FIN 562Discussion comments

July 2006

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OUTLINE

The diversification discountThe diversification discount Synergies in valuationsSynergies in valuations Value and use of financial researchValue and use of financial research

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DIVERSIFICATION DIVERSIFICATION

DISCOUNTDISCOUNT

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DIVERSIFICATION DISCOUNT

Definitional statements:Definitional statements: Diversified firms trade at a discount relative Diversified firms trade at a discount relative

to what they would be worth if they had to what they would be worth if they had not, or were not, diversified.not, or were not, diversified.

The total value of a diversified firm is les The total value of a diversified firm is les than the sum of its diversified parts.than the sum of its diversified parts.

Diversification results in a discount in Diversification results in a discount in value.value.

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DIVERSIFICATION DISCOUNT

Justification and basis:Justification and basis: Fact based argument:Fact based argument:

Empirical evidence exists that demonstrates the Empirical evidence exists that demonstrates the discount discount

Common sense based arguments:Common sense based arguments: Diversity is difficult to manageDiversity is difficult to manage Different businesses require different skill setsDifferent businesses require different skill sets

Opinion based arguments:Opinion based arguments: ““Grass is greener on the other side of the fence”Grass is greener on the other side of the fence”

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DIVERSIFICATION DISCOUNT

But there are counter-arguments to support the But there are counter-arguments to support the case that diversification case that diversification increasesincreases value: value:

Diversified customer bases Diversified customer bases Diversified product mixesDiversified product mixes Diversified locationsDiversified locations Diversified suppliersDiversified suppliers Diversified management skillsDiversified management skills Diversified capital sourcesDiversified capital sources Counter-cyclicalityCounter-cyclicality

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DIVERSIFICATION DISCOUNT

Then, why does there appear to be a Then, why does there appear to be a diversification discount?diversification discount?

Arguments on slide 5 are validArguments on slide 5 are valid But, perhaps diversification also: But, perhaps diversification also:

Conjures up bad memories.Conjures up bad memories. Is associated with bad managers.Is associated with bad managers. Has never been effectively tested.Has never been effectively tested. Has never been properly isolated in research.Has never been properly isolated in research.

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DIVERSIFICATION DISCOUNT

Maybe past diversifications conjure up bad Maybe past diversifications conjure up bad memories in those who value companiesmemories in those who value companies

The market has a memoryThe market has a memory Analysts have memoriesAnalysts have memories ““Once burned, twice shy.”Once burned, twice shy.”

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DIVERSIFICATION DISCOUNT

Maybe diversification is associated with Maybe diversification is associated with bad managers.bad managers.

Empire and resume buildersEmpire and resume builders ““Deal” addiction peopleDeal” addiction people ““Job” creatorsJob” creators Greedy charlatansGreedy charlatans

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DIVERSIFICATION DISCOUNT

Maybe diversification has never been Maybe diversification has never been effectively testedeffectively tested in the market.in the market.

Difficult to find good examples.Difficult to find good examples. Perfect business “fits” rarely occur because Perfect business “fits” rarely occur because

people and reality get in the way.people and reality get in the way.

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DIVERSIFICATION DISCOUNT

Maybe diversification has never been Maybe diversification has never been properly isolated in research.properly isolated in research.

Myriads of factors influence valueMyriads of factors influence value Isolating the impact of diversification is Isolating the impact of diversification is

difficult to dodifficult to do

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DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors:Valuations are influenced by many factors: People issuesPeople issues

Quality of managementQuality of management Quality of governanceQuality of governance

Company issuesCompany issues Degree of diversificationDegree of diversification PerformancePerformance SynergiesSynergies StrategiesStrategies

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DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors:Valuations are influenced by many factors: • Capitalization issuesCapitalization issues

Degree of over-leverageDegree of over-leverage Degree of over payment in a dealDegree of over payment in a deal

Environmental issuesEnvironmental issues Business cycleBusiness cycle Market perceptionMarket perception Market confusionMarket confusion Market “greed of the moment”Market “greed of the moment”

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DIVERSIFICATION DISCOUNT

Valuations are influenced by many factors:Valuations are influenced by many factors: Industry issuesIndustry issues Type of businessType of business Margin structureMargin structure Capital intensityCapital intensity Counter cyclicality or otherwiseCounter cyclicality or otherwise

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DIVERSIFICATION DISCOUNT

Conclusions and observations:Conclusions and observations: The diversification discount needs to be The diversification discount needs to be

kept in context. Understand the concepts, kept in context. Understand the concepts, but don’t apply them indiscriminately. but don’t apply them indiscriminately.

