The Search for
Synergy
at
Standard Aero
B.M. van Sleeuwen (April 2003)
Faculty of Management and Organization University of Groningen
Principal of research: Standard Aero International Public Edition
Mentors: G. Gemser (University of Groningen) W. Westerman (University of Groningen) F. Lopez (Standard Aero International)
Preface
‘Integration decisions are often justified by the synergies they create. Synergies exist when assets are worth more when used in conjunction with each other than separately. Synergies of some form are essential for integration to be successful. Integration offers little or no potential benefits when they do not exist.’
- T.N. Hubbard
‘Don’t talk about synergies, they are never delivered’
- CEO, European Multinational
As part of graduating as a Master of Science in International Business at the University of Groningen, this paper is written at Standard Aero International in Tilburg.
This paper contains a research on the identification of an acquisition opportunity for SA. As part of this research a literature research was conducted to define the concept of synergy. Furthermore a methodology for SA in order to identify and value synergy is presented.
This is a public edition of the paper since the largest part of the paper is not available for
publication due to confidentiality agreements with Standard Aero. If a chapter or paragraph cannot be published it is presented as not available (N.A.).
First of all I would like to thank my university mentors, Gerda Gemser and Wim Westerman, for their guidance in my research. Next I would like to thank my mentor at SA Int., Fergus Lopez, and the people at SA Int. especially René van Doorn, Mike Ménard and Ad Timmermans for making my research at Standard Aero possible and for their help in conducting the research.
Finally I would like to thank my parents and my sister for their moral support in my years at university.
Ben van Sleeuwen, Tilburg, April 2003
Executive summary
This research is conducted to provide recommendations to Standard Aero (SA) on the acquisition of a component manufacturer in Europe. Criteria were developed for a search and screening process on a suitable acquisition candidate. Furthermore recommendations on the identification and valuation of synergy were made in order to analyze whether an acquisition of a component manufacturer would add value to the portfolio of the Dunlop Standard Aerospace Group (DSAG, the mother company of Standard Aero).
SA is a MRO (Maintenance Repair and Overhaul) provider for several turbine engines. The objective for acquiring a component manufacturer is twofold. The first goal is to increase the Intellectual Property on turbine engines and their components of the organization. The second goal is to realize profitable growth for DSAG.
Within SA the assumption exists that aerospace manufacturing companies are more profitable than the MRO activities of SA. This assumption seems to be correct after testing the profitability of aerospace manufacturing companies that are listed on the New York and/or London stock exchange. The search for an acquisition candidate active in the manufacturing of turbine engine components was partly justified in this way.
The first part of the paper contains several analyses, which cannot be published in the public edition due to confidentiality agreements
The second part of the paper discusses the concept of synergy. In order to identify and value synergy, a methodology has been developed by analyzing the perspective of several authors on this concept. Synergy can be seen a cause and effect relationship. When two companies decide to work together by merging or acquiring, sources can be identified that lead to either positive or negative synergy effects. The positive effects (benefits) and the negative effects (antagonisms) can be valued by using qualitative and quantitative terms.
Based on the work of Campbell and Goold and Janssen and van Heuvelen, a methodology is
proposed in this paper to identify synergy sources and effects when SA decides to acquire a
component manufacturer. Synergy can be valued by calculating the impact the synergy effects have
on future revenues of the combined company. The value is deducted by using the Discounted Cash
Flow formula for synergies as proposed by Janssen and van Heuvelen.
PREFACE ... 1
EXECUTIVE SUMMARY ... 2
CHAPTER I: INTRODUCTION AND RESEARCH FRAMEWORK... 4
§ 1.1 I
NTRODUCTION... 4
§ 1.2 P
ROBLEMB
ACKGROUND... 6
§ 1.3 R
ESEARCHF
RAMEWORK... 12
CHAPTER II SEARCH & SCREENING ... 17
CHAPTER III SYNERGY ... 18
§ 3.1 I
NTRODUCTION... 18
§ 3.2 V
ALUE CREATION... 22
§ 3.3 I
NTEGRATION... 26
§ 3.4 S
YNERGYM
ETHODOLOGY... 28
§ 3.5 S
YNERGY PERSPECTIVE OFS
TANDARDA
ERO... 29
CHAPTER IV CONCLUSION AND RECOMMENDATIONS... 29
REFERENCES ... 30
Chapter I: Introduction and Research Framework
§ 1.1 Introduction
When the Wright brothers made their first motorized flight in 1903, they probably did not anticipate the scale of the worldwide aerospace business today. Nowadays the aerospace industry is a multi- billion dollar industry encapsulating military, commercial and industrial sectors. In the US alone over 650 million passengers traveled on commercial aircraft in the year 2000, which was good for a total profit of almost 7 billion dollar
1. One of the main drivers for the enormous amount of air traffic today, is the evolution of aerospace technology during the 20
thcentury. One of the main drivers for the evolution was the design and production of aircraft and engines for military purposes. In the US alone 50,000 warplanes a year were built during WWII
2. Without WWII and the Cold War the development of the jet engine would not have had such an enormous impulse. It was partly due to this technology that air travel became available for an increasing amount of people. Another driver of aerospace evolution were pioneers such as Juan Trippe. He was the founder of Pan Am airlines. Trippe convinced Boeing in building the first American Jet Airliner, the 707. In the 1960’s he also convinced Boeing of building the Jumbo jet, the Boeing 747
3. This is an aircraft capable of carrying 450 passengers. These drivers together with an overall worldwide economic growth, made air travel available for an increasing amount of people over the last 50 years
In this chapter we will look at some of the characteristics of the aerospace industry, its players and the role of Dunlop Standard Aero in the industry.
§ 1.1.1 Industry characteristics
Flying is regarded as the safest mode of transportation on the planet. One of the reasons for this fact is the strict legislation in the industry. Safety is the keyword within aviation. Strict guidelines and operating procedures within the industry are controlled by aviation authorities such as the US
‘Federal Aviation Authority’ (FAA) or the British ‘Civil Aviation Authority’ (CAA). Aircraft need to be certified by these authorities in order to make legal flights within the appropriate air territories. Aircraft manufacturers need to comply with the rules set by aviation authorities when they design and manufacture new aircraft. Developing new aircraft and engines is a time consuming and high cost process. An aircraft is a capital-intensive product. Aircraft are usually produced in low volumes. The technology involved in designing and manufacturing aircraft is complex. It often takes many years before the aircraft concept actually comes of the drawing board. Mainly due to this fact there is a lot of consolidation within the industry. Boeing for example merged with McDonnell Douglas in 1997 and became by far the world’s largest aerospace company
4. It has an employee base of more than 200.000 people and total revenue of more than $55 billion
5.
1 Source: Air Transport Association, http://www.airlines.org, January 2003
2 Source: http://www.pbs.org, February 2003
3 Source: http://www.pbs.org, February 2003
4 Source: http://www.boeing.com, January 2003
5 Source: http://www.fortune500.com January 2003
§ 1.1.2 Industry players
The main focus of this paper is the commercial aviation industry. In this industry we can roughly make a division of the following players. The end-customers can be the passengers and cargo that are transported by commercial airline companies (e.g. KLM, US Airways, Singapore Airlines).
These airline companies buy their planes from aircraft manufacturers such as Boeing, Airbus or Embraer. The aircraft are equipped with engines that are provided by engine manufacturers (e.g.
General Electric, Snecma, Pratt & Whitney). MRO (maintenance, repair and overhaul) companies service these engines. The MRO provider can either be an aircraft operator, an engine manufacturer, or an independent. In order to provide an authorized overhaul, a MRO company needs to have licenses from the engine OEM (Original Equipment Manufacturer). These licenses have a relative high cost for non-OEM independent MRO providers, which limits their profits. Aircraft operators do not pay for the licenses of engines that they use to power their aircraft. Engine OEM’s have high R&D (Research & Development) costs, which they try to win back, not by selling their engines at high margin prices, but by selling the parts for the aftermarket at high margin prices. Engines are sold at relatively low margins to achieve a high volume. This business model also applies to aircraft manufacturers. Aircraft are sold at ‘give-away‘ prices and the sales and service of spare parts for service provide the profit for the aircraft manufacturer. In order to protect their aftermarket engine OEM’s only provide licenses at high costs. This forms a trade barrier to potential competing MRO suppliers. Recently this traditional aviation business model has come under a lot of pressure from PMA manufacturers (Parts Manufacturer Approval). These are companies that are authorized by aviation authorities to produce aircraft or engine spare parts. Since they do not incur the same R&D costs as the OEM’s, they can sell the parts at a much lower price, and are thereby offering a serious threat to the traditional business model.
§ 1.1.3 Dunlop Standard Aerospace Group
The Dunlop Standard Aerospace Group (DSAG) is a worldwide company involved in the Aerospace Industry. DSAG is totally owned by Doughty Hanson & Co., which is one of Europe’s largest private equity funds. DSAG is involved in the design and manufacturing of specific aerospace products, and in the repair and overhaul for turbine engines. The Dunlop Aviation group manufactures wheels and brakes, heat exchangers for aircraft engines, valves, and specialized rubber components. The Standard Aero group is involved in the maintenance, repair and overhaul (MRO) of turbine engines for military, commercial and industrial applications. Standard Aero is a Canadian company by origin and was set up in 1911 in Winnipeg. It now has an employee base of 2500 people worldwide. The activities of Standard Aero are divided by three geographical areas, which are Canada, USA and International. Standard Aero International (will be further referred to as SA Int.) has in turn three operating facilities outside Canada and the USA; these are Standard Aero Tilburg v.o.f. (currently 200 employees), Standard Aero Singapore (30 employees) and Standard Aero Sydney (Australia) (20 employees). The headquarters of the SA Int. division are in Tilburg (the Netherlands). SA Int. is responsible, next to the division’s primary activities, as outlined above, for the identification of opportunities for profitable growth. SA Int. is the principal of the research discussed in this paper. In Figure 1.1 an organizational chart is presented of DSAG.
SA currently provides MRO services to a variety of turbine engines. The segments that SA
currently serves are airline companies, business aviation companies, private aircraft owners and
governments. These segments involve airplanes or helicopters that carry the aforementioned
engines.
Figure 1.1 Organizational chart of the Dunlop Standard Aerospace Group
6§ 1.2 Problem Background
Fundamental idea of any commercial organization is to build shareholder value. In order to create value above industry average, companies must perform better than their competitors (Porter, 1980).
In addition, the value creation possibilities differ between industries (Porter, 1987).
Since the 1980s companies have felt increasing pressures for the renewal of their operations and organization in order to build more shareholder value. The sources of these pressures include new technology, globalization of markets, deregulation of industries, and shift from the public to private sector (Baden-Fuller, 1997).
A corporate renewal can be defined as a process through which firms seek a better competitive position in relation to their competitors, and respond to changes in environment in order to survive or create more shareholder wealth (Baden-Fuller, 1997).
Growth is closely linked to corporate renewal. If a company wants to sustain and grow its business it needs to assess its competitive position continuously. Next to growing its market share on existing products a company needs to look for opportunities for investment in new products and/or markets.
Basically companies can renew by making use of two different sources: internal and external sources. Internal sources include learning, research and development, and external sources contain collaborative arrangements, acquisition and mergers (Laamanen, 1997).
§ 1.2.1 DSAG’s Growth
Dunlop Standard Aero has seen growth in revenue and profits over the last five years
The growth of the MRO business is under pressure from the competition from the OEMs. The OEMs are increasingly seeking more market share in the aftermarket service of their engines. There are several reasons for this development. The sale of spare parts of OEM’s is under pressure from PMA manufacturers. These companies sell spare parts at lower prices than the OEM and are
6 Source: http://www.dunlopstandard.com April 2003
gaining market share in this sector. The sale of spare parts is an important share of the revenue for an OEM. OEMs are looking for more aftermarket sales to increase their revenues. The aftermarket provides a more stable level of revenue. The cash gained from the aftermarket sales can be used to fund research and development of new engines. The OEMs try to capture the aftermarket by offering service contracts together with the sale of new engines to the operators.
