytics with 58% of firms with revenue exceeding $5 billion viewing data analytics as a core component of M&A analysis; firms with annual revenue under $500 million showed less interest in such tools.⁴⁷

Data analytical tools can be applied throughout the M&A process. For example, text reading software can organize the review of legal contracts through key word (or phrase) searches based on names, locations, and dollar amounts. A page by page review of legal documents, once time consuming, can now be done automatically. Another application is in assessing the target firm’s talent pool by identifying the number of employees with certain types of degrees or certifications and length of work experience. Comparisons can be made between the target’s and acquirer’s compensation structures to determine what changes might have to be made and the potential impact on the combined firm’s cost structure. Automated natural language processing (i.e., training computers to understand all forms of human communication) can be used to assess the intellectual property of the target firm and to cross-reference those descriptions of the property with other databases to avoid potential future litigation or regulatory challenges.

While data analytics can provide valuable insights, it is subject to significant limitations. It is predicated implicitly on the notion that more data is better than less. A deluge of data makes it difficult to focus on what is really important. While software can sift through reams of data to identify patterns, it is not always clear that the patterns are not simply an anomaly or whether they are significant and sustainable over time. Furthermore, the management of the target firm is likely to balk at handing over voluminous data during due diligence. As explained elsewhere, it is in the interest of sellers to comply with requests for specific data rather than to go through the exhaustive and expensive process of supplying large volumes of data. Analytical tools can be expensive, difficult to use, and appear to executive decision makers as “black boxes.” When executives don’t understand how the conclusions were reached, they are less likely to have a high degree of confidence in them.

Some Things to Remember

The acquisition process consists of 10 phases. The first phase defines the business plan. If an acquisition is believed necessary to implement the business strategy, an acquisition plan is developed during the second phase, in which key objectives, available resources, and management preferences for completing an acquisition are identified. The next phase consists of the search for appropriate acquisition candidates. The screening phase is a refinement of the search phase. How the potential acquirer initiates first contact depends on the urgency of completing a deal, target size, and access to highly placed contacts within the target firm. The negotiation phase consists of refining valuation, deal structuring, conducting due diligence, and developing a financing plan. Integration planning must be done before closing. The closing phase includes wading through all the necessary third-party consents and regulatory and shareholder approvals. The postclosing integration phase entails communicating effectively with all stakeholders, retaining key employees, and identifying and resolving immediate cash flow needs. While commonly overlooked, the postclosing evaluation is critical if a firm is to learn from past mistakes.

Chapter Discussion Questions

1. 5.1 Identify at least three criteria that might be used to select a manufacturing firm as a potential acquisition candidate. A financial services firm? A high-technology firm?
2. 5.2 Identify alternative ways to make “first contact” with a potential acquisition target. Why is confidentiality important? Under what circumstances might a potential acquirer make its intentions public?
3. 5.3 What are the differences between total consideration, total purchase price/enterprise value, and net purchase price? How are these different concepts used?
4. 5.4 What is the purpose of the buyer’s and the seller’s performing due diligence?
5. 5.5 Why is preclosing integration planning important?
6. 5.6 In a rush to complete its purchase of health software producer HBO, McKesson did not perform adequate due diligence but, rather, relied on representations and warranties in the agreement of sale and purchase. Within 6 months following closing, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the preceding 3 fiscal years to correct for accounting irregularities. The company’s stock fell by 48%. If HBO’s financial statements had been declared to be in accordance with GAAP, would McKesson have been justified in believing that HBO’s revenue and profit figures were 100% accurate? Explain your answer.
7. 5.7 Find a transaction currently in the news. Speculate as to what criteria the buyer may have employed to identify the target company as an attractive takeover candidate. Be specific.
8. 5.8 Fresenius, a German manufacturer of dialysis equipment, acquired APP Pharmaceuticals for $4.6 billion. The deal includes an earnout, under which Fresenius would pay as much as $970 million if APP reaches certain future financial targets. What is the purpose of the earnout? How does it affect the buyer and the seller?
9. 5.9 Material adverse change clauses (MACs) allow parties to the contract to determine who will bear the risk of adverse events between the signing of an agreement and the closing. MACs are frequently not stated in dollar terms. How might MACs affect the negotiating strategies of the parties to the agreement during the period between signing and closing?
10. 5.10 Despite disturbing discoveries during due diligence, Mattel acquired The Learning Company (TLC), a leading developer of software for toys, in a stock-for-stock transaction valued at $3.5 billion. Mattel had determined that TLC receivables were overstated, a $50 million licensing deal had been prematurely put on the balance sheet, and TLC brands were becoming outdated. TLC also had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven to become a big player in children’s software, Mattel closed on the transaction, aware that TLC cash flows were overstated. After restructuring charges associated with the acquisition, Mattel’s consolidated net loss was $82.4 million on sales of $5.5 billion. Mattel’s stock fell by more than 35% to end the year at about $14 per share. What could Mattel have done to protect its interests better?

Answers to these Chapter Discussion Questions are available in the Online Instructor’s Manual for instructors using this book (https://textbooks.elsevier.com/web/Manuals.aspx?isbn=9780128150757).

Someone once said that it is difficult to make predictions especially about the future. But that has not gotten in the way of prognosticators peering into their crystal balls about the outlook for driverless or autonomous cars. The autonomous vehicle components and advanced driver assisted systems market is expected to ramp up very quickly over the next few years from a relatively modest $3 billion level in 2015. Consulting firm Bain & Company sees this sector achieving annual sales of $25 billion by 2025. Goldman Sachs’ analysts see the market growing to $96 billion in 2025 before reaching a mind-numbing $290 billion in 2035.

Emboldened by such optimism, familiar names like Google and Uber have raced ahead of their competitors by investing billions of dollars in developing their own technologies, building test cars, and recording millions of miles on city streets. They have also signed partnerships with automakers such as Chrysler and Volvo. Similarly, Tesla has clocked 1.3 billion test miles from its proprietary Auto Pilot equipped cars.

In 2016, Google moved its own self-driving car project into a new operating unit called Waymo and announced plans to start a ride-sharing service using semi-autonomous minivans made by Fiat Chrysler by the end of 2017. Volkswagen formed a new division to focus on ride-sharing and other mobility services. Mercedes introduced a car capable of driving itself at highway speeds.

Suppliers of automotive semiconductors took note of these market developments. Qualcomm announced in October 2016 its acquisition of NXP, the largest automotive chip supplier. The combination of Qualcomm and NXP created the industry’s largest portfolio of sensors, networking and other components critical to autonomous driving vehicles, putting pressure on other chip makers seeking to become competitive in this market.

In an apparent attempt to leapfrog its rivals, mega chip manufacturer Intel announced on March 13, 2017 that it had inked a deal to acquire Israeli based Mobileye for an eye-popping all-cash offer valuing the firm at $15.3 billion, or $63.44 per share. This amounted to a 34% premium to its prior close of trading day price on the New York Stock Exchange. The purchase price is 42 times 2016 actual annual revenue and 60 times net income.

Why was Intel willing to pay so much for Mobileye? With more than one-half of its revenue coming from chip sales to the maturing personal computer market, Intel has been under substantial pressure to diversify into faster growing semiconductor markets. In recent years, the firm’s revenue and profits have stagnated resulting in the firm laying off 12,000 employees in 2016. At a conference in April 2016, Intel CEO Brian Krzanich discussed plans to transform the firm from one focused on PCs to one that “powers the cloud and billions of smart, connected computing devices.” How would this transformation take place? By focusing on high-growth, data intensive applications where it can achieve leadership positions, while making the firm more efficient and profitable. One such opportunity is the driverless vehicle market. For Intel, Mobileye may have appeared to be a “must do deal” to gain a competitive edge in this market and to prevent competitors from buying the firm.

Driverless cars require immense computing power, including microchips able to crunch reams of data in seconds. In an effort to expand its presence in the automotive segment, the firm has signed partnerships, first with BMW and later Delphi Automotive, an auto supplier. Intel has taken a 15% ownership stake in Here, a digital mapping business owned by a consortium of German automakers. The Mobileye acquisition extends Intel’s strategy to invest in data-intensive market opportunities that build on the company’s strengths in semiconductor chip design, computing and connectivity from the cloud, through the network, to devices.

What is Intel getting for its money in buying Mobileye? Mobileye supplies integrated cameras, chips and software for “driver-assisted” systems which represent the building blocks for self-driving cars to more than two dozen vehicle manufacturers. Founded in 1999, the company currently accounts for 70% of the global market for driver assistance and anti-collision systems. Intel intends to give the firm substantial operating independence and has integrated its own automated driving group with Mobileye’s operations under the direction of Mobileye’s Chairman and co-founder Amnon Shashua.

The tie-up between Intel and Mobileye could potentially accelerate innovation in autonomous car technology. Much of the impetus for Mobileye’s innovation has come from Mr. Shashua. Mobileye’s advance driver assisted systems collect imaging and location data that can be used to create what the company calls RoadBook, a vast digital map of roadways in the U.S. and Europe. This will help autonomous vehicles navigate safely city streets.