Remember that valuations are not simple. Remember that valuations are not simple. Focused strategies and implementation are Focused strategies and implementation are required.required.

People who do deals are self serving. They People who do deals are self serving. They can argue either side dependent upon which can argue either side dependent upon which makes them money at the time.makes them money at the time.

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SYNERGIES IN M&ASYNERGIES IN M&A

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SYNERGIES

Definition number 1: Increase in profits Definition number 1: Increase in profits through combination of entities.through combination of entities. Eliminate G&AEliminate G&A Absorb then increase middleman’s profitAbsorb then increase middleman’s profit

Definition number 2: Increase in value Definition number 2: Increase in value through strategic fit of two entities based on through strategic fit of two entities based on industry, channel, product or other factors.industry, channel, product or other factors. Sell more through same sales effortSell more through same sales effort Product enhancementsProduct enhancements Achieve dominant market shareAchieve dominant market share

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SYNERGIES-EXAMPLES Banking: Elimination of duplicative G&A.Banking: Elimination of duplicative G&A. Retail: Increase in sales and margins Retail: Increase in sales and margins

through elimination of middlemen.through elimination of middlemen.• Telecom: Develop dominant market share.Telecom: Develop dominant market share.• OPEC: Collaboration leading to monopoly.OPEC: Collaboration leading to monopoly.• Internet sales: Increased volume through Internet sales: Increased volume through

channel (Amazon).channel (Amazon).• Distribution: Elimination of duplicative Distribution: Elimination of duplicative

G&A.G&A.• Manufacturing: Reduction of capital Manufacturing: Reduction of capital

employed.employed.

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SYNERGIES-MACADAM CAPITAL We always normalize incomeWe always normalize income

Eliminate duplication (Sarbanes, audit, executive Eliminate duplication (Sarbanes, audit, executive salaries, etc.)salaries, etc.)

Reflect operating cost savingsReflect operating cost savings

We model enhanced contribution in our sale We model enhanced contribution in our sale transactionstransactions Incremental channel gross profits Incremental channel gross profits Elimination of duplicate logistics costsElimination of duplicate logistics costs Elimination of duplicate sales costsElimination of duplicate sales costs

We value market dominance and industry We value market dominance and industry consolidationconsolidation

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SYNERGIES-CAUTIONS

Synergies can be real, but are vastly over-Synergies can be real, but are vastly over-ratedrated

Implementation is critical to achieving any Implementation is critical to achieving any synergistic benefitssynergistic benefits

There must be an acquirer and an acquiree There must be an acquirer and an acquiree to have much in the way of synergistic to have much in the way of synergistic savingssavings

Overpaying is too often the norm, and most Overpaying is too often the norm, and most of the incremental value is lost, despite of the incremental value is lost, despite comments to the contrarycomments to the contrary

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VALUE AND USE OF VALUE AND USE OF RESEARCHRESEARCH

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VALUE OF RESEARCH

Scientific methodology rather than opinions Scientific methodology rather than opinions and “MSU” approachand “MSU” approach

Foundation for practical actionsFoundation for practical actions Reduce complexities to manageable issuesReduce complexities to manageable issues Learning and training for futureLearning and training for future Proof that BS is not the only answerProof that BS is not the only answer

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USE OF RESEARCH

Corporate financial decisionsCorporate financial decisions Investment banking engagements (valuations Investment banking engagements (valuations

and execution)and execution) Consulting engagementsConsulting engagements

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PRACTICAL VIEW

Financial research:Financial research: Must be understandableMust be understandable Must be delivered succinctlyMust be delivered succinctly Must make common sense or be thoroughly Must make common sense or be thoroughly

and completely provenand completely proven

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EXAMPLE OF RESEARCH

Measuring diversification discount:Measuring diversification discount: Ability to isolate is questionable and Ability to isolate is questionable and

measurement is even tougher measurement is even tougher But raising, analyzing and debating the But raising, analyzing and debating the

subject are invaluable steps subject are invaluable steps Debunk common sense Debunk common sense Demonstrate lack of simplicity surrounding Demonstrate lack of simplicity surrounding

issuesissues Provides ammunition for good CFO’s to force Provides ammunition for good CFO’s to force

companies to think before they actcompanies to think before they act