Foundations of Financial Management: An Analysis (Part 80)

“Money is usually attracted, not pursued.”

Jim Rohn

External Growth through Mergers

(Part D)

by

Charles Lamson

Premium Offers and Stock Price Movements

Few merger candidates are acquired at their current market value. Typically, a merger premium of 40 to 60% (or more) is paid over the premerger price of the acquired company.

It is not surprising that a company that is offered a large premium over its current market value has a major upside movement. The only problem for the investor is that much of this movement may occur before the public announcement of the merger offer. If a firm is selling at $25 per share when informal negotiations begin, it may be $36 by the time an announced offer of $40 is made. Still, there are good profits to be made if the merger goes through.

The only problem with this strategy or of any merger-related investment strategy is that the merger may be called off. In that case the merger candidate's stock, which shot up from $25 to $36, may fall back to $25, and the johnny-come-lately investor would lose $11 per share.

Two-Step Buyout

Another merger ploy is the two-step buyout. Under this plan the acquiring company attempts to gain control by offering a very high cash price for 51% of the shares outstanding. At the same time, it announces a second, lower price that will be paid later either in cash, stock, or bonds. As an example, an acquiring company may offer stockholders of a takeover target company a $70 cash offer that can be executed in the next 20 days (for 51% of the shares outstanding). Subsequent to that time., the selling stockholders will receive $57.50 in preferred stock for each share.

The buyout procedure accomplishes two purposes. First, it provides a strong inducement to stockholders to quickly react to the offer. Those who delay must accept a lower price. Second, it allows the acquiring company to pay a lower total price than if a single offer is made. In the example above, a single offer may have been made for $68 a share. Assume 1 million shares are outstanding. The single offer has a total price tag of $68 million while the two-step offer would have called for only $63,875,000 dollars.

An example of a two-step buyout was the Mobil Oil attempt to acquire 51 percent of Marathon Oil shares at a price of $126 in cash, with a subsequent offer to buy the rest of the shares for $90 face value debentures. In this case Marathon Oil decided to sell to U.S. Steel, which also made a two-step offer of $125 in cash or $100 in notes to later sellers. Incidentally, before the bidding began, Marathon Oil was selling for $60 a share.

The SEC has continued to keep a close eye on the two-step payout. Government Regulators fear that smaller stockholders may not be sophisticated enough to compete with arbitrageurs or institutional investors in rapidly tendering shares to ensure receipt of the higher price. The SEC has emphasized the need for a pro rata processing of stockholder orders, in which each stockholder receives an equal percentage of shares tendered.

Similar measures to the two-step buyout are likely to develop in the future as companies continue look for more attractive ways to acquire other companies. Such new activity can be expected in the mergers-and-acquisitions area where some of the finest Minds in the investment banking and legal Community are continually at work.

Summary

Corporations may seek external growth through mergers to reduce risk, to improve access to the financial markets through increased size, or to obtain tax carryforward benefits. A merger may also expand the marketing and management capabilities of the firm and allow for new product development. While some mergers promise synergistic benefits (the 2 + 2 = 5 affect). This can be an elusive feature, with initial expectations exceeding subsequent realities.

The cash purchase of another corporation takes on many of the characteristics of a classical capital budgeting decision. In a stock-for-stock exchange, there is often a trade-off between immediate gain or dilution in earnings per share and future growth. If a firm buys another firm with a P/E ratio lower than its own, there is an immediate increase in earnings per share, but the long-term earnings growth prospects must also be considered. The ultimate objective of a merger, as is true of any financial decision, is stockholder wealth maximization, and the immediate and delayed effects of the merger must be evaluated in this context.

To the extent that we are diminishing the overall risk of the firm in a merger, the post-merger P/E ratio and market value may increase even if the potential earnings growth is unchanged. Business risk reduction may be achieved through acquiring another firm that is influenced by a set of factors in the business cycle opposite from those that influence our own firm, while financial risk reduction may be achieved by restructuring the post-merger financial arrangements to include less debt.

In the unsolicited tender offer for a target company, offers are made at values well in excess of the current market price, and management of the target company becomes trapped and the dilemma of maintaining its current position versus agreeing to the wishes of the acquiring company, and even the target company's own stockholders. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 595-597*

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