Intel also aims to broaden its offerings beyond just chips to a wider suite of products that driverless vehicles will require. By doing so, Intel hopes to attract auto makers wanting to produce driverless cars but who do not want to invest in developing their own in-house expertise.

The deal promises to roil the automotive suppliers market. Suppliers like Nvidia and Qualcomm, whose products are currently more aligned with the automakers needs, could soon see this competitive advantage weakened as autonomous car technology takes hold in the industry. Intel will be the first supplier to offer a fully integrated end-to-end cloud computing based solution to autonomous car driving. This means that Intel will be the first supplier to offer the software capability to capture and verify a car sensor’s recognition of a road obstacle by transmitting the image through a network to a cloud based server for validation in real time.

While all this sounds good on paper, the challenges of making it happen in a timely manner are substantial. Intel has missed hyper-growth opportunities in the past. Its failure to capitalize on a “once-in-a-generation opportunity” presented by the growing popularity of smartphones and tablets all but ceded the market to Qualcomm. This left Intel anxious not to miss the driverless car opportunity.

But concerns abound. The biggest may be timing. Intel may be considerably ahead of the time when autonomous cars hit the roads in large numbers. Regulators are having trouble coming to grips with which rules such cars should follow. Uber, the industry-leading ride sharing service, halted its driverless car tests in California because local officials said the firm did not have the required permits; its tests in Pittsburgh Pennsylvania are continuing. In Europe, regulators have been slow to identify the requirements for autonomous cars to take to the road. Moreover, on December 20, 2017, European regulators ruled that Uber will be regulated as a traditional taxi service. This could blunt the firm’s competitive edge in this market and slow their planned introduction of autonomous cars in selected Western European countries.

In a 2017 survey, 48% of respondents said they would never purchase a driverless car, as they were uncomfortable with the loss of control and that they did not trust the technology. The survey results also show a decline in consumer interest in driverless cars across all age groups, with only 20% of people 25–34 years of age comfortable with fully autonomous cars. While young people are more comfortable than older people, they are becoming more cautious about the technology.⁴⁸ Nevertheless, people do want some autonomous technology in their cars, but it would seem that it will be some time before the majority of consumers will accept fully autonomous vehicles.

Another concern is that Intel’s track record in exploiting new opportunities does not inspire confidence. Intel has been able to corner the PC market for more than 30 years. But in recent years it has lost its mojo in dominating other fast growing segments of the chip market. Critics argue that Intel substantially overpaid for Mobileye as it did for cyber security firm, formerly known as McAfee. In 2016, it sold the McAfee for $4.3 billion, $3.2 billion less than it had paid five years earlier.

Much of the creativity in Mobileye is centered around a relatively few people. Intel knows that it must be careful not to allow its bureaucracy to alienate Mobileye personnel. This probably explains why Intel has merged its driverless car unit with Mobileye, with Mobileye management in control.

While Mobileye is the dominant firm in this space for now, competition is intensifying. The firm is competing with its own customers. It sells its products to Autoliv and Delphi Automotive, both of whom are developing their own automated driving products. Other competitors include such well financed firms as Bosch, Nvidia, and even Google. Apple has also been rumored to be a potential entrant, although it may be too late at this point.

Supplying parts to the auto industry has traditionally been a low margin business. Since there are many suppliers all producing similar components, carmakers have traditionally put pressure on them to lower their selling price. With many companies now pursuing the same opportunity (autonomous cars), today’s leading edge technology is likely to become a commodity product in the future. Staying ahead of others in terms of new technology will require substantial ongoing investment in research and development. Cognizant of this risk, Intel hopes to wring out $175 million in sustained annual cost from the deal to help recover the premium it is paying Mobileye shareholders for their shares. History shows that the actual magnitude and timing of realizing these savings often is highly problematic.

With any technology driven opportunity, being first often is a two-edged sword. There is no assurance that Intel and Mobileye’s proposed solution will be accepted by automakers as the industry standard longer-term as new innovations threaten to offer better solutions. Moreover, public acceptance of driverless cars could take much longer than expected pushing the realization of the expected growth in autonomous vehicles further into the future. Timing issues have long bedeviled prognosticators: predictions of a cashless society have been around for decades yet paper currency is still widely circulated in many developed economies.

Being first and being dominant does provide the potential for creating substantial barriers to new entrants. These include achieving economies of scale in producing integrated modular systems of cameras and sensors and driving up the valuations of new startups making acquisition a less attractive market entry option. Firms seeking to enter the market may be discouraged from doing so as their cost structures will initially at least be much higher due to lower sales volumes than market leaders and buying new technology could become prohibitively expensive.