Updated 7/6/2023

“Why do mergers and acquisitions carry such a high degree of risk? In almost all cases, the seller, who has operated the business for years, knows much more about it and its weak spots than does the buyer.”

Phil Fisher

Companies allocate more to mergers and acquisitions (M&A) than any other option for capital allocation. For many businesses, M&A is the most important and expensive choice to pursue their strategic goals. M&A activity since 1995 has averaged over 8% of market capitalization globally, and in 2021 that activity only accelerated with $1.9 trillion in the US and $3.8 trillion globally.

As the bull market continues, M&A activity will continue to bloom as M&A activity tends to follow trend market trends. And as the enthusiasm for deals continues, the two most popular buzzwords around M&A, revenue and cost synergies, will continue to swirl.

As we will discover, most M&A activity fails, with only 1/3 of all deals proving successful for both the acquiree and the acquired. The basic idea is that M&A creates value for shareholders, but typically to the seller’s benefit.

In today’s post, we will learn:

• The Two Types of Synergies
• Analyzing Cost Synergies
• Analyzing Revenue Synergies
• The Reality of M&A Synergies

Okay, let’s dive in and learn more about M&A synergies.

The Two Types of Synergies

Synergy is the idea that combining two companies will perform better than the sum of the parts. In M&A terms, synergy is the potential benefit both companies will achieve by combining their powers and is often the driving force behind the merger or acquisition.

Many CEOs and boards of directors believe combining two companies will create greater efficiency, scale, or revenue growth than the separate parts can produce.

These different synergies are believed to be achieved through greater:

• Revenue increases
• Talent combinations
• Improved technology
• Cost reductions

Additional benefits are combining products or markets, cross-selling opportunities, productivity increases, and more, among the many possible benefits that entice mergers and acquisitions.

But the main goal of mergers and acquisitions is to achieve financial improvements for the combined company, both for shareholders and the company. If they combined can create greater scale or efficiency, they can drive greater performance for the company.

Many M&A deals died at the altar of greater scale and efficiency; some of the bigger-name deals that failed were:

• The merger of AOL with Time Warner in 2001
• Quaker Oats bought Snapple in 1994
• Google buying Motorola in 2012
• Microsoft buying Nokia in 2013

Of course, not all deals go south; tons of successful mergers and acquisitions were successfully able to realize M&A synergies, such as:

• Disney buying Pixar
• Disney buying Marvel
• Exxon buying Mobil
• Google buying Android

Many companies, such as Google, Microsoft, Cisco, and Constellation Software, to name a few, use M&A activity to enhance their products and services and advance their tech to keep pace with more innovative companies.

In many cases, using M&A activity as a capital allocation makes more sense than paying a dividend, buying back shares, or reinvesting in the company. Much of those decisions depend on where the company is in its life cycle, its maturity, or its industry.

For example, a company such as Visa (V) is a mature company in a mature industry that is a market leader with not a ton of reinvestment opportunities; thus, they choose to do small add-ons to enhance their product offerings or buyback shares/dividends as their means of capital allocation.

Any M&A activity comes down to what kind of synergy the deal can create for the combination of companies; there are two main types of M&A synergy:

• Cost
• Revenue

Historically, other synergies play far less of a role, so let’s examine cost synergies first.

Analyzing Cost Synergies

Cost synergies are by far the most reliable of the two, with almost 1/3 of all CEOs acknowledging that they either achieved all or more of hope-for-cost synergies.

There are many reasons why companies realize cost synergies before revenue synergies, among them operating efficiencies or reducing redundancies. It is easier to cut costs than to generate revenues, all things being equal. And many companies operate far more efficiently than others, and therefore they realize cost synergies far quicker than revenue synergies. All of which help make the combined company profitable at a quicker pace.

Here is a non-exhaustive list of some cost-saving synergies many companies will tout in press releases when announcing any M&A activity:

• Research and Development: Either company may have access to better R&D that, when implemented with the merged company, will lead to improvements in a product or service while allowing room to cut costs in production without sacrificing quality. For example, when Cisco acquires a company that produces a better widget, but Cisco has better manufacturing skills, it allows cheaper production of that widget, thus lowering costs for the merged company.
• Lower Salaries and Wages: With the merger or acquisition, there is no need for two CEOs or two CFOs, and so on down the line, thus reducing labor. These kinds of reductions can flow down the organizational ladder.
• Sales and Marketing: Improved or better sales and marketing channels can reduce costs for the merged company.
• Supply Chain Efficiencies: If either company has access to better channels of supply chain relationships through either technology or relationships, those efficiencies can drive down costs.
• Shared Technology: If one of the companies has access to better technology, that technology can help the merged company operate more efficiently, reducing costs in communications or other areas.

