The Weak-Meet-Weak Approach to M&A
Combining two weak companies may result in one that is very successful
January 27, 2012
Minus one plus minus one equals minus two, at least when it comes to basic math. Doubling a negative always yields twice as negative of an outcome. Or does it? Not necessarily.
Combining two weak companies may result in one that is very successful when it comes to dealmaking, but the equation does not always hold true when attempting to save two troubled companies. Sometimes two companies that are operating in the red can merge and collectively turn their negative results into a positive outcome. Combining two weak companies may result in one that is very successful. This may seem contrary to popular belief and the countless acquisitions in which strong companies have successfully acquired weak ones. To be sure, the strong-takes-weak acquisition strategy is often effective for both parties, and has a long history of success. But there's a case to be made for weak-meets-week too.
An example of two financially stressed companies uniting is Kmart Holdings Corporation's acquisition of Sears, Roebuck and Co., a deal that closed on March 24, 2005. The two companies cited several reasons for combining forces:
* Sears had begun investing in new, larger, off-mall stores, called Sears Grand. Earlier in the year, Sears had purchased dozens of current Super Kmart locations; the merger permitted the combined company to accelerate that process.
* Proprietary brands held by both companies could be made more accessible to their target demographics by leveraging their combined real estate holdings. This was estimated to be an expected $200 million a year in revenue synergies.
* At least $300 million a year in cost savings was expected annually, particularly in the supply chain and in administrative overhead.
* The establishment of a shared customer-focused culture between the two companies was estimated to yield improvements in revenue per unit area.
* Preservation of two brands post-merger allowed Sears Holdings to focus on different customer demographics, without alienating either group.
Another example is the merger of XM and Sirius. According to their balance sheets, both were operating unprofitably and saddled with debt before forming Sirius XM Radio Inc. The combined company now has more than 18.5 million subscribers, making it the second-largest radio company, based on revenue, in the country. These examples demonstrate how weak-meets-weak mergers can be very lucrative-especially when the two companies stand to share fixed costs and target audiences.
As a result, mergers and acquisitions are most prevalent within sectors that are home to businesses with large fixed costs and diminishing revenues, such as chain stores and manufacturers. Below is a look at a typical company within these sectors:
* Chain Stores - Chain stores have numerous categories of fixed costs. These can include multiple store leases; the cost of one or more warehouse distribution centers; a corporate headquarters; and a myriad of fixed personnel costs required to manage the tasks in various departments ranging from finance, accounting, the supply chain and inventory to marketing, merchandising, human resources and advertising. These fixed overhead costs and expenses, along with all variable costs, must be covered by the gross margin dollars created on sales from the retail stores.
* Manufacturers - Likewise, manufacturers have high fixed cost components, related to property, plant and equipment. When not operating a manufacturing plant at maximum efficiency, the actual hourly price of these cost components rises dramatically. Factories operating fewer than three shifts (and certainly less than two) face skyrocketing per-unit manufacturing costs.
Faced with stagnant or diminishing sales due to a down economy, many retailers and manufacturers have fallen into continual loss positions over the past three years, forcing them to reduce their variable costs. As fixed costs, such as rent, taxes, insurance and payroll, remain the same, often this is not enough, and losses continue. As the balance sheet weakens and credit becomes less available, the company continues to deteriorate. This is a difficult position to be in-and one that is unattractive to most acquirers.
However, when certain business conditions exist, the opportunity to merge with another underperforming company may be the best solution for both entities, as they face the same challenges. Recognizing these conditions may lead management to seek a merger with another poorly performing company rather than declare bankruptcy. Examples of conditions that are conducive to a weak-meets-weak merger include:
