Why do Business Engage in Business Combinations?

Get the answer of: Why do Business Engage in Business Combinations?

Reasons for Firms to Combine:

A common economic phenomenon is the combining of two or more businesses into a single entity under common management and owner control. During recent decades, the United States and the rest of the world have experienced an enormous number of corporate mergers and takeovers, transactions in which one company gains control over another.

According to Thomson Financial, the number of mergers and acquisitions globally in 2006 exceeded 34,785 with a total value of more than $3.5 trillion. Of these deals more than $ 1.4 trillion involved a U.S. firm. As indicated by Exhibit 2.1, the magnitude of recent combinations continues to be large.

As with any other economic activity, business combinations can be part of an overall man­agerial strategy to maximize shareholder value. Shareholders—the owners of the firm—hire managers to direct resources so that the firms value grows over time. In this way, owners receive a return on their investment. Successful firms receive substantial benefits through enhanced share value. Importantly, the managers of successful firms also receive substantial benefits in salaries, especially if their compensation contracts are partly based on stock market performance of the firm’s shares.

If the goal of business activity is to maximize the firm’s value, in what ways do business com­binations help achieve that goal? Clearly, the business community is moving rapidly toward busi­ness combinations as a strategy for growth and competitiveness. Size and scale are obviously becoming critical as firms compete in today’s markets. If large firms can be more efficient in delivering goods and services, they gain a competitive advantage and become more profitable for the owners.

Increases in scale can produce larger profits from enhanced sales volume despite smaller (more competitive) profit margins. For example, if a combination can integrate successive stages of production and distribution of products, coordinating raw material purchases, manufac­turing, and delivery can result in substantial savings.

As an example, Ford Motor Co.’s acquisition of Hertz Rental (one of its largest customers) enabled Ford not only to ensure demand for its cars but also to closely coordinate production with the need for new rental cars. Other cost savings resulting from elimination of duplicate efforts, such as data processing and marketing, can make a single entity more profitable than the separate parent and subsidiary had been in the past.

Although no two business combinations are exactly alike, many share one or more of the following characteristics that potentially enhance profitability:

i. Vertical integration of one firm’s output and another firm’s distribution or further processing.

ii. Cost savings through elimination of duplicate facilities and staff.

iii. Quick entry for new and existing products into domestic and foreign markets.

iv. Economies of scale allowing greater efficiency and negotiating power.

v. The ability to access financing at more attractive rates. As firm size increases, negotiating power with financial institutions can increase also.

vi. Diversification of business risk.

Business combinations also result because many firms seek the continuous expansion of their organizations, often into diversified areas. Acquiring control over a vast network of dif­ferent businesses has been a strategy utilized by a number of companies (sometimes known as conglomerates) for decades. Entry into new industries is immediately available to the parent without having to construct facilities, develop products, train management, or create market recognition.

Many corporations have successfully utilized this strategy to produce huge, highly profitable organizations. Unfortunately, others have discovered that the task of managing a widely diverse group of businesses can be a costly learning experience. Even combinations that purportedly take advantage of operating synergies and cost savings often fail if the inte­gration is not managed carefully.

Overall, the primary motivations for many business combinations can be traced to an increasingly competitive environment. Three recent examples of large business combinations provide interesting examples of some distinct motivations to combine: Google and YouTube, Procter & Gamble and Gillette, and Sprint and Nextel. Each is discussed briefly in turn.

Google and YouTube:

On October 9, 2006, Google, Inc., announced plans to make its largest purchase to date by acquiring YouTube(dot)com, the increasingly popular consumer media video-sharing Web site. The acquisition was an all-stock transaction valued at $1.65 billion. Google planned to operate YouTube as a separate operating unit and maintain its brand name.

Many viewed the acquisi­tion as Google’s attempt to stay ahead in the emerging technology game because several other prominent companies including Microsoft Corp. and Yahoo, Inc., had previously expressed interest in YouTube. Yahoo’s recent offers to purchase the social networking site Facebook(dot)com and News Corp.’s purchase of MySpace(dot)com also could have motivated Google’s interest in YouTube.

YouTube (founded in February 2005) quickly emerged as one of the most dominant forces in the Internet video market. However, as of the date of the acquisition, it was still a relatively unprofitable company. By aligning YouTube’s rising market presence with one of the most powerful and established firms in the internet arena. Google hoped to realize YouTube’s poten­tial profits by giving it a more effective business model. For example, Google planned to unlock YouTube’s advertising power much more fully than the previous owners were able to accomplish.

Google was also in a position to help YouTube with another issue its previous owners were ill equipped to handle- its vast legal problems stemming from copyright infringe­ments. Furthermore, Google hoped that its name recognition would bring more credibility to the Web site and generate even more new users.

The acquisition reflects an ongoing phenomenon in corporate growth and strategy: estab­lished Internet companies buying out start-ups. As is the case with Google and YouTube, such acquisitions appear to have immediate benefits for both the acquirer and the target. YouTube clearly needed experienced and business-savvy owners to maximize profits while Google needed to stay ahead in the Web-video industry.

There have been hundreds of acquisitions like this in recent years by firms like Google. Yahoo, and Microsoft, and these firms will need to continue acquiring smaller firms to stay ahead of the game. Market reaction to the news was positive as Google’s stock climbed $8.50 in the week following the announcement.

Procter & Gamble and Gillette:

On October 1, 2005, in its largest acquisition to date. Procter & Gamble (P&G) announced the completion of its acquisition of Gillette Company in a transaction valued at approximately $57 billion. Under the agreement, P&G issued 0.975 share of its common stock for each share of Gillette common stock. Both P&G and Gillette manufacture and distribute a wide variety of consumer products including many personal care, home cleaning, and food products.

Prior to the deal, Gillette and P&G operated in more than 30 and 80 countries, respectively. P&G has expertise in developing, manufacturing, and distributing leadership brands including 16 brands each of which produces sales of more than $1 billion. The Gillette acquisition added five more brands to this category.

P&G’s plan for the acquisition included utilizing its increased size to accelerate market entry for new and existing products. P&G’s international operations encompass marketing and distribution networks in developing markets such as China, Russia, Mexico, and Turkey. By utilizing existing marketing and distribution capabilities for Gillette products, P&G anticipated sales growth for many Gillette brands. Expected economies of scale from the combination include the ability to negotiate greater value in advertising from broadcasters and other media companies and from suppliers.

Finally, because both P&G and Gillette are primarily consumer product firms, they share many similar business functions. Cost-saving synergies are available by reducing duplicate costs and creating other efficiencies. In particular, P&G notes in its press release announcing the combination that it “anticipates enrollment reductions of approximately 6,000 employees, or about four percent of the combined workforce of 140,000. Most of these reductions should come from eliminating management overlaps and consolidation of business support functions.”

Sprint and Nextel:

In August 2005, Sprint Corporation announced its merger with Nextel Communications, Inc., in a transaction valued at $35 billion. The acquisition was only the latest in a series of combi­nation activities in the wireless communications industry. Many viewed Sprint’s purchase of Nextel as a competitive response to recent moves by other large national wireless companies.

In the past several years, growth by Verizon Wireless and Cingular had produced customer bases of approximately 47 and 42 million, respectively. Then Cingular increased its market share by acquiring ATT Wireless. With the Nextel acquisition. Sprint is able to rapidly com­pete for market share with Verizon Wireless and Cingular (now part of AT&T) by adding 15 million customers for a total base of approximately 35 million.

According to Sprint, it expected the combined Sprint Nextel to deliver operating cost and capital investment synergies with an estimated net present value of more than $12 billion.

The expected synergies include these:

i. Saving operating expenses by reducing the number of cell sites and switches.

ii. Reducing capital expenditures by extending Sprint’s technology to the combined customer base.

iii. Optimizing customer care, billing, and IT costs by consolidating operations, infrastructure support costs, and overhead.

iv. Reducing combined sales and marketing costs.

v. Obtaining large-volume discounts for equipment, warehousing facilities and procedures, and product distribution.

Beyond cost synergies, research and development resulting in timely new communication service offerings to the market ultimately will determine success in this highly competitive industry. Through business combinations, wireless communications firms not only assem­ble large amounts of financial resources for developing new technologies but also position themselves for marketing resulting products to more customers. For example, the com­bined capabilities position Sprint to remain competitive with the largest wireless carriers in the industry with enhanced wireless multimedia, Web browsing, and music and data transmission.