How to value competitors;
a systematic guide
date: 22 March, 2005
D.H. Snel dhsnel@yahoo.com
06 28653881 A&Co International B.V.
Supervisor A&Co: A. Ying University of Groningen, Holland Faculty of management & organisation
www.rug.nl/bdk
1st supervisor: dr. W. Westerman 2nd supervisor: drs. J. Waalkens
1
B&Co’s brand-portfolio:
How to value competitors;
a systematic guide
date: 22 March, 2005
D.H. Snel dhsnel@yahoo.com
06 28653881 A&Co International B.V.
Supervisor A&Co: A. Ying University of Groningen, Holland Faculty of management & organisation
www.rug.nl/bdk
1st supervisor: dr. W. Westerman 2nd supervisor: drs. J. Waalkens
2
Preface
Because of the speed in decision taking of A&Co’s recruitment and the fashionable product, I chose to do my research at A&Co international. Now, a few months later, that choice has proven to be exactly what I needed. It has been a great, challenging time in which I got the chance to learn a lot. A&Co really provides its interns with the resources to both acquire useful practical skills and work on their studies. What company offers its interns an office the size of a gym?
As I was part of the “Groninger Connection” every now and then someone asked whether it was a plague or something. Since Bas Schrama interns from the university of Groningen are particularly popular at the finance department of A&Co. It sure has had its impact on the working atmosphere for me. Piet Schutter, my fellow intern, and I had our own corner together with our “temporary mother” Renee Wansink, who had the patience to answer our stupid questions again and again. For me the “bar-like” conversations we had during those days and the squash-contest with Piet combined with hard work and the interesting topics in which we could assist made it a great time.
Of course some people deserve some special attention. At the university of Groningen my supervisor Wim Westerman, whose enthusiasm and subtle guidance helped me a lot, deserves special attention here. I think my thesis now is a lot more to-the point thanks to him. Furthermore I would like to thank co-supervisor Jan Waalkens for his pleasantly un- financial orientation and attention for the transfer of information.
Within A&Co both my supervisor Andrew Ying, whose knowledge-level has been an inspiring experience for me and Renee Wansink, who taught me the importance of “details, details, details and details”, contributed heavily to the quality of the content of this thesis.
Next to them I would like to thank Yves, Serge, Wendy, Renske, Sara, Tjiddo, Cristel, Bas and of course last but not least Nanda “I love to drive that Jag” Maliepaard.
Anyway, I liked writing this thesis, now I hope the reader will like reading this study on the topic of corporate valuation. Let the “real life” begin!
Douwe Hendrikjan Snel dhsnel@yahoo.com
Company names and figures have been changed in this version to ensure complete confidentiality.
© The contents of this thesis belong to the author and A&Co
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Index
Preface... 2
Index... 3
Executive Summary... 6
Chapter 1: Research Outline ... 8
1.1. Introduction... 8
1.2. Research context ... 8
1.2.1. A&Co & B&Co ... 8
1.2.2. Strategic context of this study... 9
1.3. Problem definition...10
1.3.1. Research objective...10
1.3.2. Main research question...10
1.3.3. Subquestions...10
1.3.4. Limiting conditions ...10
1.4. Research type, perspective and boundaries ...11
1.4.1. Research type...11
1.4.2. Perspective and boundaries...11
1.5. Theoretical framework...12
1.5.1. Introducing the framework ...12
1.5.2. Literature linked to the theoretical framework...14
1.6. Data; sources, methods for gathering and analysis ...15
1.6.1. Data sources ...15
1.6.2. Data gathering...16
1.6.3. Data analysis ...17
1.6.4. Data usage summary...17
1.7. Simultaneous research: analysis of new markets...18
1.8. Research model ...18
Part ONE: Valuation method ...20
Chapter 2: Literature review on valuation perspectives...21
2.1. Introduction...21
2.2. Strategic perspective ...21
2.2.1. External environment...22
2.2.2. Internal environment; strategy and the business system ...23
2.2.3. Internal environment; competitive advantage ...23
2.2.4. Scenario analysis ...24
2.2.5. Overview of strategic perspective ...25
2.3. Financial perspective ...25
2.3.1. Balance sheet based methods...26
2.3.2. Income statement based methods...26
2.3.3. Discounted cash flow techniques...27
2.3.4. Value creation...28
2.3.5. Options...28
2.4. Integration of strategy and finance...29
2.5. Summary...30
Chapter 3: Literature review on valuation sequence ...31
3.1. Introduction...31
3.2. Stage 1: Acquiring firm characteristics...31
3.2.1. Strategic context ...32
3.2.2. Cultural context ...32
3.2.3. Business Idea...33
3.2.4. Value drivers...33
3.3. Stage 2: Target firm characteristics; “as is” value ...34
3.4. Stage 3: Target firm opportunity value ...34 4
3.5. Stage 4: Synergy value ...35
3.5.1. Integration approaches...35
3.5.2. Classification of synergies...36
3.5.3. Synergy problems ...36
3.6. Stage 5: Integration costs...37
3.7. Linking the stages to the valuation tools...37
3.8. Summary...39
Chapter 4: Expert interview results...40
4.1. Introduction...40
4.2. Valuation perspectives; interview results...40