Notice that these are items related to the income statement and are operating expenses. These expenses are the quickest to realize because eliminating redundancies is quick. Moving on to realizing operational synergies by adopting a shared culture and methodology leads to additional cost savings.

Many in the industry refer to cost synergies as hard synergies because they are tangible benefits you can see on paper.

The list above is far from comprehensive; much depends on the combined companies’ industry. They can realize additional cost savings from patents, taxes, and the merging of operating methodologies.

For example, the recent Fiserv merger with First Data announced that the combined company anticipated $900 million in cost synergies over the following five years, which they stated would be driven by the reduction in staffing, streamlining of technology, operational efficiencies, and process improvements.

A simple way to analyze anticipated cost synergies is to compare the two companies and determine which company is more efficient in using expenses. In other words, a company with a better operating margin tends to have better-operating efficiency. Then compare those margins to industry standards and predict if the new combined company can achieve these marks.

Remember that any stated, anticipated synergies will take years to realize, and to expect a company to hit the ground running after a merger or acquisition is not logical, to quote Spock.

Typically, these cost synergies take two to three years to achieve after completing the merger or acquisition. The period, known as the “phase-in” period, can take some time to slowly absorb operational efficiencies and cost savings into the new company.

In fact, some costs actually rise during integration, as one-time costs associated with combining companies come into play. Sometimes merging cultures and processes takes time or doesn’t play out as planned, leading to increased costs or the risk of the merger destroying value because of the lack of cost synergies.

Analyzing Revenue Synergies

Now we focus on the sexier side of mergers, acquisitions, and revenue synergies. Revenue synergy comes from the idea that the combined company will generate higher revenues than the sum of their companies.

The anticipation that the combined might of the two companies will allow revenues to flow from the mere sight of the combined companies.

However, the reality is far different, with over 70% of all M&A activity failing to achieve anticipated revenue synergies. The most common reasons for failure to achieve these anticipated glory days are delays in implementing plans, underestimating costs and difficulties, and the flat-out overestimation of anticipated synergies.

Today, capturing those anticipated revenue synergies typically takes longer than realizing the cost synergies, referring back to the Fiserv example I highlighted earlier. They anticipated realizing over $500 million in revenue synergies over the next five years. The latest earnings report stated they were on track to achieve that goal in less than three years.

McKinsey & Company notes that realizing revenue synergies is more complicated because it involves creating realistic revenue targets, learning new workflows for the combined company, and creating new sales strategies for the new teams. All of these items take time to implement and realize; meanwhile, Wall Street and shareholders wait impatiently for the realization of these M&A synergies.

There are three main revenue synergies that companies anticipate from mergers and acquisitions:

• Cross-selling: For example, a clothing retailer may cross-sell additional accessories such as belts, jewelry, or perfume to increase revenues. Or the computer company may offer service warranties or software upgrades as enticements to boost revenues.
• Adding new products or combining products: When Disney purchased both Pixar and Marvel, it gave them new products, animation, and additional library material to offer to its customers via Disney+ many years later.
• Access to New Markets: When Facebook purchased Instagram in 2012, it had zero revenues, but Facebook felt that Instagram would expand the company’s market reach and give them access to new markets.

The above is a short list of some of the more common revenue synergies available from M&A, but there are others, such as price increases, because the acquisition removes competition, allowing price increases.

Below is an example from the recent Square (SQ) announcement of their intention to acquire Afterpay, the BNPL (buy now, pay later) provider:

“Combined, Square and Afterpay’s complementary businesses present an opportunity to drive growth across multiple strategic levers, including:

• Enhance both the Seller and Cash App ecosystems. Afterpay’s global merchant base will accelerate Square’s growth with larger sellers and expansion into new geographies, while helping to drive further acquisition of new Square sellers. Afterpay will expand Cash App’s growing product offering, enable customers to manage their repayments, and help customers discover new merchants when the Afterpay App is integrated into Cash App.
• Bring added value, differentiation, and scale to Afterpay. Afterpay will benefit from Square’s large and growing customer base of more than 70 million annual transacting active Cash App customers and millions of sellers, which will expand Afterpay’s reach and growth both online and in-person. Afterpay consumers will receive the benefits of Cash App’s financial tools, including money transfer, stock and Bitcoin purchases, Cash Boost, and more.
• Drive long-term growth with meaningful revenue synergy opportunities. Square believes Afterpay will be accretive to gross profit growth with a modest decrease in Adjusted EBITDA margins expected in the first year after completion of the transaction. Square sees an opportunity to invest behind Afterpay’s strong unit economics as well as attractive growth synergies, including the opportunity to introduce offerings and drive incremental growth for sellers and increased engagement for Cash App customers.”