This growth can be identified as organic as it was predominantly caused by expanding market share in existing product market combinations. In the last five years DSAG has not seen any acquisitions.
Under its previous owner BTR (British Tire and Rubber) Standard Aero performed two major acquisitions in the nineties. In 1995 it bought TOPPS in Tilburg (the Netherlands). TOPPS was established as a joint venture between KLM and Chromalloy gas turbine. Its main business from its start in 1989 was the assembly of engines for the Fokker-50 airframe. In 1991 it became a MRO facility for PW100 and GEM42 engines. In 1996 Standard Aero acquired Alliance Engines Inc. in Maryville, Tennessee (USA). This company was an overhaul shop for APUs (Auxiliary Power Unit) and the Honeywell 331 and 731 turbine engines. It was established as a joint venture between Duncan Aviation and KC Aviation. Soon after the acquisition, Standard Aero introduced the license for the overhaul of Rolls Royce AE3007 engines, which it already obtained on 1992 in Maryville.
Although DSAG did not make any major acquisition over the last 6 years, it does play a major role in the overall growth strategy of the company. It has an ambition to grow dramatically over the next few years in order to become a multi billion-dollar company. The company has identified three different strategies of growth. First it wants to grow its existing business by growing market share.
Second it wants to expand its activities by acquiring more companies. Third it wants to venture new companies, by innovating new products. The focus of the research is on the second of these three strategies.
§ 1.2.2 DSAG’s Growth Objectives
Profitable growth is the main goal for the entire company. The focus in this research will be the selection of an acquisition candidate that will increase the ROS and RONA of the whole group within five years from the acquisition.
§ 1.2.3 Acquisitions & Mergers
An acquisition is a transaction in which one firm buys controlling or total interest in another firm with the intent of more effectively using a core competence by making the acquired firm a subsidiary business within its portfolio (Hitt et. al., 1997). Acquisitions can also be used in business-level strategic management by acquiring competencies and capabilities to strengthen respective business (Haspeslagh & Jemison, 1991). A merger refers to a transaction in which two firms agree to integrate their operations on a relatively coequal basis because they have resources and capabilities that together may create a stronger competitive advantage (Hitt et. al., 1997).
Although Mergers & Acquisitions (M&A) are widely accepted as a strategy for growth, the practice
shows that it hardly is a successful strategy. There has been a lot of research on the failure rates of
M&A. The overall conclusion of all these researches is that more than half of them are unable to
create more value after the merger or acquisition. Figure 1.2 gives an overview of different studies
on M&A failure rates.
Figure 1.2 M&A failure rates
7The success of acquisition and mergers has been studied on at least five perspectives: strategy, economics, finance, organization theory, and human resource management (Finkelstein, 1999).
Strategic management has studied different acquisition strategies and company performance.
Research in economics has examined acquisition performance accounting-based measures. The studies in the field of finance have focused on the stock market responses to acquisitions and mergers. The organizational research has focused on post-combination integration issues, the importance of effective communication, and how acquisitions affect careers.
Recently, the research of acquisitions and mergers has focused on two subjects: Human relations in acquisitions and mergers and post-merger integration issues (Mikkonen, 2000). Sirower (1999) mentions that perhaps the most important challenge is to determine what the new mission is of the combined organization. And furthermore, how to organize to accomplish the new mission.
Tetenbaum (1999) found in his research that 60-80% of all mergers are financial failures when measured by their ability to outperform the stock market or deliver profit increases. These failures are primarily due to an overemphasis on the deal itself to the virtual exclusion of attention to the subsequent integration of the companies. DeVoge (2000) discusses the human issues in her study.
She argues, based on her research, that the human issues are most crucial factors explaining the success of acquisitions and mergers.
Enroth and Larsson (1996) have also reached to the similar findings in their study. Larsson (1999) has developed a model, which combines the five different perspectives of acquisitions and mergers mentioned in the beginning of this paragraph. It gives a strong influence on both the human resource management and the integration issues. The integrative merger and acquisition model is presented in figure 1.3.
7 Source: Jansen S.A., Pre and Post Merger-Integration in Cross Border Transactions, 2000.
Figure 1.3 An Integrative Merger and Acquisition Model, Larsson (1999)
The model connects combination potential, organizational integration and employee resistance and links them to the synergy realization. Synergy is considered as the best way to measure success of acquisitions and mergers. The main concepts of this model are presented as follows:
•
Combination potential of acquisitions and mergers refers to both the strategic similarity and the strategic complementarity of operations of the joining firms.
•
Organizational integration is defined as the degree of interaction and coordination between the two firms involved in a merger or an acquisition.
•
Employee resistance is described as the individual and collective integration of the joining companies.
•
Synergy realization is the combination of the factors above.
§ 1.2.4 DSAG’s Strategic Architecture
N.A.
§ 1.2.5 Background DSAG Corporate Strategy
N.A.
§ 1.2.6 Acquisition Candidate Selection
The strategic architecture of DSAG forms the starting point for the research of an acquisition
candidate. However there are a large number of companies that are active in the manufacturing of
powerplants. An analysis needs to be made which company is most suitable for SA to acquire in
order to achieve the aforementioned growth goals. In this analysis the scope the available resources
(predominantly financial) within the company have to be taken into account. This is the process of identifying a suitable acquisition candidate for SA. In this research a structured method will be described and followed in order to come up with a company or division that will be a suitable acquisition candidate for SA. In this method selection criteria need to be identified on which a selection can be based. The methodology will be described within the research framework.
§ 1.2.7 Synergy
The end goal of acquiring a component supplier is to increase the overall profitability within 5 years for DSAG. The company needs to make a sound investment decision when acquiring another company. This company will form a part of the entire portfolio of the firm.
According to Goold & Luchs (1993), the primary issues for corporate strategy in the 1990s are how to identify the businesses that should form a core portfolio for a firm, and how to discover ways of creating value for those businesses. In the case of DSAG the issue is to select a firm that will create value for the entire portfolio. Next to increasing the revenues and the profit of the entire portfolio of DSAG, the increase of profitability (ROS) is crucial. Value creation for DSAG can therefore be seen as a combination of all these three objectives. Goold & Luchs (1993) identified three alternative answers to the question of value creation for businesses in firm portfolio.