4.2.1. Strategic perspective...40
4.2.2. Financial perspective: comparable companies...42
4.2.3. Financial perspective: comparable acquisitions...44
4.2.4. Financial perspective: discounted cash flow ...45
4.2.5. Financial perspective: interpretation of results...46
4.3. Valuation sequence; interview results ...48
4.4. Summary...50
Chapter 5: Proposed valuation method...51
5.1. Introduction...51
5.2. Current practice at A&Co and Liz ...51
5.2.1. A&Co’s method...51
5.2.2. B&Comethod ...53
5.3. User demands ...54
5.4. Proposed valuation method for A&Co ...54
5.4.1. Proposed method’s working area...54
5.4.2. Proposed valuation method ...55
5.5. Summary...58
PART TWO: Case study & conclusions ...59
Chapter 6: A&Co...60
6.1. Introduction...60
6.2. A&Co’s characteristics...60
6.2.1. Macro environmental factors...60
6.2.2. Industry structure ...61
6.2.3. Scenarios; trends and patterns ...62
6.2.4. A&Co’s generic strategy & product attributes...64
6.2.5. Business system...64
6.2.6. Cultural variables ...65
6.2.7. SWOT-analysis & competitive advantage ...66
6.2.8. Comparable companies & value drivers ...67
6.2.9. Target firm requirements ...67
6.3. Evaluation of proposed method...68
6.4. Summary...68
Chapter 7: French Connection...69
7.1. Introduction...69
7.2. Short screening of French Connection ...69
7.3. FCUK’s characteristics ...70
7.3.1. Macro environmental additions for the UK ...70
7.3.2. Generic Strategy & product attributes ...70
7.3.3. Business system & cultural variables ...71
7.3.4. SWOT-analysis & competitive advantage ...72
7.3.5. Ownership structure ...73
7.3.6. FCUK news overview ...73
7.3.7. FCUK share performance vs. FTSE 100 and competitors...74
7.3.8. Comparable companies & value drivers ...75
7.3.9. Comparable acquisitions ...75
7.3.10. DCF-analysis ...76 5
7.3.11. Interpretation of results; “as is” value range...80
7.4. Target firm opportunity value ...82
7.5. Synergy value ...82
7.6. Integration costs...84
7.7. Total target firm value...85
7.8. Evaluation of proposed method...86
7.9. Summary...87
Chapter 8: Conclusions...88
8.1. Introduction...88
8.2. Practical results...88
8.2.1. Proposed valuation method ...88
8.2.2. Value of French Connection (FCUK) ...89
8.3. “Added value” ...90
8.4. Shortcomings ...90
8.5. Recommendations ...91
8.5.1. Academic recommendations...91
8.5.2. Practical recommendations...91
8.6. Summary...92
References ...93 Appendices part one: ... Error! Bookmark not defined.
Appendix 1.A. Interview planning ...Error! Bookmark not defined.
Appendix 1.B. Interview preparation ...Error! Bookmark not defined.
Appendix 1.C. Important formulas...Error! Bookmark not defined.
Appendix 2.A. Macro environmental factors ...Error! Bookmark not defined.
Appendix 2.B. Industry structure...Error! Bookmark not defined.
Appendix 2.C. Business system ...Error! Bookmark not defined.
Appendix 2.D. Competitive advantage ...Error! Bookmark not defined.
Appendix 2.E. Scenario analysis...Error! Bookmark not defined.
Appendix 2.F. Balance sheet based methods...Error! Bookmark not defined.
Appendix 2.G. Income statement based methods...Error! Bookmark not defined.
Appendix 2.H. Discounted cash flow methodology ...Error! Bookmark not defined.
Appendix 2.I. Adjusted present value ...Error! Bookmark not defined.
Appendix 2.J. Real options theory ...Error! Bookmark not defined.
Appendix 3.A. Cultural context...Error! Bookmark not defined.
Appendix 3.B. Business idea ...Error! Bookmark not defined.
Appendix 3.C. Value based management ...Error! Bookmark not defined.
Appendix 3.D. Target firm opportunity value; option grid ...Error! Bookmark not defined.
Appendix 3.E. Synergy value...Error! Bookmark not defined.
Appendix 4.A. Interview results ...Error! Bookmark not defined.
Appendix 4.B. Reversed valuation ...Error! Bookmark not defined.
Appendix 5.A. Target firm scorecard...Error! Bookmark not defined.
Appendices part two: ... Error! Bookmark not defined.
Appendix 6.A. A&Co’s strategy and products ...Error! Bookmark not defined.
Appendix 6.B. Business system and company structure ...Error! Bookmark not defined.
Appendix 6.C. Comparable companies & value drivers...Error! Bookmark not defined.
Appendix 7.A. Shop opening plans 2005 ...Error! Bookmark not defined.
Appendix 7.B. Ownership structure FCUK ...Error! Bookmark not defined.
Appendix 7.C. News Overview FCUK...Error! Bookmark not defined.
Appendix 7.D. DCF-analysis FCUK...Error! Bookmark not defined.
Appendix 7.E. Opportunity value FCUK ...Error! Bookmark not defined.
Executive Summary 6
Introduction: This study is performed at A&Co international - a Dutch, international lifestyle brand with an annual turnover of 1 billion euros. In 1990 the company has been taken over by B&Co, a large US holding that encompasses 50 apparel-brands. The A&Co-deal was B&Co's first, large, European acquisition. Via A&Co some B&Co-brands are launched in Europe. Apart from these growth opportunities, A&Co is also leveraging its knowledge of European markets by searching for interesting European parties to acquire. It fueled the need for a written document that surfaces and combines important knowledge regarding valuation of competitors. In support of this strategic direction this study has been done.
Outline: This thesis shows how A&Co can value its competitors systematically. Its main goal is to provide the management of A&Co with a method to value a potential takeover candidate in support of A&Co’s current growth strategy in Europe. To ensure the achievement of this objective, this research is divided in two parts with their own basic questions. The first part investigates the best way to analyse potential takeover candidates and the second part contains a case study that analyses the value of French Connection, a European competitor, for A&Co. This case study is used also to test and calibrate the proposed valuation method.
User demands: To ensure the design of a relevant method for A&Co’s management, the proposed method needs to fulfil the following user demands. It should deliver:
• A framework in which all activities to derive a target firm’s value and their sequence are presented schematically.
• A list of sources of information needed for each type of analysis.
• A clear definition of outputs that need to be delivered stage by stage.
• A distinction in different types of value (i.e. “as is” value vs. synergy value).
• A guide on using the different types of analysis and interpreting the outputs, thereby surfacing assumptions underlying them.
Literature review: As a starting point current literature regarding valuation has been reviewed.
Proper strategic analysis needs to precede more financially oriented topics. Starting point is to explicitly analyse macro-environmental variables, future scenario’s, industry structure and the company’s internal environment (business system & competitive advantage). Contrary to expectations the multiple-method proved to be very relevant. Furthermore discounted cash flow-valuation (DCF) is very applicable. The well-known economic value added (EVA) is not efficient to use, because it delivers the same results as DCF and DCF is more straightforward for valuation, while EVA is more a management accounting-tool. Option- methods are theoretically interesting, but in real-life their use is very limited, due to the amount of simplifications. The analysis of different value drivers for both the acquiring and target firm and a classification of synergy sources proved to be very applicable as well.
Interview results review: Experiences from practitioners both in- and outside A&Co are used to improve the method’s applicability. To supplement current literature analysis of comparable acquisitions, the use of multiples and issues in interpretation of results are dealt with here. It
is explained how a DCF-, comparable acquisitions and (implied) multiple approach can be 7 combined. Assuming a good comparison is found, comparable acquisition value necessarily is higher than the “as is” DCF-value range, because it includes more elements of target firm value. This is crucial for the interpretation of valuation results.
Proposed valuation method: To ensure a correct valuation of a potential target firm, the following value determining variables should be analysed. Different elements of value are surfaced, which is crucial for the determination of maximum prices that can be paid for a target firm.
1. A&Co’s characteristics: Comparable strategic picture of A&Co & Target firm requirements
2. Short target firm screening: Comparison of target to target firm requirements 3. Target firm characteristics: Strategic and financial picture Æ “as is” value 4. Target firm opportunity value: Internal improvements and strategic options 5. Synergy value: Comparison of strategic pictures of A&Co and the target firm 6. Integration costs: Fees, management time, disruption etc.
7. Total target firm value: extensive review of results and assumptions
French Connection (FCUK): Using the proposed valuation method, a valuation of FCUK has been made. This listed fashion company is best known for its controversial marketing campaigns surrounding the core “FCUK”-brand. Some operational problems and a self- willed, unpopular owner have led to a “fcuking” volatile share price development in 2004.
This led to the conclusion that FCUK is a very interesting, potential target firm for A&Co.
Added value: In comparison to the old “implicit” situation the new proposed valuation method adds value in a few areas. Important “tacit knowledge” regarding the topic of valuation of competitors is surfaced. Furthermore the valuation method has been extended to ensure a better strategic and financial picture of a target firm. Analysis A&Co’s characteristics, opportunity value of the target firm and integration costs are added for example. Next to that especially the strategic analyses are extended. Finally the method also generates comparable results when multiple potential target firms are evaluated.
Final remarks: Valuation unfortunately is largely based on judgment. An important conclusion however is that this valuation method does help to systematically create a both strategic and financial view on a potential target firm. Using it clearly assists in building a better view on possible future strategic directions for the target firm and therefore supports the development of indispensable sound judgment. As a result of that, the use of the method as proposed in this thesis for the valuation of potential target firms can be helpful for A&Co.
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Chapter 1: Research Outline
1.1. Introduction
“Getronics offers 350 mn. in shares and cash for PinkRoccade - FD, November 2004
“Battle for LSE enters next phase” - FD, December 2004
“Procter & Gamble pays $ 56bn. for Gilette”- FD, January 2005
Why on earth does a company like P&G offered to pay $ 56 bn. for Gillette, a company with an annual turnover of only $ 10bn.? What is the rationale behind these numbers and why do different companies come up with different values? The soap surrounding the takeover of Pinkroccade and the battle for a united European stock exchange continue to dominate financial headlines. News headlines like these fuelled my fascination with the subject of valuation. It resulted in the decision to write my thesis on this subject.
In this chapter the outline of my research will be presented. In structuring a research at least the following parts and their cohesion must be dealt with: the problem definition, the concepts to be used, datasources, methods to gather and process data and finally the methods for data analysis (De Leeuw, 2003, p. 88).
First the research context is introduced in section 1.2. Section 1.3. deals with the problem definition of this research. After that the research type, perspective and boundaries will be outlined in section 1.4. The theoretical framework will be described then in section 1.5. A short description of literature used and their relevance is given here as well. After this, section 1.6. gives the various datasources and describes the ways to gather and analyse the data. This is followed by section 1.7., which shows the relation with a research that is performed simultaneously. Finally in section 1.8. the research model relates the subquestions of this research to the different chapters.
1.2. Research context
A brief history of A&Co and B&Co is given in the first subsection. Subsection 1.2.2. gives the context of this research after that.
1.2.1. A&Co & B&Co
A&Co is a rapid growing Dutch consumer brand organisation present all over Europe, which has just opened its first selling points in the United States. It was founded in 1975 by mr. Jan de Boer, A&Co’s current CEO, using the labels Albert (menswear) and Jannie (womanswear). Later in the ‘80s these two brands were merged to form the brand A&CO.
Currently the company has a turnover of about 1 billion euros and 3500 employees.
A&Co main business is building the A&Co brand. It markets a wide product range from A&Co-branded apparel for Women, Men, Kids, Sports and fragrances to A&Co-accessories.
The main distribution channels are wholesale (department stores, franchises & shop-in- shops), retail (own stores or concessions) and factory outlets. The retail channel combines
highest risks with the highest potential margins. Apart from this home-shopping, which 9 contains e-commerce and catalogues, is gaining importance. A&Co’s core competencies are marketing, supply chain management and design. Design and marketing activities are being done in the Netherlands while A&Co outsources its production to the Far East (China), Near East (India) and Eastern Europe mostly.
In 1990 A&Co was completely taken over by B&Co, a listed, US-based apparel company with a portfolio of 50 brands worldwide and an annual turnover of more than 6 bn. euros (2003). B&Co Inc. was founded in 1950. B&Co went public in 1971, with net sales that year of $200 million. To compensate a stagnating core brand, B&Co follows a diversifying strategy. Next to B&Co’s own brand, known, other B&Co-brands are C, D, E and F. A&Co currently is B&Co’s biggest brand outside the United States. A&Co’s results are important indicators of European markets for B&Coand are disclosed individually in the reports that B&Co files with the SEC1. Growth and profit margin developments are monitored closely by analysts worldwide. Via the network of A&Co B&Co-brands like B&Co, C, D and E are marketed in Europe while the A&Co brand is introduced simultaneously to the United States through B&Co channels. This means that the A&Co organisation is transformed from a mono-brand company into a multi-brand company to support that strategy in Europe.
Because of the fact that A&Co is a subsidiary of B&Co, some additional issues need to be dealt with. The ultimate decision whether or not an acquisition will be made is the responsibility of B&Co senior management. A&Co is responsible for the important task to search and analyse suitable target firms thoroughly and the eventual integration process.
1.2.2. Strategic context of this study
Within A&Co Finance the research has been done at the New Business Development department, the “internal strategic consultant” of A&Co, located at the corporate headquarter in Duivendrecht. Responsibilities of this department include business analysis, organic growth opportunities, acquisitions and various projects like the B&Co-A&Co integration and the recent move from the design centre from Duivendrecht to Rotterdam.
A&Co is planning to continue growth along two paths: the first is by autonomous growth and the second is by acquisition of other existing brands that fit the strategic profile. B&Co's multi-brand-strategy has led to a search for European acquisition-possibilities by A&Co’s management. My research is focused on supporting A&Co’s management in the acquisition decision-making by developing a method and applying that method on a relevant case for A&Co. The imminent leave of my supervisor at A&Co requires the surfacing of important tacit knowledge2 regarding the valuation of competitors. To reduce the future dependency on expensive external parties an internal guide on these subjects adds value for A&Co.
Furthermore given the fact that A&Co has not done any acquisitions in the past, a systemised study to one of the key topics in the entire acquisition process – valuation – is very useful.
1 SEC: Securities and Exchange Commission (US); government agency that regulates US’ financial markets.
2 Tacit knowledge refers to the level of practical, routine, naturalised knowledge that underlies everyday activities in an organisation. Source: Oxford Reference Online
1.3. Problem definition 10
Scientific research starts with outlining the research objective, the main research questions, subquestions and the limiting conditions. Together they compose the problem definition (De Leeuw, 2003, p. 85). These parts will be dealt with below.
1.3.1. Research objective
Provide the management of A&Co with a method to systematically value a potential takeover candidate in support of A&Co’s current growth strategy in Europe.
1.3.2. Main research question
This research is divided in two parts with their own basic questions:
1. How should A&Co analyse the value of a potential takeover candidate?
2. What is the economic value of French Connection, a European competitor, for A&Co?
1.3.3. Subquestions
The following subquestions have been formulated to further structure the research:
1. a. What methods can be used to value a potential takeover candidate according to current literature and how useful are these methods?
b. What methods can be used to value a potential takeover candidate according to experts on this field of knowledge and how useful are these methods?
c. Analysing the results of questions 1. a & b., A&Co’s current method and A&Co’s user demands, what is the best method for A&Co to value a potential takeover candidate?
2. a. Applying the method developed above: What is the economic value of French Connection for A&Co?
b. How can the method applied be improved using the experiences from the valuation of French Connection?
1.3.4. Limiting conditions
There are two kind of limiting conditions in doing research: limiting conditions regarding research content and regarding research process (De Leeuw, 2003, p. 85).
There are a few content limiting conditions relevant to this research. First the end result will have to comply with the general rules and prescriptions for scientific research and thesis’s as set by the University of Groningen. A second limiting condition is the use of confidential information in the final report. The version of the final report that will be posted at the internet site of the university will have to be “anonimised” completely. A limiting condition regarding the process is that the research within the A&Co organisation has to be finished in six months.
1.4. Research type, perspective and boundaries 11
In this section the type of research is explained, as well as the basic perspective and the boundaries.
1.4.1. Research type
De Leeuw (2003) compares pure scientific with applied field research. Characteristics of applied research are a focus on application, policy, action, decision-making and design while scientific research is focused on fundamental theory. Clearly this thesis can be seen as applied field research.
This thesis can be further classified as policy supporting. It is focused on providing tangible knowledge that can be used in a specific customer’s situation (De Leeuw, 2003, p. 205).
Providing a method that supports acquisition strategy decision-making, which is suited for the specific situation of A&Co and analysing prospected target firms with that method, is a clear example of this.
1.4.2. Perspective and boundaries
The general way to look at an organisation and inter- or intra-organisational problems influences the direction of research (De Leeuw, 1990, p. 103). A perspective concerning financial and strategic aspects of organisations is most likely to cover the way to look at the organisational reality in this research. My perspective here is to see organisations as cash generating entities based on certain strategic variables that are operating in a competitive environment.
Furthermore important decisions that need to be made when developing a method are decisions regarding purpose, boundaries, organisational level, parts of the system and zooming in or out on the system (De Leeuw, 1990, p. 95). Different authors use different definitions for models, methods, concepts etc. In this thesis the word method is used to refer to the final objective; a method to value takeover candidates systematically. The relevance of this valuation method is given in the research objective and context above. The organisational level to look at follows from my perspective in the previous section. A high level is needed to see organisations as loose cash generating entities in their environment. Of course during this research zooming in on certain strategic or financial variables within the model or system may be needed. The aspects of the system to look at are the strategic and financial variables of the entities involved in the valuation method that influence their cash generating capacities. The organisational level and the aspects to look at together define the boundaries for this method. In the theoretical framework in the next part of this section these boundaries will become more clear.
Apart from the boundaries of the subjects of this thesis another important boundary is a specification of the situation(s) in which the method is valid (De Leeuw, 2003, p. 54). In essence this method is developed for use in A&Co’s (internal) strategic environment.
However, it can be used for other organisations with other strategic and financial variables as well. The method will have to be modified then to fit in these new variables.
1.5. Theoretical framework 12
In this section the theoretical framework as well as a short discussion of the relevance of the literature described in chapters two and three is given. The theoretical framework is used to structure the analysis of current relevant literature in this thesis.
1.5.1. Introducing the framework
A theoretical framework is a system of variables and their relations (Verschuuren, 1986, p.
136). It also shows the basic research perspective, the elements and their mutual relations (De Leeuw, 2003, p. 56). Further explanation of the framework is given on the next pages.
Before proceeding to the framework, please note that:
• The left part of the theoretical framework is marked by a roman number one and is called “valuation perspectives”. It consists of the theoretical (valuation) tools grouped by perspective to analyse and understand the elements of:
• The right part of the framework, which is marked by a roman number two, is called
“valuation sequence”. It shows the variables in the real world and their relations that ultimately determine the value of a potential takeover candidate. This part of the framework fits the definition above.
To further underline the separation of the two parts of the framework, different colours have been used. In the left part of the framework the financial perspective follows the strategic perspective. The reason for this is that a strategic “picture” needs to be developed first before financial modelling can make any sense. Further descriptions are given after the framework, which is presented on the next page.
Looking from a strategic and financial perspective and using the tools described in the left- hand side, the right-hand side of the framework can be analysed. The right-hand part of the framework is an overview of the relevant variables to analyse when determining the value of target firm. The numbers in the boxes indicate the sequence in which this should be done.
Starting point is an analysis of the characteristics of the acquiring firm (1) (A&Co in this case). Target firm requirements are developed in this stage as well following from the own firm characteristics. Then in the next stage the target firm characteristics (2) are analysed, which ultimately leads to the “as is” value of this firm. Using these two sets of characteristics a comparison can be made as well. To derive total target stand-alone value the opportunity value of the target firm (3), which measures the value of internal strategic options, needs to be calculated in stage three. Then an estimate of the potential synergy value (4) and integration costs (5) needs to be made based on the comparison between the two company’s characteristics. When these five variables (box 1 to 5) have been analysed, the total potential value of a target company for the acquirer can be calculated, which is the final stage.
13
Box 4. Synergy value:
• Operational
• Financial
• Ownership
-
+
+
+ Figure 1.1. Theoretical framework
II. Valuation sequence (chapter three) I. Valuation
perspectives (chapter two)
Valuation perspectives:
1. Strategic:
• External &
internal environmen- tal analysis
• Scenario analysis
2. Financial:
• Multiples
• Cash flow discounting
• Economic Value Added
• Real options
Box 2. Target firm characteristics:
• Strategic context
• Cultural context
• Business idea
• Value drivers Æ “as is” value
Box 3. Target firm opportunity value:
• Operational improvements
• Strategic options
Box 6. Total target firm value
Box 1. Acquiring firm characteristics:
• Strategic context
• Cultural context
• Business idea
• Value drivers
Æ Target firm requirements
Box 5. Integration costs:
• Disruption costs
• Transaction costs
• Restructuring costs C
o m p
a r i s o n
1.5.2. Literature linked to the theoretical framework 14
This subsection is a short overview of the relevant literature to this thesis. For a detailed description see chapters two and three. The literature is linked to the boxes (variables) in the theoretical framework.
I. Valuation perspectives (Strategic and financial)
Tools for analysis and understanding: To be able to analyse the value of a potential takeover candidate a set of tools is needed. As will become clear in the next chapter these techniques also represent the strategic and financial management perspective. In the left box of the framework these techniques are grouped by perspective as can be seen by the sub-boxes.
1. Strategic perspective: analysis of the external and internal environment, competitive advantage, scenario analysis
2. Financial perspective: Multiples, discounted cash flow techniques including Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), Economic Value Added (EVA) (value creation) and (real) options theory
II. Valuation sequence
Box 1 & 2. Characteristics of acquiring and target firm: Characteristics of the acquiring and target firm are a crucial determinant of a potential target firm’s value. Basically the value of a potential target firm is the “as is” value plus the value of opportunities and synergies (Rappaport, 1998) minus integration costs (Copeland et al, 2000, p. 120). Apart from the valuation tools above relevant literature for these elements concerns:
• Strategic context
• Competitive advantage framework
• (Inter)national & company cultural variables
• Scenarios; business ideas
• Value based management
The relevant strategic and financial variables that ultimately influence the cash generating capacity of the companies can be surfaced using this literature.
Box 3, 4 & 5. Target firm opportunity value, synergy value and integration costs: As written above, internal opportunity value, synergies and integrating costs influence the potential value of a takeover candidate. Comparing the business ideas and the strategic and cultural context of the two entities, an estimate has to be made of potential realisable synergies involved. Again the tools from the left part of the framework in figure 1.1 are useful to analyse this.
Literature that can be helpful in this case concerns:
• Synergies; operating & financial
• Synergy ownership, biases and difficulties
• Mergers and acquisitions; integration approaches
• Scenarios; business ideas & overlap 15
• (Real) options theory
Integration costs are often forgotten in the heat of a deal (Copeland et al, 2000, p. 119). This is the reason that they are explicitly dealt with here. The literature above helps to specify potential sources of difficulties and therefore extra costs.
Box 6. Value of target firm: Eventually the impact of “as is” value, target firm’s (internal!) opportunities, synergies and integration costs on the total realisable cash flows of the entity involved is the determinant of value of the prospected target firm. The (valuation) tools from the left side of the framework play a significant role here again in determining value.
Of course the true value to the acquiring firm is the value of the target firm minus the takeover price. Paying too much premium for an entity therefore destroys value for the acquiring company (Rappaport, 1998). Although being an important issue this will not be dealt with in this thesis in much detail, because this belongs to a later stage in the acquisition process –actual negotiations. Target firm value is split up in its determinants and theoretically can be estimated stage-by-stage using this method.
1.6. Data; sources, methods for gathering and analysis
First the sources of data used are described here. Additional information is given about the gathering of information about French Connection. Then the methods to gather and analyse the data from the sources described above are dealt with.
1.6.1. Data sources
There are six classes of datasources: documents, databases, media, the field, researchers’
experience and the experimental field (De Leeuw, 2003, p. 99). To be able to answer the research questions from section 1.3., the following sources of data will be used in this study:
• Documents (articles, books, A&Co’s internal information sources (including financial data), valuation reports of investment banks, etc.)
• Databases (internet & university)
• Media (newspapers & internet)
• Field; Management of A&Co & B&Co
• Field; Outside experts from investment banks and private equity firm
The strategic and financial data needed for the valuation of French Connection needs some extra explaining. French Connection is listed at the London Stock Exchange (LSE). It also has a lot of financial data available for analysis through the frequently publicised reports.
A huge amount of sources for specialised company information is available. The sources mentioned here by no means include all possible sources3. The table below shows a classification of sources and some possible real-life examples to illustrate it.
3 These information sources are based on interview results and experiences from my period at A&Co
Table 1.1. Information sources for competitor analysis 16
Classification: Examples:
1 General (economy, country etc.) IMF, Worldbank, Economical Intelligence Unit, etc.
2 Industry data Bloomberg.com, finance.yahoo.com, etc.
3 Target firm data Target firm management, target firm website, target firm financials
4 News sources ft.com, fd.nl, hoovers.com, finance.yahoo.com, etc.
5 A&Co's internal sources A&Co’s management, internal documents
6 (Specialised) Reports Analysts’ reports
Most of the sources, except “management” and internal sources, are accessible on the internet. Analysts’ reports are a different category in a way. They can deal with all the other categories of information. In the context of this research specialised analysts’ reports regarding certain companies are meant.
1.6.2. Data gathering
De Leeuw (2003) does not provide a detailed overview of data analysis and gathering. There are three ways to gather data: using existing data, observation and interviewing (Baarda & De Goede, 1998, p. 134). Considering that this thesis does not discuss behavioural characteristics, gathering existing data and interviewing will be the techniques used to gather the needed data.
Using existing data is an efficient and good way to start a research, whereas the interviews will be used to obtain knowledge and opinions from external experts and from A&Co’s management. The interviews will be used to gather information on the opinions of experts on valuation in chapter four, to create a picture of the current valuation method of A&Co in chapter five and to describe the user demands of A&Co’s management in chapter five.
Because the information that will be obtained during the interviews will be qualitative by nature (versus quantitative), semi-structured interviews will be used. The main topics and some open questions are detailed in advance with this interview form.
The main disadvantages of interviewing are that interviewees (and interviewers!) might not know the motivations behind their own behaviour and that the human memory tends to work selectively (Baarda & De Goede, 1998, p. 143). And of course the results here refer to the way the interviewees say they handle things, which may not be the same as the way they actually do handle things. In the context of this research it is virtually impossible to check this. Where possible, as a check valuation reports have been reviewed. Within A&Co this can and has been done, but outside A&Co the problem unfortunately remains. Therefore some variance between the results presented here and the real world cannot be ruled out.
Because of the boundaries regarding time within this research process, six experts have been interviewed. Of course the reliability of the conclusions drawn from such a small research population may be limited. To ensure the quality of the input of this chapter, diverse, well- educated and experienced interviewees were selected. Different persons with differing backgrounds have been interviewed for this part of the research. Both people within and outside the A&Co organisation were selected to enhance the perspective of this study. An owner of a private equity firm (BVPE), a controller of a media group (NDC Holding) in the
middle of a takeover process and an investment banker (NIBCapital) have been interviewed 17 outside A&Co. The CFO of A&Co, my supervisor at A&Co and the interviewee that heads B&CoM&A-department were interviewed within A&Co and parent company B&Co. My supervisor at A&Co and the head of B&Co's M&A-department both have an “investment banking”-background (First Boston Credit Suisse).
Appendix 1.A presents an overview of the people that were interviewed and their backgrounds as well as the objective for interviewing them. Appendix 1.B amongst other things contains a list of questions and topics that were discussed during those interviews.
Due to the limited size of the population in this research, the methods described here may not apply for practice in general.
1.6.3. Data analysis
The basic form of analysis is desk research. In this research activities like quantitative and qualitative analysis, simulation, statistics and schematic structuring (Baarda & De Goede, 1998, p. 112) are meant with desk research.
Another important method of analysis, which needs to be mentioned separately, is case study. This method is used to analyse competitors and to test and improve the developed valuation method. In this context a case study can be defined as an intensive study of certain aspects at one or more organisations (Braster, 2000, p. 21). A combination of qualitative (strategic) and quantitative (financial) information is used in this case study. Furthermore the case study is used to implement theory into practice instead of developing or testing theory (Braster, 2000, p. 30).
1.6.4. Data usage summary
To summarise the results of this section the following table shows the chapters related to the datasources and methods for gathering and analysis.
Table 1.2. Data; methods for gathering and analysis
Chapter Source: Gathering: Analysis:
(Internal) Documents Databases
Media Outside experts A&Co's management
Documents Use existing data
A&Co's management Interviews
Media Use existing data Desk research
Databases Interviews Case study
(Internal) Documents A&Co's management
8: Conclusions Outside experts Interviews
A&Co's management Use existing data Documents
2 & 3 (1.a): Literature review Use existing data Desk research
4 (1.b): Expert interview results review Interviews Desk research
5 (1.c): Proposed valuation method Desk research
6 & 7 (2.a & b): Case study French Connection
Desk research
For readers that are less familiar with some of the more financial topics, the key formulas are 18 summarised in appendix 1.C.
1.7. Simultaneous research: analysis of new markets
During my period with A&Co Piet Schutter, a fellow senior student of the University of Groningen, performed a research at the same department as well. The subject of his thesis is analytical examination of potential new markets. This section defines the mutual relationships of the two theses. Especially the fields where the results are complementary will be given. Also issues in which some overlap exists are described.
This research is focused on delivering a method to systematically value potential takeover candidates. The other research deals with systematic analysis of new markets. A resemblance can be found in the mutual goal to deliver a systematic tool for analysis (of different subjects). Overlap exists between the analysis of different strategic options for a takeover candidate in this research and the analysis of options to enter a market in Piet’s research.
Also some of the financial literature used will be the same.
More important for A&Co are the potential complementary points. An example is that Piet’s research explicitly analyses a country’s market potential. For this thesis sales estimates based on assumptions are needed to build cash flow forecasts. Future growth and return figures can be better estimated using specific country data next to more aggregate measures such as GDP-figures, and spending patterns.
1.8. Research model
This section gives an overview of the parts of the research and their sequence. It also links the subquestions to the chapters. The number of the subquestion is behind the relevant chapter number. As shown by the feedback loops between chapters 5, 6, 7 and 8, parts of this research are structured as an iterative process.
Chapters 1 to 5 contain the answer to main question 1 and will be publicly available:
• In chapters 2 and 3 subquestion 1.a is answered. This will provide a review of current literature regarding valuation tools and valuation of takeover candidates. These results are used as a key input in designing the method in chapter 5.
• Chapter 4 answers subquestion 1.b using the provisional results from chapters 2 and 3.
Thereby it includes the opinion of experts in this field of knowledge to the method.
• Chapter 5 analyses the results from the previous chapters, A&Co’s user demands and A&Co’s current valuation method. Based on this it presents the method best suited for A&Co to value potential takeover candidates. Thereby answering subquestion 1.c.
Chapters 6, 7 and 8 together are the second part of this research. They contain a (partly) confidential case study based on the method developed in part 1:
• In Chapters 6 and 7 subquestion 2.a. and 2.b. are answered and one competitor of 19 A&Co, French Connection is systematically valued based on the method developed in part 1 to support the acquisition decision making within A&Co’s management. The findings of these chapters also will be used to evaluate and improve the method. Chapter 6 contains an analysis of A&Co’s characteristics and chapter 7 focuses on French Connection.
• Chapter 8 contains the - partly confidential - main conclusions of this thesis.
Shortcomings and recommendations are dealt with as well in this final chapter.
Although the two parts can be seen and read separately, parts of this research are done iteratively. The model below shows the parts, the subquestions and the chapters of this research schematically:
Figure 1.2. Research model
The entire research outline has been presented now. The next chapters contain the results from this study.
Part TWO:
Main question 2: Case study & conclusions Part ONE:
Main question 1: Valuation method
Chapter 1: Outline
Chapter 4 (1.b.):
Expert interview results’
review
Chapter 5 (1.c):
Proposed Valuation Method
Chapter 8 (2.b):
Conclusions Chapter 6 & 7 (2.a):
Case study:
“French Connection”
Chapter 2 & 3 (1.a):
Literature review
20
Part ONE: Valuation method
Part TWO:
Main question 2: Case study & conclusions Part ONE:
Main question 1: Valuation method
Chapter 1: Outline
Chapter 4 (1.b.):
Expert interview results’
review
Chapter 5 (1.c):
Proposed Valuation Method
Chapter 8 (2.b):
Conclusions Chapter 6 & 7 (2.a):
Case study:
“French Connection”
Chapter 2 & 3 (1.a):
Literature review
21
Chapter 2: Literature review on valuation perspectives
2.1. Introduction
Following the brief discussion of the theoretical framework in the previous chapter, the tools mentioned there are dealt with extensively here. Important demands to this literature from practice are applicability, efficiency and relevance. All literature is tested for usefulness applying these demands. This section represents the author’s opinion following from the results from this study. The subquestion that will be answered in the next two chapters is:
1.a. What methods can be used to value a potential takeover candidate according to current literature and how useful are these methods?
Firstly sections 2.2 and 2.3 describe the strategic and financial perspective to develop the tools that are needed for analysis of the right-hand part of the framework from chapter one.
Then section 2.4. integrates the two perspectives to show the combined importance of strategy and finance. A summary of this chapter is given in section 2.5.
2.2. Strategic perspective
The general perspective is repeated below. Relevant literature is analysed to support that perspective:
“Organisations are viewed as cash generating entities based on certain strategic variables, that are operating in a competitive environment”.
As shown in my perspective certain strategic variables are the base of the structure on which an organisation builds its value. A strategic analysis of a takeover candidate is the starting point for each analysis of a potential acquisition. There is no point in performing all kinds of in-depth financial analysis before a strategic picture has been developed.
A too narrow focus on financial issues can be an important reason for mergers and acquisitions to fail. A financial tunnel vision focusing on value and return on investment solely and acquisition-teams consisting of finance-people are characteristics of these failures.
Successful buying companies position their financial analysis within an overall strategic framework of goals and intentions. Another important success factor is a blend of backgrounds and mindsets in the analysing and deciding team (Marks & Mirvis, 2001).
The strategic variables and relationships with the competitive environment that influence the cash generating ability of a company are dealt with in this section. Earning returns above the cost of capital ultimately drives company value. To achieve this sustainable competitive advantage must be developed and exploited. A picture of a company’s ability to generate these advantages must be built therefore.
This section deals with competitive issues, which are needed as an input to predict future 22 competitive advantages and therefore future cash flows. First a view on the competitive environment in which a company operates has to be developed. Analytical tools to describe a company’s external environment are outlined in subsection 2.2.1. Then tools to analyse the way a company deals with its competitive environment are described. The business system- and generic strategies-analysis are the tools defined in subsection 2.2.2. The internal environment of resources, capabilities and core competences, which together define competitive advantage, are described in subsection 2.2.3. Then a different way of thinking about future uncertainty is dealt with in subsection 2.2.4. Finally subsection 2.2.5. presents an overview of the strategic tools used here.
2.2.1. External environment
Analysing the external environment of a company is the first step in competitive analysis.
There is a distinction between the macro- and meso-environment. In this thesis I will use a macro-environmental analysis that takes into account external factors. This will be supplemented by Porter’s five forces framework, which defines its industry structure, to analyse a company’s meso-environment (De Wit & Meyer, 1998, p. 346).
External shocks and performance: Major macro external developments are not explicitly considered in Porter’s well-known, five forces model. External shocks and their influence on competitive dynamics need to be considered as well. The impact of these underlying forces influences performance of individual competitors and the industry as a whole (Copeland et al, 2000, p. 237).
The macro environmental developments that need to be analysed on a global scale are political, economical, societal, technological and demographical factors (“PEST&D”). In this case especially potential big changes and their impact are important. Appendix 2.A. describes these factors in more detail.
Industry structure: In his famous article Porter (1985) defined the elements that determine industry- attractiveness. As said above external macro-environmental shocks were not taken into account here. Profitability potential differs between industries. The main argument is that this profitability potential always is a function of five forces that will be dealt with in more detail below. The five forces influence sales quantities, prices, costs, required investments and therefore potential ROIC. Companies competing in an industry are trapped in a way to the short-term competitive dynamics of their industry. In the long run companies can reshape industry characteristics through innovative strategies and business systems though. Appendix 2.B. describes the five forces separately.
Usefulness: From a strategic perspective analysis of the macro environmental factors (“PEST&D”) as well as the industry structure provides a good picture of the external environment of a company. Industry structure was more or less the starting point of analysis in practice. Analysis of general economic conditions and forecasts of markets, countries and continents has been observed as an implicit part of target firm analysis. However a framework for macro-environmental analysis (“PEST&D”) was not observed. Perhaps the limited direct applicability of parts of this framework such as societal factors is a reason for this. For a complete picture it seems logical to do take into account all these factors though.
