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The battle for NYSE Euronext raises specific questions for its shareholders, and highlights larger issues for any CFO involved in a merger.
Vincent Ryan, CFO Magazine
June 1, 2011
Shareholders often have to approve a merger or acquisition before it is consummated. That should be a meaningful check on a company's management and board, but shareholders frequently rubber-stamp what management decides, failing to question deeply which bid is superior and even whether a merger makes sense at all.
The shareholders of NYSE Euronext had an opportunity this past spring to cross-examine management about the proposed merger of the stock exchange's parent with Deutsche Boerse. At that time, the Deutsche Boerse proposal valued NYSE Euronext at $10 billion, well under the competing $11.3 billion combined bid from Nasdaq OMX Group and IntercontinentalExchange (ICE). But NYSE Euronext's management rejected the Nasdaq/ICE bid twice, and, as a result, Nasdaq and ICE tendered their offer to shareholders. In the middle of the back-and-forth, many questions about the deal remained unanswered.
What could shareholders have demanded to know? Below are five basic questions that must be posed for almost any deal. This line of questioning is derived from "The Value of Synergy," a 2005 paper by Aswath Damodaran, professor of finance at New York University's Stern School of Business and author of numerous books on corporate finance and valuation.
1. Are there real synergies to be gained?
Management often justifies large transactions by citing operating and financial synergies, but in his paper, Damodaran describes synergies as "often promised and seldom delivered." To increase value, he says, synergy has to affect the inputs to valuation. So it must produce higher cash flows from existing assets, higher expected growth rates, a longer growth period, or a lower cost of capital.
While the NYSE Euronext deal could lead to economies of scale and increased market power, stakeholders should cast a cold eye on the more dubious synergies. For example, NYSE Euronext and Deutsche Boerse touted the merger as diversifying the revenue stream by bringing the NYSE into the market for high-margin, fast-growing derivatives.
But in and of itself, that diversification will not raise the combined value of those two or any other merging firms. That's especially true when the companies are publicly traded and have investors that are already diversified and thus don't need the company to diversify its own revenue streams. (Indeed, in times of relatively normal economic growth, markets are skeptical of the ability of highly diversified companies to deliver robust shareholder returns, and they often apply a "diversification discount.")
Likewise, some operating synergies, like claims of better growth prospects, are hard to value and envision preacquisition. A combined firm may be able to earn higher returns on its investments, find more investments than the two firms could independently, or maintain high returns for a longer period, but that's hard to prove prior to the merger.
2. Do the savings add up?
Cost synergies are the easiest to model, says Damodaran. Deutsche Boerse and NYSE Euronext quickly found an extra €100 in projected cost savings when the number put forth by Nasdaq/ICE surpassed theirs. Acquirers also have a better chance of delivering cost cuts because they are concrete and may have "explicit mechanisms for follow-up and monitoring," says Damodaran.
While one-time cuts increase a merged company's value, the speed with which they happen matters. And it is ongoing cost savings that have a bigger impact, because they boost operating margins over a longer term. Otherwise, lacking more detail — including where, exactly, the cuts will come from — it's difficult to compare the numbers from competing bidders.
3. Who gets the spoils?
If synergies do add significant value to a corporate tie-up, the next question becomes, Who gets the gains from the synergy? says Damodaran. Another way to frame the question is, Who has the bargaining power — the target or the acquirer?
For example, "If the cost savings [in a proposed deal] are unique to one acquiring firm, it will be able to demand a higher percentage of the synergy benefits," says Damodaran. But if the cost savings are more general, and available to a competing bidder, "the target firm's stockholders are likely to receive a larger share.
"For a target firm to extract the bulk of the synergy premium, it has to be able to open up the bargaining process and force the acquiring firm to match the bids of others," says Damodaran. "A second bidder makes the process much easier because you can play them off against each other."
4. Are the buyer's shares overvalued?
In general, when a company uses its stock as consideration in a takeover, management is signaling that its shares are overvalued, says Damodaran. As of early May, Deutsche Boerse's shares had risen 9% since its February announcement, and the company's price-to-earnings ratio was 25, compared with NYSE Euronext's 12.2. Indeed, one of the factors that could have driven up Deutsche Boerse's stock was shareholders' belief that they would get the New York Stock Exchange for a bargain price.
"Any time stock is part of a transaction, you have the issue of 'Am I being paid with something that is overpriced?' It's basically inflated currency," Damodaran says. While Nasdaq's bid is less than one-quarter cash, the difference has to be considered. "The value of cash is not debatable," he says.
5. Is it really worth it?
NYSE chairman Jan-Michiel Hessels called the unsolicited offer from Nasdaq and ICE "illusory" and "fraught with unacceptable execution risk." But that could be said for just about any merger proposal. The chance of a strategic transaction failing is substantial. In numerous studies since the 1980s, mergers have been found, more often than not, to earn returns less than the cost of capital and to lead to lower stock and operating performance postacquisition. In addition, a significant number are reversed fairly quickly.
"The [NYSE–Deutsche Boerse deal] reminds me of DaimlerChrysler," Damodaran says. "Two different cultures [are] meeting. I'm not sure the net effect is going to be good for either one." A negative for the Nasdaq/ICE deal is that it would use $3.8 billion in debt, possibly leading to a credit-rating downgrade of Nasdaq OMX.
While NYSE Euronext shareholders should scrutinize all offers, Damodaran says he would be much more worried if he were a shareholder of Deutsche Boerse, Nasdaq OMX, or ICE. Buyers tend to overpay, for various reasons. As he notes, "There is more bad stuff that can happen on that side of the transaction."
Vincent Ryan is senior editor for capital markets at CFO.