As you can see, Square anticipates this acquisition will position them to capture the growing use of the BNPL ecosystem and allow it to offer another service for its Cash App users.

It doesn’t tie any specific monetary goals in this announcement, but as the closing gets closer, there will probably be announcements regarding some of the anticipated synergies in the coming years.

Although it is tempting to get excited and assume that all the anticipated revenue synergies will come to life for the newly combined company, many investors assume that sales will double merely by combining the two companies and from the increased cross-selling opportunities.

The Reality of M&A Synergies

The announcement of mergers and acquisitions is often met with enthusiasm on Wall Street; typically, the announcement generates a price increase for the acquired company, especially if Wall Street approves the merger.

Recently, Square announced they would acquire Afterpay in an all-stock deal, and both companies’ prices jumped 10 to 15% in the market following the announcement.

That tracks with the 30% premium that is the norm for acquirers to pay for their acquisitions.

Typically, when M&A is announced, there is a flurry of activity and excitement as investors anticipate the increased revenue growth from the shiny new toy, but as mentioned earlier, those M&A synergies don’t pan out around 70% of the time.

Combining two companies is hard and full of difficult transitions for management and staff to combine cultures, workflows, processes, and technology. There is often a learning curve for everyone to learn new processes, systems, and products to make or sell.

It can take years to assimilate all people, systems, and products to the level of performance needed to achieve the desired goals. The more complex the M&A, the longer these M&A synergies will take to realize.

There are many reasons why M&A activity fails:

• Misvaluation: The acquirer pays too much for the acquisition, and the company can never realize the return on investment. A perfect example is the Bank of America acquisition of Countrywide.
• Failure to Integrate Culture: M&A history is littered with examples of failed M&A from the failure to integrate company cultures, especially across global M&A deals.
• Bad Integration Process: Failing to plan for the challenges ahead to integrate operating systems, inventory processes, technology adaptions, or the training of employees on the new systems can lead to struggles for many years.

The list above is not exhaustive but highlights some challenges of combining two companies and illustrates the patience required when investing in a new combined company.

Not all M&A is a bottomless pit; in fact, there are many successful mergers and acquisitions, and tons of companies on Wall Street use the activity to enhance their businesses.

Many successful companies are also some of the best businesses to own, such as:

• Berkshire Hathaway
• Google
• Microsoft
• Facebook
• Roper Technologies
• Constellation Software
• SS&C
• Cisco
• Intel

All of the above businesses have used M&A synergies to drive the success of their business over the years. And many of these CEOs, such as Warren Buffett, are among the best capital allocators in the business.

A quick and easy way to determine how successful a company is at M&A synergies and their impacts on its returns is to analyze the ROIC (return on invested capital) over a long period, such as ten years or more. The more successfully a company can integrate another company and still achieve high rates of return on invested capital, debt, and equity, the better long-term returns the company will generate.

Warren Buffett continues to advocate for these ideas in his shareholder letters and speeches over the years, and that advice holds true even today.

Investor Takeaway

Capital allocation is the CEOs’ and board of directors’ number one job. Analyzing a company’s track record of how it treats shareholder capital goes a long way toward deciding whether we want to give this person our capital.

Part of that analysis is understanding M&A activity, particularly M&A synergies, which drive the urge to merge.

The better we understand what drives one company to buy or merge with another, the better we will understand some of the CEO’s capital allocation decisions.

Considering that a large portion of the announced M&A activity will not turn out as the company anticipates, it is a good idea to look for companies and CEOs with a track record of successfully integrating other businesses.

Leaders such as Warren Buffett and Mark Leonard help illustrate this idea. Remember that it is not enough to grow the top line or revenue; it must also drive value creation for the shareholders and business.

Some companies are serial acquirers, which is part of the business DNA, and many of them successfully use this strategy to improve their business, but the same rules apply. We must assess how these M&A synergies will grow and improve our investment.

And with that, we will wrap up our discussion for today.

As always, thank you for taking the time to read today’s post, and I hope you find some value in your investing journey. If I can further assist, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave