Exam 5: Implementation: Search Through Closing: Phases 310 of the Acquisition Process

In the context of M&A, synergy represents the incremental cash flows generated by combining two businesses. Identify the potential synergies you believe could be realized in Google's acquisition of Nest that could be achieved by leveraging other Google products and services. Be specific. Identify synergies Google is not likely to realize by operating the firm as a wholly-owned largely autonomous subsidiary. Speculate as to why Google has chosen to operate Nest in this manner.

Elaborate multimedia presentations made to potential lenders in an effort to "shop" for the best financing are often referred to as the "road show."

McKesson HBOC Restates Revenue McKesson Corporation, the nation’s largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1 billion stock deal in early 1999. The transaction was touted as having created the country’s largest comprehensive health care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998 revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice, and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the new chair of McKesson HBOC. As one of the decade’s hottest stocks, it had soared 38-fold since early 1992. McKesson’s first attempt to acquire HBO in mid-1998 collapsed following a news leak. However, McKesson’s persistence culminated in a completed transaction in January 1999. In its haste, McKesson closed the deal even before an in-depth audit of HBO’s books had been completed. In fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm, Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to surface. By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This evidence underscored HBO’s efforts to deliberately accelerate revenues by backdating contracts that were not final. Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing so, they were able to boost reported earnings, the company’s share price, and ultimately the purchase price paid by McKesson. In mid-July, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the past 3 fiscal years to correct for accounting irregularities. The company’s stock had fallen by 48% since late April when it first announced that it would have to restate earnings. McKesson’s senior management had to contend with rebuilding McKesson’s reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not having adequate access to HBO’s records, McKesson decided to close the transaction anyway. -Assume an audit had been conducted and HBO's financial statements had been declared to be in accordance with GAAP. Would McKesson have been justified in believing that HBO's revenue and profit figures were 100% accurate?

The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company's diversified mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost competitiveness but also potentially subjects the company to a variety of global uncertainties. K2’s success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The company’s external analysis at the time showed that the most successful sporting goods suppliers will be those with the greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands. Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them manage the supply of products and the allocation of shelf space. The firm’s primary customers are sporting goods retailers. Many of K2’s smaller retailers and some larger retailers were not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals. The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand recognition and financial resources with whom K2 did not compete. However, they could easily enter K2’s currently served markets. In the company’s secondary business, sports apparel, it did face stiff competition from some of these same suppliers, including Nike and Reebok. K2’s internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2 was its relatively small size in comparison to major competitors. As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent within five years; and reduce its debt-to-equity ratio to the industry average of 25 percent in the same period. The business strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2 planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than China. All this required an implementation strategy. K2 decided to avoid product or market extension through partnering because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy would build on the firm’s great success, in recent years, acquiring and integrating smaller sporting goods companies with well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams. Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment. In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings. K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm against the business plan. In its acquisition plan, K2’s overarching financial objective was to earn at least its cost of capital. The plan’s primary non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and promotional products that could be easily integrated into K2’s current operations. The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a merger, the target’s sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain management, key employees, customers, distributors, vendors and other business partners of both companies. An evaluation of financial risk showed that borrowing under K2’s existing $205 million revolving credit facility and under its $20 million term loan, as well as potential future financings, could substantially increase current leverage, which could – among other things – adversely affect the cost and availability of funds from commercial lenders and K2’s ability to expand its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital. Ultimately, management set some specific preferences: the target should be smaller than $100 million in market capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The initial search, by K2’s experienced acquisition team, would involve analyzing current competitors. The acquisition would be made through a stock purchase – and K2 chose to consider only friendly takeovers involving 100 percent of the target’s stock – and the form of payment would be new K2 non-voting common stock. The target firm’s current year P/E should not exceed 20. After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash flows, complementary product offering, and many licenses with most of the major sports leagues and college teams. Fotoball USA represented a premier platform for expansion of K2’s marketing capabilities because of its expertise in the industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2 believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high earning growth rate of the combined firms. Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is a very young company and many of its investors were looking to make their profits through the growth of the stock. The offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet deadlines in a timely order. Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely, reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated at $909 million – an increase of $82.7 million over the sum of the standalone values of the two firms. Based on Fotoball’s outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious dilution of earnings. To determine the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion of the combined firms revenues would be contributed by each of the players and then applied that proportion to the synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2, only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8 million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball’s stock at the time. The synergies and the Fotoball’s relatively small size compared to K2 made it unlikely that the merger would endanger K2’s credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the addition of Fotoball would help diversify and smooth K2’s revenue stream, which had been subject to seasonality in the past. Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best practices of both firms. On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after, senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any immediate concerns. -What alternatives to M&As could K2 have employed to pursue its growth strategy? Why were the alternatives rejected?

The buyer's ability to obtain adequate financing is a closing condition common to most agreements of purchase and sale.

There is no need for the seller to perform due diligence on its own operations to ensure that its representations and warranties in the definitive agreement are accurate.

What are the potential threats to Google's current vision and business strategy?

All of the following are true of closing except for

Exxon Mobil’s (Exxon) Unrelenting Pursuit of Natural Gas Believing the world will be dependent on carbon-based energy for many decades, Exxon continues to pursue aggressively amassing new natural gas and oil reserves. This strategy is consistent with its core energy extraction, refining, and distribution skills. As the world’s largest energy company, Exxon must make big bets on new reserves of unconventional gas and oil to increase future earnings. _____________________________________________________________________________________ Exxon has always had a reputation for taking the long view. By necessity, energy companies cannot respond to short-term gyrations in energy prices, given the long lead time required to discover and develop new energy sources. While energy prices will continue to fluctuate, Exxon is betting that the world will remain dependent on oil and gas for decades to come and that new technology will facilitate accessing so-called unconventional energy sources. During the last several years, Exxon continued its headlong rush into accumulating shale gas and oil properties that began in earnest in 2009 with the acquisition of natural gas exploration company XTO Energy. While natural gas prices have remained well below their 2008 level, Exxon used the expertise of the former XTO Energy personnel, who are among the most experienced in the industry in extracting oil and gas from shale rock, to identify the most attractive sites globally for future shale development. In 2010, Exxon acquired Ellora Energy Inc., which was active in the Haynesville shale fields in Texas and Louisiana, for $700 million and properties in Arkansas’s Fayetteville shale fields from PetroHawk Energy Corp. In 2011, Exxon bought TWP Inc. and Phillips Resources, which were active in the Marcellus shale basin, for a combined $1.7 billion. Exxon is betting that these properties will become valuable when natural gas prices again rise. By mid-2011, Exxon Mobil had added more than 70 trillion cubic feet of unconventional gas and liquid reserves since the XTO deal in late 2009 through acquisitions and new discoveries. Exxon is now the largest natural gas producer in the United States. The sheer size of the XTO acquisition in 2009 represented a remarkable departure for a firm that had not made a major acquisition during the previous 10 years. Following a series of unsuccessful acquisitions during the late 1970s and early 1980s, the firm seemed to have developed a phobia about acquisitions. Rather than make big acquisitions, Exxon started buying back its stock, purchasing more than $16 billion worth between 1983 and 1990, and spending about $1 billion annually on oil and gas properties and some small acquisitions. Exxon Mobil Corporation stated publicly in its 2009 annual report that it was committed to being the world’s premier petroleum and petrochemical company and that the firm’s primary focus in the coming decades would likely remain on its core businesses of oil and gas exploration and production, refining, and chemicals. According to the firm, there appears to be “a pretty bright future” for drilling in previously untapped shale energy properties—as a result of technological advances in horizontal drilling and hydraulic fracturing. No energy source currently solves the challenge of meeting growing energy needs while reducing CO2 emissions. Traditionally, energy companies have extracted natural gas by drilling vertical wells into pockets of methane that are often trapped above oil deposits. Energy companies now drill horizontal wells and fracture them with high-pressure water, a practice known as “fracking.” That technique has enabled energy firms to release natural gas trapped in the vast shale oil fields in the United States as well as to recover gas and oil from fields previously thought to have been depleted. The natural gas and oil recovered in this manner are often referred to as “unconventional energy resources.” In an effort to bolster its position in the development of unconventional natural gas and oil, Exxon announced on December 14, 2009, that it had reached an agreement to buy XTO Energy in an all-stock deal valued at $31 billion. The deal also included Exxon’s assumption of $10 billion in XTO’s current debt. This represented a 25% premium to XTO shareholders at the time of the announcement. XTO shares jumped 15% to $47.86, while Exxon’s fell by 4.3% to $69.69. The deal values XTO’s natural gas reserves at $2.96 per thousand cubic feet of proven reserves, in line with recent deals and about one-half of the NYMEX natural gas futures price at that time. Known as a wildcat or independent energy producer, the 23-year-old XTO competed aggressively with other independent drillers in the natural gas business, which had boomed with the onset of horizontal drilling and well fracturing to extract energy from older oil fields. However, independent energy producers like XTO typically lack the financial resources required to unlock unconventional gas reserves, unlike the large multinational energy firms like Exxon. The geographic overlap between the proven reserves of the two firms was significant, with both Exxon and XTO having a presence in Colorado, Louisiana, Texas, North Dakota, Pennsylvania, New York, Ohio, and Arkansas. The two firms’ combined proven reserves are the equivalent of 45 trillion cubic feet of gas and include shale gas, coal bed methane, and shale oil. These reserves also complement Exxon’s U.S. and international holdings. Exxon is the global leader in oil and gas extraction. Given its size, it is difficult to achieve rapid future earnings growth organically through reinvestment of free cash flow. Consequently, megafirms such as Exxon often turn to large acquisitions to offer their shareholders significant future earnings growth. Given the long lead time required to add to proven reserves and the huge capital requirements to do so, energy companies by necessity must have exceedingly long-term planning and investment horizons. Acquiring XTO is a bet on the future of natural gas. Moreover, XTO has substantial technical expertise in recovering unconventional natural gas resources, which complement Exxon’s global resource base, advanced R&D, proven operational capabilities, global scale, and financial capacity. In the five-year period ending in 2010, the U.S. Energy Information Administration (EIA) estimates that the U.S. total proven natural gas reserves increased by 40% to about 300 trillion cubic feet, or the equivalent of 50 billion barrels of oil. Unconventional natural gas is projected by the EIA to meet most of the nation’s domestic natural gas demand by 2030, representing a substantial change in the overall energy consumption pattern in the United States. At current consumption rates, the nation can count on natural gas for at least a century. In addition to its abundance, natural gas is the cleanest burning of the fossil fuels. A sizeable purchase price premium, the opportunity to share in any upside appreciation in Exxon’s share price, and the tax-free nature of the transaction convinced XTO shareholders to approve the deal. Exxon’s commitment to manage XTO on a stand-alone basis as a wholly owned subsidiary in which a number of former XTO managers would be retained garnered senior management support. By keeping XTO largely intact in Fort Worth, Texas, Exxon was able to minimize differences due to Exxon Mobil’s and XTO’s dissimilar corporate cultures. -Wht was the total purchase price or enterprise value of the transaction?

What are the differences between total consideration, total purchase price/enterprise value, and net purchase price? How are these different concepts used?

Describe Google's investment strategy? What are the factors driving their investment strategy? How might shareholders eventually react to this strategy? How might this investment strategy hurt the firm long-term?

Bank of America Acquires Merrill Lynch Against the backdrop of the Lehman Brothers' Chapter 11 bankruptcy filing, Bank of America (BofA) CEO Kenneth Lewis announced on September 15, 2008, that the bank had reached agreement to acquire mega–retail broker and investment bank Merrill Lynch. Hammered out in a few days, investors expressed concern that the BofA's swift action on the all-stock $50 billion transaction would saddle the firm with billions of dollars in problem assets by pushing BofA's share price down by 21 percent. BofA saw the takeover of Merrill as an important step toward achieving its long-held vision of becoming the number 1 provider of financial services in its domestic market. The firm's business strategy was to focus its efforts on the U.S. market by expanding its product offering and geographic coverage. The firm implemented its business strategy by acquiring selected financial services companies to fill gaps in its product offering and geographic coverage. The existence of a clear and measurable vision for the future enabled BofA to make acquisitions as the opportunity arose. Since 2001, the firm completed a series of acquisitions valued at more than $150 billion. The firm acquired FleetBoston Financial, greatly expanding its network of branches on the East Coast, and LaSalle Bank to improve its coverage in the Midwest. The acquisitions of credit card–issuing powerhouse MBNA, U.S. Trust (a major private wealth manager), and Countrywide (the nation's largest residential mortgage loan company) were made to broaden the firm's financial services offering. The acquisition of Merrill makes BofA the country's largest provider of wealth management services to go with its current status as the nation's largest branch banking network and the largest issuer of small business, home equity, credit card, and residential mortgage loans. The deal creates the largest domestic retail brokerage and puts the bank among the top five largest global investment banks. Merrill also owns 45 percent of the profitable asset manager BlackRock Inc., worth an estimated $10 billion. BofA expects its retail network to help sell Merrill and BlackRock's investment products to BofA customers. The hurried takeover encouraged by the U.S. Treasury and Federal Reserve did not allow for proper due diligence. The extent of the troubled assets on Merrill's books was largely unknown. While the losses at Merrill proved to be stunning in the short run—$15 billion alone in the fourth quarter of 2008—the acquisition by Bank of America averted the possible demise of Merrill Lynch. By the end of the first quarter of 2009, the U.S. government had injected $45 billion in loans and capital into BofA in an effort to offset some of the asset write-offs associated with the acquisition. Later that year, Lewis announced his retirement from the bank. Mortgage loan losses and foreclosures continued to mount throughout 2010, with a disproportionately large amount of such losses attributable to the acquisition of the Countrywide mortgage loan portfolio. While BofA's vision and strategy may still prove to be sound, the rushed execution of the Merrill acquisition, coupled with problems surfacing from other acquisitions, could hobble the financial performance of BofA for years to come. When Companies Overpay—Mattel Acquires The Learning Company Mattel, Inc. is the world’s largest designer, manufacturer, and marketer of a broad variety of children’s products selling directly to retailers and consumers. Most people recognize Mattel as the maker of the famous Barbie, the best-selling fashion doll in the world, generating sales of $1.7 billion annually. The company also manufactures a variety of other well-known toys and owns the primary toy license for the most popular kids’ educational program “Sesame Street.” In 1988, Mattel revived its previous association with The Walt Disney Company and signed a multiyear deal with them for the worldwide toy rights for all of Disney’s television and film properties Business Plan Mission Statement and Strategy Mattel’s mission is to maintain its position in the toy market as the largest and most profitable family products marketer and manufacturer in the world. Mattel will continue to create new products and innovate in their existing toy lines to satisfy the constant changes of the family-products market. Its business strategy is to diversify Mattel beyond the market for traditional toys at a time when the toy industry is changing rapidly. This will be achieved by pursuing the high-growth and highly profitable children’s technology market, while continuing to enhance Mattel’s popular toys to gain market share and increase earnings in the toy market. Mattel believes that its current software division, Mattel Interactive, lacks the technical expertise and resources to penetrate the software market as quickly as the company desires. Consequently, Mattel seeks to acquire a software business that will be able to manufacture and market children’s software that Mattel will distribute through its existing channels and through its Website (Mattel.com). Defining the Marketplace The toy market is a major segment within the leisure time industry. Included in this segment are many diverse companies, ranging from amusement parks to yacht manufacturers. Mattel is one of the largest manufacturers within the toy segment of the leisure time industry. Other leading toy companies are Hasbro, Nintendo, and Lego. Annual toy industry sales in recent years have exceeded $21 billion. Approximately one-half of all sales are made in the fourth quarter, reflecting the Christmas holiday. Customers. Mattel’s major customers are the large retail and e-commerce stores that distribute their products. These retailers and e-commerce stores in 1999 included Toys “R” Us Inc., Wal-Mart Stores Inc., Kmart Corp., Target, Consolidated Stores Corp., E-toys, ToyTime.com, Toysmart.com, and Toystore.com. The retailers are Mattel’s direct customers; however, the ultimate buyers are the parents, grandparents, and children who purchase the toys from these retailers. Competitors. The two largest toy manufacturers are Mattel and Hasbro, which together account for almost one-half of industry sales. In the past few years, Hasbro has acquired several companies whose primary products include electronic or interactive toys and games. On December 8, 1999, Hasbro announced that it would shift its focus to software and other electronic toys. Traditional games, such as Monopoly, would be converted into software. Potential Entrants. Potential entrants face substantial barriers to entry in the toy business. Current competitors, such as Mattel and Hasbro, already have secured distribution channels for their products based on longstanding relationships with key customers such as Wal-Mart and Toys “R” Us. It would be costly for new entrants to replicate these relationships. Moreover, brand recognition of such toys as Barbie, Nintendo, and Lego makes it difficult for new entrants to penetrate certain product segments within the toy market. Proprietary knowledge and patent protection provide additional barriers to entering these product lines. The large toymakers have licensing agreements that grant them the right to market toys based on the products of the major entertainment companies. Product Substitutes. One of the major substitutes for traditional toys such as dolls and cars are video games and computer software. Other product substitutes include virtually all kinds of entertainment including books, athletic wear, tapes, and TV. However, these entertainment products are less of a concern for toy companies than the Internet or electronic games because they are not direct substitutes for traditional toys. Suppliers. An estimated 80% of toy production is manufactured abroad. Both Mattel and Hasbro own factories in the Far East and Mexico to take advantage of low labor costs. Parts, such as software and microchips, often are outsourced to non-Mattel manufacturing plants in other countries and then imported for the assembly of such products as Barbie within Mattel-owned factories. Although outsourcing has resulted in labor cost savings, it also has resulted in inconsistent quality. Opportunities and Threats Opportunities New Distribution Channels. Mattel.com represents 80 separate toy and software offerings. Mattel hopes to spin this operation off as a separate company when it becomes profitable. Mattel.com lost about $70 million in 1999. The other new channel for distributing toys is directly to consumers through catalogs. The so-called direct channels offered by the internet and catalog sales help Mattel reduce its dependence on a few mass retailers. Aging Population. Grandparents accounted for 14% of U.S. toy purchases in 1999. The number of grandparents is expected to grow from 58 million in 1999 to 76 million in 2005. Interactive Media. As children have increasing access to computers, the demand for interactive computer games is expected to accelerate. The “high-tech” toy market segment is growing 20% annually, compared with the modest 5% growth in the traditional toy business. International Growth. In 1999, 44% of Mattel’s sales came from its international operations. Mattel already has redesigned its Barbie doll for the Asian and the South American market by changing Barbie’s face and clothes. Threats Decreasing Demand for Traditional Toys. Children’s tastes are changing. Popular items are now more likely to include athletic clothes and children’s software and video games rather than more traditional items such as dolls and stuffed animals. Distributor Returns. Distributors may return toys found to be unsafe or unpopular. A quality problem with the Cabbage Patch Doll could cost Mattel more than $10 million in returns and in settling lawsuits. Shrinking Target Market. Historically, the toy industry has considered their prime market to be children from birth to age 14. Today, the top toy-purchasing years for a child range from birth to age 10. Just-In-Time Inventory Management. Changing customer inventory practices make it difficult to accurately forecast reorders, which has resulted in lost sales as unanticipated increases in orders could not be filled from current manufacturer inventories. Internal Assessment Strengths Mattel’s key strengths lie in its relatively low manufacturing cost position, with 85% of its toys manufactured in low-labor-cost countries like China and Indonesia, and its established distribution channels. Moreover, licensing agreements with Disney enable Mattel to add popular new characters to its product lines. Weaknesses Mattel’s Barbie and Hot Wheels product lines are mature, but the company has been slow to reposition these core brands. The lack of technical expertise to create software-based products limits Mattel’s ability to exploit the shift away from traditional toys to video or interactive games. Acquisition Plan Objectives and Strategy Mattel’s corporate strategy is to diversify Mattel beyond the mature traditional toys segment into high-growth segments. Mattel believed that it had to acquire a recognized brand identity in the children’s software and entertainment segment of the toy industry, sometimes called the “edutainment” segment, to participate in the rapid shift to interactive, software-based