Q&A: What are synergies in takeovers and mergers?

Look at any major takeover or merger in the news and you’ll come across the concept of synergies….

For example:

‘‘The deal has potential synergies that make some observers drool.’‘

That’s the Wall Street Journal, commenting on Time Warner’s merger with AOL in 2000. How wrong they were!

But, sometimes the doubters are also proved wrong.

Back in 2004, investors and analysts were doubtful that Spanish banking giant Santander would be able to achieve its ambitious plan of stripping out £300million of costs from Abbey National when it made a £9.6bn bid. In fact, Santander delivered the £300million of cost synergies a year ahead of schedule. Profits at Abbey, which were £16million in the year of takeover, rose to £1.5bn at Santander UK in 2009.

More recently, the Kraft Foods takeover of Cadbury involved the acquirer (Kraft) assuming significant potential for cost and revenues synergies to help justify the price paid for Cadbury. At the time of the deal, Kraft targeted around £450million of annual cost savings by the end of the third year. It remains to be seen whether Kraft will achieve this target.

The role of synergies in M&A

The primary objective of any takeover is to create value for shareholders that exceeds the cost of the acquisition. In fact, synergies are fundamentally the only tangible justification for a takeover.

Synergies represent the extra value that can be created from the takeover. Assuming that the buyer has to pay a reasonable price for the takeover target, then no value has been created at that point.

For example, consider a business valued at £10 million by the market (e.g. from the market capitalisation on the stock market).

A buyer comes along and, after negotiation and due diligence, agrees to pay £13 million to complete the takeover. The buyer has paid a bid premium of 30% (or £3 million) to complete the takeover.

The shareholders of the target business are happy. But the shareholders of the buyer business will need to be convinced that the price was worth paying. They have had to pay £3 million over the apparent value
of the business to achieve the takeover.

How can the bid premium be justified? Only if the takeover achieves synergies worth at least £3 million in value terms (e.g. the NPV of future synergies).

In practice, synergies are “easier said than done.” While cost synergies are difficult to achieve, revenue synergies are even harder. The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it.

Cost synergies

Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations

Potential sources of cost synergies include:

- Headcount reduction (redundancies)
- Elimination of surplus facilities
- Reduced overheads (e.g. consolidate functions such as accounting, IT and marketing)
- Increased purchasing power (greater bargaining power with suppliers due to greater combined size)

Revenue synergies

Revenue synergies refer to the ability to sell more products/services or raise prices due to the deal.

Potential revenue synergies include:

- Marketing and selling complementary products
- Cross-selling into a new customer base
- Sharing distribution channels
- Access to new markets (e.g. through existing expertise of the takeover target)
- Reduced competition