•
First, diversification must be limited to those businesses with synergy potential. Synergy can be achieved when the performance of a portfolio of businesses adds up to more than the sum of its parts.
•
Second the corporate strategy must be focused on exploiting core competencies across different businesses and/or industries. Hamel & Prahalad (1990) argued that the corporate portfolio should be considered as a portfolio of technological competencies, rather than a portfolio of businesses.
•
Third, building a collection of businesses, which fit the managerial ‘dominant logic’ of managers and their management style, is one of the best ways to diversify successfully.
Prahalad & Bettis (1986) argued that, ‘A dominant general management logic is defined as the way in which managers conceptualize the business and make critical resource allocation decisions – be it technologies, product development, distribution, advertising, or in human resource management’.
The main focus in this research will be on identifying the sources of potential synergy. The second and third answers of Goold & Luchs are considerations for the direction of growth. These considerations have already been taken by DSAG and have been explained in the preceding paragraphs. They form the starting point for the acquisition selection.
Synergy is an important factor to consider whether the acquisition will add value to a firm’s portfolio. After the selection of an acquisition candidate DSAG needs to analyze whether synergy can be created and whether this will add value to the existing portfolio. The acquisition candidate will be an aircraft engine component supplier with which Standard Aero will integrate. The aforementioned considerations of this research lead to a definition of a research goal and a research question. These will be discussed in the next chapter.
Synergy is commonly defined as 1+1=3. This definition of synergy does not allow a detailed
analysis of possible synergy benefits for companies. In this research a definition of synergy needs to
be identified which can be used to assess and value the benefits of acquiring a company. This
assessment is crucial to identify whether SA will be able to achieve its growth targets when
acquiring a company involved in the manufacturing of aerospace powerplants. The methodology
that will be used to identify and value synergy will be described in the research framework
§ 1.3 Research Framework
In this chapter a research framework will be laid out in order to make a systematic and orderly approach to the collection and analysis of data. The research framework will consist of the following:
•
Research goal
•
Research question
•
Methodology
•
Conceptual model
§ 1.3.1 Research goal
In order to add value to the existing portfolio DSAG wants to research the possibility to acquire a company involved in the manufacturing of aerospace powerplant systems. There are three distinct objectives that can be identified in this research. First the assumption, whether aerospace manufacturing firms are more profitable than the ERO activities of Standard Aero, needs to be tested in order to validate the research of an acquisition candidate involved in aircraft engine component manufacturing. Second the acquisition candidate needs to be selected. Third an analysis needs to be made on the creation of value to the existing portfolio of DSAG by acquiring an aircraft engine component manufacturer. The goal is to provide recommendations on all of these three objectives to the management group of Standard Aero.
These conditions are summed up in the following goal for this research:
To provide recommendations to Standard Aero on the acquisition of a company involved in the manufacturing of aerospace powerplant systems and the creation and valuation of synergy after the acquisition.
§ 1.3.2 Research question
In order to fulfill the objective in this research the following question needs to be answered:
Whether and which company involved in the manufacturing of aerospace powerplant system should Standard Aero acquire and how can this acquisition create synergy in order to add value to the existing portfolio of DSAG?
The main research question is subsequently broken down into separate sub questions, which need to be answered.
•
Are aerospace manufacturing firms more profitable than the Engine Repair and Overhaul activities of Standard Aero?
•
Which company involved in the manufacturing of aerospace powerplant systems should Standard Aero acquire?
•
How can synergy be obtained when acquiring a component manufacturer and how will this add
value to the existing portfolio of DSAG?
§ 1.3.3 Research scope
In order to fulfill the stated objectives within the set time period of six months the scope will be narrowed. First only turbine engines that provide propulsion to fixed wing aircraft will be considered in this research. Second the acquisition company needs to be a company or a division of a company with less than $ 250 million in revenues, due to the financial limitations of DSAG. Third the acquisition candidate will be searched in the geographical area of Europe. And finally this research will not give recommendations on divestment of companies in the existing portfolio.
§ 1.3.4 Methodology
Since this research has three distinct research questions the methodology in order to answer these questions and to fulfill the stated research objective will be split up in three different parts.
§1.3.4.1 Profitability Analysis
The assumption whether aerospace manufacturing firms are more profitable than the ERO activities of Standard Aero needs to be tested in order to validate the research of an acquisition candidate involved in aircraft engine component manufacturing. This will be done by testing a sample of companies involved in aerospace manufacturing. By using their annual financial reports their profitability will be analyzed. The ROS per year (Return on Sales or operating margin) will be calculated over a period of five years. These figures will be compared with the ROS of Standard Aero of the past five years.
§1.3.4.2 Acquisition Candidate Selection
The acquisition candidate needs to be selected. Standard Aero wants to acquire an aircraft engine component supplier. In order to make a structured selection a few issues need to be considered.
First of all the acquisition candidate will need to offer synergetic benefits to Standard Aero. This means that the activities of the acquisition candidate need to be related to the activities of Standard Aero. The main activity of Standard Aero is to provide MRO for turbine engines. SA only provides MRO to a number of specific engine models. An overview of these engine models can be seen in figure 1.6.
Figure 1.6 Standard Aero engine MRO programs by type and OEM (Source: Standard Aero 2003)
Considering the scope of this research, the acquisition candidate needs to be involved in fixed wing aircraft engines. This means that the engine programs that are related to this research are only the turbofan and turboprop type engines. In order to increase the possibility of synergetic benefits the acquisition candidate needs to be involved in the manufacturing of components for at least one of the engines in the turbofan or turboprop engine programs of SA. Since the end goal of the
Rolls Royce Pratt & Whitney Honeywell General Electric
Turboshaft GEM42
A250
Turbofan AE3007 CF34
Turboprop T56/501D PW100
AE2100 PT6A
APU GTC36 & 85 series
Marine & Industrial Engines 501K LM1600
acquisition is to add value to the existing portfolio of DSAG another important consideration needs to be made. Not all engine programs are in the same phase of their product life cycle. It is generally acknowledged that products in a decline phase are less profitable and offer less future opportunities than products in a growth phase.
In order to establish which products offer the best opportunities for SA a portfolio analysis will be made. A portfolio analysis analyses the balance of an organization’s strategic business units. It is a key aspect of strategic capability to ensure that the portfolio is strong (Johnson & Scholes, 1999).
Portfolio analysis can be used to describe the current range of SBUs and to assess the ‘strength’ of the mix both historically and against future scenarios. The Boston Consultancy Group (BCG) proposed one of the first ways of classifying business units – in relation to market growth and company relative market share. This portfolio analysis will be made for two different years, 2000 and 2002, in order to give a dynamic view of the portfolio. From this analysis the two most promising engines will be selected. Once these engines are selected, a further analysis of these engine types will be made.
According to its strategy Standard Aero wants to build complete turbine engines. The know-how and capabilities that are associated with the development and production of turbine engines would increase its competitive advantage in the turbine engine industry. This would allow SA to offer a higher valued product to the end customer, the operator. SA does not have the know-how and capabilities at this moment since it is only active on the aftermarket of turbine engines. If it were to produce the engines on which it currently performs MRO, this would mean that SA would need to acquire an OEM such as GE or Rolls Royce. This scenario does not fit the existing resources of the company, since most OEMs have a revenue size which is many times larger than $ 250 million.
If the engine manufacturers are not an option for acquisition, SA should look for component suppliers of one or more of these OEMs. However since a turbine engine consists of a relatively large number of different parts (up to thousands of different parts), the question arises on which parts SA should focus.
An answer to this question can be given by looking at the value of the different parts. The goal of SA is to increase know how and capabilities in development and production. This can also be seen as to increase the intellectual property (IP) of the organization. Those parts that involve high IP in the design and production stage are then of interest to SA. Since IP usually involves high investment it is a logical assumption that those parts that have a high value have a high corresponding IP.
Every part of an aircraft engine has a specific financial value. When an aircraft engine is overhauled parts that not pass inspection are either repaired or replaced. Generally it costs the customer more when a part is replaced instead of repaired. When a part is replaced with a new part SA buys the part from the engine OEM. The engine OEM may or may not manufacture this part in-house.
Engine parts that are not made in-house by the OEM are however sold through the OEM with a premium. In engine maintenance the cost of spares and material represent 60-70% of the total overhaul cost of an engine. Prices for new parts from OEMs have increased in excess of 60% over the past 10 years
8. An analysis of the material usage for overhaul at SA will be made. This analysis will provide an insight in those parts that form the highest costs in an annual overhaul for a specific engine. The acquisition candidate selection will then be based on those companies that are involved in manufacturing those parts that represent the highest value (costs).
8 Source: MRO Management, PMA Parts thrust into new markets, p 10, June 2002
Another reason for performing this material value analysis can be found in the repair strategy of SA. Since it costs the customer less when a component is repaired rather than replaced, SA has been focusing on repair development of parts. The material value analysis identifies those parts that are renewed and thus not repaired. If SA can gain the necessary know-how and capabilities of the design and production of these parts it will be able to leverage this to the repair development of those parts. Therefore SA would gain the most potential benefit if it looks at acquiring know-how and capabilities of the parts that represent the highest value in terms of renewal.
Considering the aforementioned scope of the research and the preceding considerations an appropriate acquisition candidate will be searched using two sources of information. First the
‘World Aviation Directory’ will be used to look for the appropriate companies. Second search engines such as Google will be used to scan the Internet to validate the information from the first source.
§1.3.4.3 Synergy Research
The potential synergetic benefits need to be identified in order to find out whether the acquisition candidate will add value to the portfolio of DSAG. This part of the research will consist of a literature research and in depth interviews. The goal of this literature research is threefold.
Integration is essential in creating synergetic benefits (Haspeslagh & Jemison 1991), so first of all literature needs to be studied whether there are specific forms of integration when acquiring a company. The most suitable form of integration for SA needs to be identified. Second the sources of synergetic benefits need to be identified. These sources can for example be the integration of production of two firms or the sharing of marketing tools.
Interviews held with acquisition experts from SA that have different company functions (e.g.
Engineering, Finance, Marketing) will give an overview of possible synergies based on the current competencies of the company. In total six interviews were conducted. Two interviews were phone conversations; the other four were face-to-face conversations. The answers on the questions were recorded on paper by the interviewer. A complete overview of the questions and the interviewed employees of SA can be found in appendix C. The questions were all open questions in order to trigger the minds of the interviewees. The questions and respective answers also initiated deeper discussion on the topics. The interviews had a time span of thirty minutes up to an hour.
Third the synergetic benefits need to be valued in order to answer the question whether the acquisition will create added value for the portfolio of DSAG. From existing literature on synergy a model will be developed that will give SA recommendations on all of these three subjects. This will be a specific model for SA that can be used to identify and value potential synergy when acquiring a company involved in the manufacturing of aircraft engines or more specific components for aircraft engines.
§ 1.3.5 Schematic representation of research
The scheme presented in figure 1.7 is derived from the conventional view of acquisitions as
described by Haspeslagh and Jemison (1991). It is a schematic description of the topics that are
covered in the research.
Research Focus
⇒ Growth by Acquisition
⇒ Increase ROS, RONA of portfolio DSAG
⇒ Selection of component supplier according to migration paths and SA domain
⇒ Profitability analysis
⇒ Portfolio Analysis
⇒ Material value analysis
⇒ Company search
⇒ Identification of synergy sources
⇒ Fit of company in DSAG strategic architecture
⇒ Valuation of Synergy
⇒ Valuation of Acquisition Candidate (not part of research) Strategic
Objectives
Search &
Screening
Strategic Evaluation
Financial Evaluation
Negotiation Agreement Integration
Figure 1.7 Conceptual model research on acquisition candidate and synergy valuation
The search and screening analyses will be discussed in chapter 2. Chapter 3 will contain the synergy
research which is part of the strategic evaluation and the financial evaluation as presented in figure
1.7. The valuation of an acquisition candidate will not form part of this research. In chapter 4
conclusions will be made and recommendations will be presented.
