Fool’s Gold

Acquirers seeking synergies would do well to shrink their expectations.
Kris FrieswickFebruary 1, 2005

Kmart and Sears were being conservative last November, they said, when they predicted a half-billion dollars of revenue and cost synergies within three years of their merger’s completion. Last month Oracle was preparing a detailed synergy estimate for its combination with PeopleSoft — which itself predicted synergies of between $167 million and $207 million from buying J.D. Edwards a couple of years earlier. And in 2004, General Electric projected $400 million to $500 million in synergies from combining its NBC unit with Vivendi Universal’s entertainment assets.

These deals might indeed make their synergy numbers. Then again, they might not. A recent McKinsey & Co. study finds that 70 percent of mergers fall short when it comes to achieving their targets for revenue synergies, while 40 percent lead to cost-synergy disappointments. And occasionally, of course, deals enter the realm of dis-synergy disasters — the classic being AOL/Time Warner’s $106 billion merger in 2001. That $1 billion synergy play, considered the 20th century’s biggest, had resulted in $99 billion of write-downs by January 2003.

Why do companies miscalculate so often? In the case of revenue synergies — top-line enhancements beyond the simple addition of two companies’ sales — McKinsey says typical reasons include unexpectedly high customer-defection levels, poor assumptions about market growth and competitive realities, and overly optimistic prospects for cross selling opportunities in a deal’s wake.

“Mergers are tough,” says Diane Sias, leader of McKinsey’s Americas postmerger management practice and co-author of the study. Synergy projections are often rushed. “It’s not until the merger is closed that you get access to all the data,” she notes, and by the time “you can have a good ‘think’ about it, you’ve changed everything for all the employees in both companies, and you have to make sure those people don’t walk out the door.”

The McKinsey study recommends that acquirers reduce their revenue synergy projections to reflect their lack of predictability, and suggests that companies avoid making “simplistic and optimistic assumptions about how long it will take to capture synergies and sustain them.” Bad assumptions make cash-flow accretion and other deal metrics look unrealistically positive, it says, “leading to substantial overestimates of synergy net present value.”

If acquirers do better at estimating cost synergies — from combining systems or operations, including through layoffs — their mistakes still can have a severe impact. The estimation of one-time costs often gets short shrift during due diligence, Sias says, and the merger’s impact on pricing and postmerger market share may not be adequately examined. And afterwards, acquirers are usually unwilling to face the reality of how much a merger disrupted business, how cost-reduction efforts eroded the customer base, or how wishful thinking might have governed the projections. Banking mergers represent an obvious case, where any talk about customer defections is avoided. But in other industries, too, says Sias, acquirers seeking historic synergy examples may find “only two or three good precedents.”

Trust the Business Sectors

What about just not projecting revenue synergies at all? That would be difficult in a world where acquirers often have to justify their offering price to investors.

When defense contractor Northrop Grumman Corp. made a hostile bid for TRW, for example, Northrop used revenue-synergy predictions to help woo reluctant TRW shareholders. “That was a very competitive situation,” says retiring CFO Chuck Noski, who joined Northrop in November 2002, while the deal was being negotiated. “Normally we don’t make [synergy] predictions, [preferring] our actions and track record to speak for itself.” By 2003, Noski notes, actual combined revenues slightly exceeded the $25 billion to $26 billion range Northrop had forecast.

Others are less sensitive about predicting revenue or cost synergies. “It’s all part of the public-relations campaign,” according to Sydney Finkelstein, a professor at the Tuck School of Business at Dartmouth College and author of Why Smart Executives Fail (Portfolio, 2003). When acquirers can’t find enough good synergy data to support their price, “they make it up,” he says. As for why companies fail to fess up to shortfalls, he suggests they’re often “honestly overestimating how they’ve done, because it’s really hard to do an honest postmortem on a merger.”

Mark Sirower, managing director of PricewaterhouseCoopers’s M&A strategy practice and author of The Synergy Trap (Free Press, 1997), says the announcement of revenue synergies presents particular challenges for acquirers because growth expectations are already reflected in the share price when the deal is announced. “You don’t get real revenue synergies until you beat the projection that is already in there,” he says. And it’s “competitively tough to beat revenue expectations. Revenue synergies assume you can take revenue away from another company.”

Some acquisitive companies, like Eaton Corp., avoid that problem by tending to forecast only cost synergies, says Finkelstein, who has studied the Cleveland-based industrial products maker. Eaton “hardly ever puts out a number for revenue synergies, because it refuses to be drawn into a game of guesswork,” he says.

Even though Northrop usually refrains from publicizing revenue synergies, it runs all those numbers internally to ensure that it values deals correctly. Noski says it pays special attention to data collected from the division and business-unit managers closest to the acquired company’s market, because those divisions will often be responsible for integrating and running the new, acquired divisions.

“The people in the business sector have to be an integral part of understanding the numbers,” he says. “You don’t want to say to them after the deal is done, ‘OK, you’re running this new business and you have to hit these numbers,’ and then have them ask, ‘What numbers, and where did they come from?’ There has to be an engagement and understanding of how we came up with the synergies.”

Keep Those Products Coming

Other executives concentrate on revenue synergies and not cost synergies. Dick Heckmann, CEO of Carlsbad, California-based sporting-goods company K2 Corp., for one, says he has based his aggressive acquisition strategy on revenue synergies since taking the helm two years ago. He developed the method as CEO of U.S. Filter, where he helped orchestrate 260 acquisitions in nine years. (U.S. Filter was sold to Vivendi SA in 1999, which sold it off in chunks between 2002 and 2004.)

“If you buy companies and start driving cost synergies, all you end up with is a pissed-off organization,” he says. “You demotivate people from acquisitions.” That’s why “we never base a merger on cost synergies, [although] we go after them if we find them.” (Heckmann says that he approves only acquisitions that are accretive to earnings and based on advantageous revenue synergies.)

But like Northrop, K2 relies heavily on its operating groups to familiarize themselves with synergy prospects in acquisitions. Indeed, K2’s six business divisions bring Heckmann proposed deals for approval, he says, because the divisions are in a better position to evaluate acquisitions in their markets. “For corporate to look for an acquisition in our fishing division is insanity,” explains Heckmann. “What does a guy at corporate know about fishing?”

K2’s divisions also are held accountable for the valuation research — including revenue-synergy projections underpinning their acquisitions. A group that fails to meet postmerger budget targets doesn’t get its bonuses. (At the corporate level, however, K2 does do quarterly evaluations of how its mergers are progressing.)

The tactic of restraining the pursuit of cost synergies draws some fire in the investment community. “I am criticized each quarter by analysts,” says Heckmann. “They want to know why our SG&A as a percentage of revenue isn’t declining with the acquisitions.” His answer: increased research-and-development spending is needed to keep K2 ahead of retailers, which often create less-expensive private-label versions of brand-name products they stock on their shelves. “You have to keep coming out with hot products,” explains Heckmann.

The level of research that K2 and Northrop both use in determining acquisition values helps them avoid the kind of corporate criticism that flows from McKinsey’s study of 160 mergers, which found top-line forecasts particularly “rife with inflated estimates.”

Says Noski, “It would surprise me, in a post-Sarbox world, if companies were making those numbers up.” Still, “some companies might say, ‘I can only absorb so much earnings-per-share dilution on the deal, and in order to achieve that threshold I need this much synergy.’ “

Kris Frieswick is a senior writer at CFO.