toys that are both entertaining and educational. Mattel believed that such an acquisition would remove some of the seasonality from sales and broaden their global revenue base. Key acquisition objectives included building a global brand strategy, doubling international sales, and creating a $1 billion software business by January 2001. Defining the Target Industry The “edutainment” segment has been experiencing strong growth predominantly in the entertainment segment. Parents are seeing the importance of technology in the workplace and want to familiarize their children with the technology as early as possible. In 1998, more than 40% of households had computers and, of those households with children, 70% had educational software. As the number of homes with PCs continues to increase worldwide and with the proliferation of video games, the demand for educational and entertainment software is expected to accelerate. Management Preferences Mattel was looking for an independent children’s software company with a strong brand identity and more than $400 million in annual sales. Mattel preferred not to acquire a business that was part of another competitor (e.g., Hasbro Interactive). Mattel’s management stated that the target must have brands that complement Mattel’s business strategy and the technology to support their existing brands, as well as to develop new brands. Mattel preferred to engage in a stock-for-stock exchange in any transaction to maintain manageable debt levels and to ensure that it preserved the rights to all software patents and licenses. Moreover, Mattel reasoned that such a transaction would be more attractive to potential targets because it would enable target shareholders to defer the payment of taxes. Potential Targets Game and edutainment development divisions are often part of software conglomerates, such as Cendant, Electronic Arts, and GT Interactive, which produce software for diverse markets including games, systems platforms, business management, home improvement, and pure educational applications. Other firms may be subsidiaries of large book, CD-ROM, or game publishers. The parent firms showed little inclination to sell these businesses at what Mattel believed were reasonable prices. Therefore, Mattel focused on five publicly traded firms: Acclaim Entertainment, Inc., Activision, Inc., Interplay Entertainment Corp, The Learning Company, Inc. (TLC), and Take-Two Interactive Software. Of these, only Acclaim, Activision, and The Learning Company had their own established brands in the games and edutainment sectors and the size sufficient to meet Mattel’s revenue criterion. In 1999, TLC was the second largest consumer software company in the world, behind Microsoft. TLC was the leader in educational software, with a 42% market share, and in-home productivity software (i.e., home improvement software), with a 44% market share. The company has been following an aggressive expansion strategy, having completed 14 acquisitions since 1994. At 68%, TLC also had the highest gross profit margin of the target companies reviewed. TLC owned the most recognized titles and appeared to have the management and technical skills in place to handle the kind of volume that Mattel desired. Their sales were almost $1 billion, which would enable Mattel to achieve its objective in this “high-tech” market. Thus, TLC seemed the best suited to satisfy Mattel’s acquisition objectives. Completing the Acquisition Despite disturbing discoveries during due diligence, Mattel acquired TLC in a stock-for-stock transaction valued at $3.8 billion on May 13, 1999. Mattel had determined that TLC’s receivables were overstated because product returns from distributors were not deducted from receivables and its allowance for bad debt was inadequate. A $50 billion licensing deal also had been prematurely put on the balance sheet. Finally, TLC’s brands were becoming outdated. TLC had substantially exaggerated the amount of money put into research and development for new software products. Nevertheless, driven by the appeal of rapidly becoming a big player in the children’s software market, Mattel closed on the transaction aware that TLC’s cash flows were overstated. Epilogue For all of 1999, TLC represented a pretax loss of $206 million. After restructuring charges, Mattel’s consolidated 1999 net loss was $82.4 million on sales of $5.5 billion. TLC’s top executives left Mattel and sold their Mattel shares in August, just before the third quarter’s financial performance was released. Mattel’s stock fell by more than 35% during 1999 to end the year at about $14 per share. On February 3, 2000, Mattel announced that its chief executive officer (CEO), Jill Barrad, was leaving the company. On September 30, 2000, Mattel virtually gave away The Learning Company to rid itself of what had become a seemingly intractable problem. This ended what had become a disastrous foray into software publishing that had cost the firm literally hundreds of millions of dollars. Mattel, which had paid $3.5 billion for the firm in 1999, sold the unit to an affiliate of Gores Technology Group for rights to a share of future profits. Essentially, the deal consisted of no cash upfront and only a share of potential future revenues. In lieu of cash, Gores agreed to give Mattel 50% of any profits and part of any future sale of TLC. In a matter of weeks, Gores was able to do what Mattel could not do in a year. Gores restructured TLC’s seven units into three, set strong controls on spending, sifted through 467 software titles to focus on the key brands, and repaired relationships with distributors. Gores also has sold the entertainment division and is seeking buyers for the remainder of TLC. -What alternatives to acquisition could Mattel have considered? Discuss the pros and cons of each alternative?

In contacting large, publicly traded firms, it is usually preferable to make initial contact through an intermediary and at the highest level of the company possible.

Microsoft Invests in Barnes & Noble’s Nook Technology Firm size often dictates business strategy. Diversifying away from a firm’s core skills often is fraught with risk. Accumulated corporate cash balances often create potential agency problems. ________________________________________________________________________________________________ Microsoft, like Apple, has been in business for three decades. Unlike Apple, Microsoft has failed to achieve and sustain the high growth in earnings and cash flow needed to grow its market value. For years, Microsoft has attempted to reduce its dependence on revenue generated from its Windows operating system software and the Office Products software suite by targeting high-growth segments in the information technology industry. Despite these efforts, the firm continues to generate more than four-fifths of its annual revenue from these two product lines. The firm’s ongoing dependence on its legacy products is not due to a lack of effort to diversify. Since 2009, Microsoft has spent more than $10 billion in financing strategic alliances and takeovers. A 2009 Internet search partnership with Yahoo Inc. designed to assist Microsoft in overtaking Google by increasing use of its Bing search engine has gained little traction. In 2011, the firm agreed to supply the mobile operating system for smartphones sold by Nokia Corp. Thus far, Windows-powered smartphones have yet to gain significant market share. That same year the software maker also acquired Skype, the Internet telephony firm, for $8.5 billion in the biggest acquisition in the firm’s history. Its contribution to Microsoft’s revenue and profit growth is unclear at this time. Despite a number of acquisitions during the last few years, Microsoft amassed a cash hoard of more than $60 billion by the end of March 2012. The amount of cash creates considerable pressure from shareholders wanting the firm either to return the cash to them through share buybacks and dividends or to reinvest in new high-growth opportunities. In recent years, Microsoft has tried to do both. Continuing to move aggressively, the software firm announced on April 30, 2012, that it would invest a cumulative $605 million (consisting of $300 million upfront with the balance paid over the next five years to finance ongoing product development and international expansion) in exchange for a 17.6% stake in a new Barnes & Noble (B&N) subsidiary containing B&N’s e-titles and the Nook e-reader technology. The new subsidiary also houses B&N’s college business, viewed as a growth area for e-books. Analysts valued the new B&N subsidiary at $1.7 billion, more than twice B&N’s consolidated value at the close of business on May 1, 2012. After the announcement, B&N’s market value jumped to $1.25 billion. As a result of the deal, the two firms will settle their patent infringement suits, and B&N will produce a Nook e-reading application for the Windows 8 operating system, which will run on both traditional PCs and tablets. Microsoft, through its Windows 8 product, has been forced to radically redesign its Windows operating system to accommodate a future in which web browsing, movie watching, book reading, and other activities occur on tablets as well as PCs and other mobile devices. While Windows 8 will have an “app store,” it is likely to have to be closely aligned with a service for buying books and other forms of entertainment to match better the offerings from its rivals. The partnership is not exclusive to Microsoft, in that B&N can pursue other alliances with the likes of Google. B&N’s e-book business is to remain aligned with the brick-and-mortar stores, of which the firm has 691 retail stores and 641 college bookstores. In making the B&N investment, Microsoft is placing another bet on an industry in which it lags behind its competitors and puts it in competition with Amazon.com Inc., Apple Inc., and Google Inc. The Nook currently runs on Google’s Android software, as does Amazon’s Kindle Fire. The two firms will share revenue from sales of e-books. The partnership also has the potential for Microsoft to manufacture e-readers and for future Nook devices to be powered by Microsoft operating systems. In addition to a much-needed cash infusion, B&N will capture additional points of distribution from hundreds of millions of Windows users around the world, potentially reaching consumers who did not do business with B&N. Previously concerned that B&N would be a marginal competitor in the e-book marketplace, investors boosted B&H shares by 58% to $20.75 on the news. This was the firm’s highest closing price in two years. The firm’s conventional (physical) book business has declined rapidly. With revenue and profits declining, B&N was looking for a strategic partner to accelerate the growth of its e-book business globally. B&N had been accepting offers from a number of potential partners since it accepted a $204 million investment from Liberty Media in 2011 and had been considering a sale or spin-off of the e-book business. B&N claims to have 27% of the U.S. e-book title sales, with Amazon capturing 60%. At one time, Amazon had almost a 90% market share of the e-book market, but this has eroded as new players, such as Apple, Google and now Microsoft, have entered. According to market research firm IHS iSuppli, Apple had 62% of the tablet market in 2011, reflecting the success of its iPad, with Amazon’s Kindle having a 6% share and B&N’s Nook a 5% share. Book publishers appear to have been encouraged by Microsoft’s investment in B&N due to their growing concern that Amazon would dominate the e-book market and the pricing of e-books if B&N were unable to become a viable competitor to Amazon.com. Unlike rivals such as Apple, Microsoft has relied mainly on partners to create hardware that runs its software, with the exception of the Xbox video game unit and the company’s ill-fated Zune media player. Microsoft is constrained by its partnerships, in that if the firm begins to create its own hardware, then it puts itself into direct competition with partners who make hardware such as tablet devices powered by Microsoft operating systems. -Speculate as to why Microsoft seems to be having trouble diversifying its revenue stream away from Windows and the Office Products suite?