Chapter II Search & Screening
N.A.
Chapter III Synergy
§ 3.1 Introduction
This chapter will deal with the third sub question of this research.
How can synergy be obtained when acquiring a component manufacturer and how will this add value to the existing portfolio of DSAG?
In order to answer this question the concept of synergy and value creation will need to be defined.
In paragraph 3.1 the concept of synergy will be analyzed using the perspectives of different authors.
In paragraph 3.2 the concept of value creation will be linked with the concept of synergy. In paragraph 3.3 post acquisition integration as a means to achieve synergy is discussed. In paragraph 3.4 a method to identify synergy will be presented. In paragraph 3.5 the perspective on synergy within Standard Aero will be analyzed. This is the perspective of key informants within the organization of how synergy can be obtained by acquiring a component manufacturer. This perspective will be analyzed by using the view on synergy from literature.
Synergy is commonly defined as 1+1=3. This definition is of limited use when a company needs to identify and value synergies. To make an analysis of potential synergy benefits possible this chapter will provide a more manageable definition and methodology of the concept of synergy.
§ 3.1.1 Background of concept
Before providing a detailed and manageable definition of the concept of synergy, this paragraph will provide an insight to the background of the concept. According to Hitt (2001) synergy is derived from a Greek word meaning ‘working together’. Throughout the last century this word has been used by a number of authors.
The concept of synergy is at the core of resource-based thinking, dating back to Penrose’s seminal contribution (Iversen, 1997). More specifically Penrose (1959), without using the actual word though, was concerned with two forms of synergy: the possibility of sharing particularly managerial resources, which is brought about due to inevitable indivisibility’s of resources, and transfer of excess (and limitedly tradable) resources. According to Porter (1987) those are the only kinds of synergy available to firms. Ansoff (1965, p. 80) describes four types of synergy:
1. Sales synergy occurs when different products use common distribution channels, common sales administration, or common warehousing.
2. Operating synergy includes higher utilization of facilities and personnel, spreading of overhead, advantages of common learning curves, and large-lot purchasing.
3. Investment synergy is the result of joint use of plant, common raw materials inventories, transfer of R&D from one product to another, common tooling and machinery.
4. Managerial synergy is possible when a new business venture faces strategic, organizational or
operating problems, which are similar to problems that the management has dealt with in the past.
Ansoff does not explain the reasons for these synergies, but Porter (1985) provides the following explanation: “sharing has the potential to reduce cost if the cost of a value activity is driven by economies of scale, learning or the pattern of capacity utilization”. A formal representation of synergy (ROI (a, b) > ROI (a) + ROI (b)
9) implies that there is more to synergy than just economies of scope (C (a, b) < C (a) + C (b)
10, (Teece, 1982 and Teece, Rumelt, Dosi and Winter, 1994). One obvious difference between the two terms is that synergy is concerned with more than the cost of production, even when production is defined in a broad sense. In other words, costs are only part of the equation (ROI=(R-C/I). Where economies of scope deal with the reduced costs of joint production (i.e. resource sharing) versus separate production, synergies are also about increasing revenue and reducing the need for investment.
From these authors we can deduct a couple of aspects of synergy. Synergy effects are created when resources of firms or business units are shared or joined. The synergy benefits do not only create cost reduction but can also increase revenues. Furthermore synergy can be broken up into different forms.
§ 3.1.2 Synergy Definitions
Lately a large number of authors deal with the concept of synergy. The following is a brief overview of definitions from a number of authors.
Haspeslagh and Jemison (1991): Synergy occurs when capabilities transferred between firms improve a firm’s competitive position and consequently its performance.
Gaughan (1991): Synergy is the capability to make a corporate combination more profitable than the profit of the two individual firms.
Goold and Luchs (1993): Synergy can be achieved when the performance of a portfolio of business adds up to more than the sum of its parts.
Sirower (1997): Synergy is increases in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently.
Rappaport (1998): To create value, the present value of synergies must be greater than the premium paid. Remember, the buyer pays the premium up front and buys an option on uncertain future synergies. In other words, the premium is an advance payment on a speculative synergy bet.
Hitt et. al. (2001): Synergy is merely a possibility of competitive advantages and value creation until appropriate and effective actions are taken.
From these definitions some commonalities can be drawn. First of all most of the definitions explain synergy as a driver for the improvement of performance. This implicates a cause and effect relation. Second synergy is identified as a way in which the company increases the performance more than the sum of the independent parts. So synergy is not just a performance improver. The definitions implicate a positive effect of connecting two companies or business units. Third most definitions imply some form of action to be taken in order to obtain the positive effects.
9 ROI: Return on Investment
10 C: Costs
If synergy is divided into a cause and effect relationship than the concept can be used to identify and value synergy benefits. First the sources of synergy must be identified. The sources bring about the possibility of the synergy benefits. Second the synergy benefits must be described. The positive or negative effects must be typified. The positive or negative effects must than be translated into quantitative terms. This is part of the valuation of synergies and will be discussed in paragraph 3.2.
Another conclusion that can be drawn from looking at the different definitions is that there is no common way of looking at the concept of synergy. Janssen and van Heuvelen (1999) identify three different approaches for the identification and realization of synergies:
•
Portfolio Approach: The company is an investor of financial interests in her daughters and aims predominantly at achieving financial synergy. The business units share financial resources of the conglomerate. A widely accepted criticism of this approach is that shareholders are much more capable of putting together a diversified portfolio in order to maximize their returns.
•
Value Chain Approach: The business units share capabilities and activities. Headquarters stimulates the cooperation of the different business departments. This approach is based on the Porterian value chain. By combining the value chains of the different business units, the mutual dependencies are portrayed. The linking of activities, capabilities and knowledge that the units share is crucial.
•
Core Competency Approach: The company is structured around a number of fundamental competencies. Headquarters has a dominant role in the strategy development of the entire company. Synergy is obtained by combining activities that have mutual competencies.
