Shareholders of publicly traded companies 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 which bid is superior and even whether a merger makes sense at all.
Currently the shareholders of NYSE Euronext have an opportunity to cross-examine management about the proposed merger of the stock exchange’s parent with Deutsche Boerse. Deutsche Boerse values NYSE Euronext at $10.2 billion, well under the competing $11.3 billion bid from Nasdaq OMX Group and IntercontinentalExchange. But NYSE Euronext’s management has rejected the Nasdaq/ICE bid twice, and as a result, Nasdaq and ICE are taking their offer directly to shareholders.
What should shareholders demand to know about the proposed deal? Below are five basic questions that should be posed about this merger — and about any potential merger, for that matter. They stem from a 2005 paper called “The Value of Synergy” 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. What are the real synergies arising from the firms’ combination?
Managements often justify large transactions by citing operating and financial synergies, but in his 2005 paper, Damodaran describes synergies as “often promised and seldom delivered.” To have an effect on value, according to him, synergy has to affect one of four inputs into valuation: 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, there are more dubious synergies that stakeholders should cast a cold eye on. For example, the NYSE and Deutsche Boerse are touting the merger as diversifying the revenue stream of the New York Stock Exchange, by bringing it into the market for high-margin, fast-growing derivatives. That’s good, but in and of itself that diversification will not have any effect on the combined value of the two firms, at least in situations where the firms are publicly traded and have diversified investors. (Indeed, in times of relatively normal economic growth, markets become pessimistic about the ability of highly diversified companies to deliver robust shareholder returns, applying a so-called 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 can be hard to prove before the merger.
2. What is the actual value of the proposed cost savings?
Cost synergies are the easiest of all operating synergies to model, says Damodaran. That’s probably why Deutsche Boerse and NYSE Euronext were able to quickly find an extra 100 euros 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,” according to Damodaran.
But while one-time cuts increase a merged company’s value, the speed with which they take place is important. And it is continuing cost savings that have the big impact, because they affect operating margins over a longer term. If Deutsche Boerse claimed $585 million in one-time savings within three years, for example, and Nasdaq/ICE claimed $740 million in one-time savings within one year, the present value of the cost cuts would make the Nasdaq/ICE proposal even more favorable. Otherwise, lacking more detail — including where, exactly, the cuts will come from — it’s difficult to compare the numbers.
3. Will the synergies accrue to the buyer or the seller?
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.”
While it’s not clear which of the two circumstances are present in the NYSE Euronext deal (more likely the second), what is clear is that NYSE Euronext shareholders were being shortchanged by the refusal of management to consider seriously the Nasdaq/ICE offer. Now that Nasdaq and ICE have launched a tender offer, the dynamic might change. “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 then play them off against each other.”
4. How overvalued are Deutsche Boerse’s shares?
Deutsche Boerse’s transaction is a stock-for-stock deal. In general, when a company uses its stock as consideration in a takeover, management is signaling that shares are overvalued, says Damodaran. Deutsche Boerse’s shares have risen 9% since its February announcement and the company’s price-to-earnings ratio is 25, compared with NYSE Euronext’s 17.6. Indeed, one of the factors that could be driving Deutsche Boerse’s stock up is shareholders’ belief that it will 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 tells CFO. While Nasdaq’s bid is less than a quarter cash, the difference has to be considered. “The value of cash is not debatable,” says Damodaran.
5. Is it worth merging at all?
New York Stock Exchange chairman Jan-Michiel Hessels calls 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 any 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 lead to lower stock and operating performance in the postacquisition period. In addition, a significant number are reversed within a fairly short time period.
“When I think about the [NYSE-Deutsche Boerse deal], I think about DaimlerChrysler,” Damodaran tells CFO. “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 be scrutinizing either deal, Damodaran says he’d be much more worried if he were a shareholder of Deutsche Boerse, Nasdaq OMX, or ICE. Buyers tend to overpay for acquisitions, for various reasons, he says: “There is more bad stuff that can happen on that side of the transaction.”