Janssen and van Heuvelen (1999) argue that the value chain approach is the best way to measure the value of synergy. This approach is suitable when two companies decide to horizontally integrate. In these circumstances the companies are usually competitors of each other, which is why the value chains are relatively similar.
In the case of SA the core competency approach is more interesting, since the company tries to develop new products and better services around its competencies. An acquisition of a component manufacturer is in fact an investment in more competencies.
§ 3.1.3 Synergy Sources
Janssen and van Heuvelen (1999) make a distinction between synergy factors and synergy effects.
The factors are the actual sources of the synergy effects. They identify three synergy factors. These are shared activities, shared knowledge and capabilities, shared image and values.
Campbell and Goold (1998) make a similar distinction in sources and benefits. They identify six types of synergy: shared know-how, shared tangible resources, pooled negotiating power, coordinated strategies, vertical integration and combined new business creation. For each of these types they explain what the possible benefits can be.
Hitt et. al. recognize four foundations to the creation of synergy. These foundations are strategic fit, organizational fit, managerial actions, and value creation.
As to strategic fit: there are four potential sources of strategic fit that can lead to synergy through
merger and acquisition activity. These sources of strategic fit are operations synergy,
R&D/technology synergy, marketing-based synergy, and management/managerial synergy. In each
instance, synergy is created through the integration of value-enhancing activities between two or more units or businesses.
Organizational fit occurs when two organizations or business units have similar management processes, cultures, systems and structures. As a foundation to synergy creation, organizational fit means that firms are characterized by a reasonably high degree of compatibility.
The third foundation of the creation of synergy concerns actions and initiatives that managers take for their firms to actually realize the competitive benefits that are promised by the prospects of different types of synergy. In other words, creating synergy requires the active management of the acquisition process. When considering the need for proactive behavior on their part to create synergy, managers should recognize the magnitude of integration issues and the pervasiveness of human resource concerns that surface often when engaged in efforts to create synergy.
Value creation is the last of the four synergy creation foundations. The point with this foundation is that, for synergy to be created, the benefits that can be derived from synergy must exceed the costs associated with developing and exploiting it. The costs that could be less than the value of the synergy that is created include those associated with (1) a purchasing premium, (2) the financing of the transaction, and (3) the set of implementation actions required to integrate the acquired unit into the existing organizational structure.
§ 3.1.4 Synergy Benefits
The synergy factors can lead to synergy effects. Janssen and van Heuvelen (1999) identify both positive as well as negative effects. The positive effects or synergy effects are economies of scale, economies of scope and learning capabilities. The negative effects or antagonisms are complexity, priority issues and inflexibility. The effects must eventually lead to a potential additional value for the company. The positive effects can lead to an increase in value through an increase in revenues, a decrease in costs, a reduction in net investments for fixed assets and working capital or a reduction in the required returns demanded by the capital markets.
Campbell and Goold (1998) give an extensive description of synergy benefits per identified type or source (see § 3.1.3).
Shared know-how: The benefits associated with the sharing of knowledge and competencies across the portfolio. It may involve sharing of best practice in certain business processes, or leveraging expertise in functional areas, or pooling knowledge about how to succeed in specific geographical regions. The know-how may be written up in manuals, policies and procedures, but very often it is less formally documented. In some cases, it is more a matter of sharing the way that skilled managers go about their work. The emphasis that many companies now give to leveraging core competencies and sharing best practices reflects the importance of this type of synergy.
Shared tangible resources: The benefits from economies of scale and elimination of duplicated effort when physical assets and resources are shared - for example, when businesses use a common manufacturing facility research laboratory. Companies often justify acquisitions of related businesses by the synergies and cost reductions that are anticipated from the sharing of resources.
Pooled negotiating power: The cost or quality benefits that can be gained from purchasing scale. It
also covers the benefits from joint negotiation with other stakeholders such as customers,
governments, universities, etc. A number of companies have identified surprisingly large benefits
through common purchasing of inputs used by several of their businesses.
Coordinated strategies: The benefits that arise from aligning the strategies of two or more businesses: for example, by reducing competition between units (e.g. by allocating markets) or coordinating reactions to shared competitors (e.g. multi-point competition). In principle, this can be an important source of synergy benefits, but striking the right balance between corporate intervention and business unit autonomy is not easy.
Vertical integration: coordinating the flow of products and services from one unit to another.
Benefits come from lower inventory costs, shared product development, better capacity utilization and improved market access. In industries such as petrochemicals and forest products, well- managed vertical integration can yield major benefits.
Combined new business creation: The creation of new businesses by combining know-how from different units, by extracting activities from different units to put into a new unit, and by internal joint ventures or alliances between units. With the increased concern for corporate regeneration and growth, several companies have placed added emphasis on this type of synergy.
§ 3.2 Value creation
Once sources for synergy and their corresponding benefits have been identified, the next step is to value the benefits and/or negative effects of synergy. There is not one common methodology in order to value synergies, although there are some authors that have tried to establish a methodology.
An important reason for valuating synergies is the price premium issue of acquisitions. Quite often acquisitions are achieved by paying a higher price than the stand-alone value of the company. The combined company will need to achieve a higher performance than the targets that were used to calculate the stand-alone value of the acquired company. This improved performance needs to be higher than the premium paid in order to create value. This performance is to be obtained from synergetic benefits. If the value of the synergetic benefits is lower than the premium paid than value is destroyed.
Hitt (2001) identifies a need for valuation by saying that mergers and acquisitions are completed to create value for shareholders. More strictly, the synergy motive for acquisitions suggests that these transactions take place in anticipation of economic gains that can result from the merging of the resources of two units or firms. Beyond this, the argument is that acquisitions should take place only when gains will accrue to acquirer firm shareholders. In free-market economies, the main interest of the firm agents/decisions (i.e. top-level managers) should be to enhance the value of shareholders’ ownership positions in the firm when seeking to create synergy through acquisitions.
So it is important to value synergy to justify price premiums on acquisitions and to satisfy the objectives of the shareholders. However it is striking that even though synergy is such an important aspect of acquisitions there is no common identified methodology. Reason for this fact may be found in the variety of synergy sources and benefits that exist. However Janssen and van Heuvelen (1999) have proposed a method in order to calculate the synergy benefits. The most important aspects of this calculation will be presented in this paper.
First Janssen and van Heuvelen (1999) make a clear distinction in value and price. Value is defined
as the value of the company or the synergy potential for the buyer. Price refers to the amount that is
agreed upon by the two parties involved in an acquisition for the actual purchase of the company.
Second the method is based on the use of the Discounted Cash Flow (DCF) valuation of companies.
According to Janssen and van Heuvelen (1999) the DCF methodology is most suitable for the valuation of synergies. The method forces the calculator to judge about the future of the company.
The focus is not on the accounting profit but on the free cash flows from the exploitation of the company. These are the profits and depreciations that result from the exploitation after deduction of the necessary investments in fixed assets and working capital (Elfers, 2001).
By using the DCF method the elements of time and chance are incorporated in the valuation of synergies. According to Sirower (1997) these are two elements that were often missing in the analysis of acquisitions.
In the methodology of Janssen and van Heuvelen (1999) the starting point for the actual calculation is the analysis of the synergy factors of the two companies. Next the possible effects are qualified.
This analysis is done by looking at the value chains of the two companies. An example of shared activities in two value chains is presented in figure 3.1. Each activity where synergies might occur is listed. After this the effects are defined as being positive or negative. Then each effect gets a score. This score is based on analysis of three different aspects. These aspects are significance (the relative size of the effect), relevance (the type of effect) and specificity (the degree of relevance of the two companies). The score ranges from 1 to 5 in absolute numbers. The number 5 describes an optimal performance on the criteria; the number 1 describes a very low chance that synergy effect will have an influence. An example of the scoring of the activities is visualized in figure 3.2.
Company infrastructure Human Resource Management Technology Development Procurement
Inbound Logistics
Production Outbound Logistics
Marketing
& Sales Service
Margin
Company infrastructure Human Resource Management Technology Development Procurement
Inbound Logistics
Production Outbound Logistics
Marketing
& Sales Service
Margin Shared
Logistics
Shared Human Resource Management
Shared Marketing
Figure 3.1 An example of shared activities in two value chains (Source: Janssen and van Heuvelen, 1999)
Effect Nature Score Comment
Inbound logistics
Inventory costs + 1 Shared warehouse
Purchase of raw materials + 1 In house production
Production
Production costs + 4 Better use of capacity
Outbound logistics
Distribution costs + 5 Better use of own transportation
Marketing and sales
Advertising costs + 3 Shared execution
Sales costs + 2 Uniting sales force (less sales people)
Technology development
R&D -/+ 4 Shared execution
Human Resource Management
Labour costs + 3 Reduce employees
Coordination - 2 Long communication lines
Company infrastructure
Accomodation costs + 5 Together under one roof
Overhead + 4 Administration, planning
Information System - 5 Improved communication necessary
Shared image and shared values
Margin + 4 Higher margin possible
Revenues + 3 Increased revenues
Figure 3.2 Example of shared activity scoring (Source: Janssen and van Heuvelen, 1999)
After the identification and scoring of effects the next step is to quantify them. Since the effects relate directly to the value chain of the company, it is relatively simple to transfer the effects into cash flows. The cash flows consist of revenues, costs, depreciations, mutations in provisions, and investments or divestments in fixed assets and working capital.
Only those effects that have a score of three or higher are quantified. The effects are quantified over
a couple of years (i.e. five or ten years). The synergetic results expressed in cash flows are
calculated by presenting the synergetic effect as a percentage in a certain year relating to a base
year. This percentage represents the degree of change in relation to the base year. A positive
percentage represents a decrease in costs or an increase in revenues. A negative percentage
represents the opposite. The percentages of five consecutive years are placed in the columns 5 to 9
of figure 3.3.
Synergy from company exploitation in case of merger between company X and Y
1 2 3 4 5 6 7 8 9
Type of activity Synergy effect Nature Base level year 1 year 2 year 3 year 4 year 5 Inbound logistics
Production Outbound logistics Marketing and sales Service
Technology development HRM
Company infrastructure Know how and capabilities Image and values
Figure 3.3 Calculation synergy from exploitation of merged companies (Source: Elfers, 2001)
Than the percentages are transformed into cash flows using a conversion rate. A decrease in production costs for example increases the free cash flows by the same amount, which leads to an conversion rate of 100%.
The chance that synergy can be realized varies per effect. The risk element is processed in the synergetic positive and negative effects. The chance of realization is often lower when the measurability of an effect is lower (as with shared values and image) and when the effect is further in the future, in other words when the uncertainty is higher.
After establishing the chances, the cash flows are calculated. The base value is multiplied by the synergy percentage, the exchange rate and the realization chance. The outcomes are calculated for each year. Then the yearly totals are summed up. The sum represents the synergetic result before taxation. The yearly totals are placed in columns 12 to 16 in figure 3.4.
Synergy from company exploitation in case of merger between company X and Y
10 11 12 13 14 15 16 17
Type of activity Synergy effect Conversion rate Probability factor year 1 year 2 year 3 year 4 year 5 Basis End Value Inbound logistics
Production Outbound logistics Marketing and sales Service
Technology development HRM
Company infrastructure Know how and capabilities Image and values
Synergetic result before taxes Tax
Synergetic result after taxes
Figure 3.4 Calculation synergy from exploitation of merged companies (Source: Elfers, 2001)
The sum of the synergetic cash flows per year represent the synergetic result before taxation. After
deduction of the appropriate company taxes the synergetic result after taxation is quantified. The
next step is to calculate the remaining cash flows, which are the depreciations, mutations in provisions, and investments or divestments in fixed assets and working capital. The remaining cash flows are displayed in figure 3.5.
Total Synergy in case of merger between company X and Y
11 12 13 14 15 16 17
Type of activity Probability factor year 1 year 2 year 3 year 4 year 5 Basis End Value Synergetic result after taxes
Investments Divestments Depreciations Working capital Other Cash flows Total Cash Flows
Discount rate
Net present value of cash flows
Total Synergy potential