Fees charged by investment bankers are never negotiable.

Which of the following is not true of the acquisition process?

The Anatomy of a Transaction: K2 Incorporated Acquires Fotoball USA Our story begins in the early 2000s. K2 is a sporting goods equipment manufacturer whose portfolio of brands includes Rawlings, Worth, Shakespeare, Pflueger, Stearns, K2, Ride, Olin, Morrow, Tubbs and Atlas. The company's diversified mix of products is used primarily in team and individual sports activities, and its primary customers are sporting goods retailers, many of which are not strongly capitalized. Historically, the firm has been able to achieve profitable growth by introducing new products into fast-growing markets. Most K2 products are manufactured in China, which helps ensure cost competitiveness but also potentially subjects the company to a variety of global uncertainties. K2’s success depends on its ability to keep abreast of changes in taste and style and to offer competitive prices. The company’s external analysis at the time showed that the most successful sporting goods suppliers will be those with the greatest resources, including both management talent and capital, the ability to produce or source high-quality, low-cost products and deliver them on a timely basis, and access to distribution channels with a broad array of products and brands. Management expected that large retailers would prefer to rely on fewer and larger sporting goods suppliers to help them manage the supply of products and the allocation of shelf space. The firm’s primary customers are sporting goods retailers. Many of K2’s smaller retailers and some larger retailers were not strongly capitalized. Adverse conditions in the sporting goods retail industry could adversely impact the ability of retailers to purchase K2 products. Secondary customers included individuals, both hobbyists as well as professionals. The firm had a few top competitors, but there were other large sporting goods suppliers with substantial brand recognition and financial resources with whom K2 did not compete. However, they could easily enter K2’s currently served markets. In the company’s secondary business, sports apparel, it did face stiff competition from some of these same suppliers, including Nike and Reebok. K2’s internal analysis showed that the firm was susceptible to imitation, despite strong brand names, and that some potential competitors had substantially greater financial resources than K2. One key strength was the relationships K2 had built with collegiate and professional leagues and teams, not easily usurped. Larger competitors may have had the capacity to take some of these away, but K2 had so many that it could withstand the loss of one or two. The primary weakness of K2 was its relatively small size in comparison to major competitors. As a long-term, strategic objective, K2 set out to be number one in market share in the markets it served by becoming the low-cost supplier. To that end, K2 wanted to meet or exceed its corporate cost of capital of 15 percent; achieve sustained double-digit revenue growth, gross profit margins above 35 percent, and net profit margins in excess of 5 percent within five years; and reduce its debt-to-equity ratio to the industry average of 25 percent in the same period. The business strategy for meeting this objective was to become the low-cost supplier in new niche segments of the sporting goods and recreational markets. The firm would use its existing administrative and logistical infrastructure to support entry into these new segments, new distribution channels, and new product launches through existing distribution channels. Also, K2 planned to continue its aggressive cost cutting and expand its global sourcing to include low-cost countries other than China. All this required an implementation strategy. K2 decided to avoid product or market extension through partnering because of the potential for loss of control and for creating competitors once such agreements lapse. Rather, the strategy would build on the firm’s great success, in recent years, acquiring and integrating smaller sporting goods companies with well-established brands and complementary distribution channels. To that end, M&A-related functional strategies were developed. A potential target for acquisition would be a company that holds many licenses with professional sports teams. Through its relationship with those teams, K2 could further promote its line of sporting gear and equipment. In addition, K2 planned to increase its R&D budget by 10 percent annually over five years to focus on developing equipment and apparel that could be offered to the customer base of firms it acquired during the period. Existing licensing agreements between a target firm and its partners could be enhanced to include the many products K2 now offers. If feasible, the sales force of a target firm would be merged with that of K2 to realize significant cost savings. K2 also thought through the issue of strategic controls. The company had incentive systems in place to motivate work towards implementing its business strategy. There were also monitoring systems to track the actual performance of the firm against the business plan. In its acquisition plan, K2’s overarching financial objective was to earn at least its cost of capital. The plan’s primary non-financial objective was to acquire a firm with well-established brands and complementary distribution channels. More specifically, K2 sought an acquisition with a successful franchise in the marketing and manufacturing of souvenir and promotional products that could be easily integrated into K2’s current operations. The acquisition plan included an evaluation of resources and capabilities. K2 established that after completion of a merger, the target’s sourcing and manufacturing capabilities must be integrated with those of K2, which would also retain management, key employees, customers, distributors, vendors and other business partners of both companies. An evaluation of financial risk showed that borrowing under K2’s existing $205 million revolving credit facility and under its $20 million term loan, as well as potential future financings, could substantially increase current leverage, which could – among other things – adversely affect the cost and availability of funds from commercial lenders and K2’s ability to expand its business, market its products, and make needed infrastructure investments. If new shares of K2 stock were issued to pay for the target firm, K2 determined that its earnings per share could be diluted unless anticipated synergies were realized in a timely fashion. Moreover, overpaying for any firm could result in K2 failing to earn its cost of capital. Ultimately, management set some specific preferences: the target should be smaller than $100 million in market capitalization and should have positive cash flows, and it should be focused on the sports or outdoor activities market. The initial search, by K2’s experienced acquisition team, would involve analyzing current competitors. The acquisition would be made through a stock purchase – and K2 chose to consider only friendly takeovers involving 100 percent of the target’s stock – and the form of payment would be new K2 non-voting common stock. The target firm’s current year P/E should not exceed 20. After an exhaustive search, K2 identified Fotoball USA as its most attractive target due to its size, predictable cash flows, complementary product offering, and many licenses with most of the major sports leagues and college teams. Fotoball USA represented a premier platform for expansion of K2’s marketing capabilities because of its expertise in the industry and place as an industry leader in many sports and entertainment souvenir and promotional product categories. K2 believed the fit with the Rawlings division would make both companies stronger in the marketplace. Fotoball also had proven expertise in licensing programs, which would assist K2 in developing additional revenue sources for its portfolio of brands. In 2003, Fotoball had lost $3.2 million, so it was anticipated that they would be receptive to an acquisition proposal and that a stock-for-stock exchange offer would be very attractive to Fotoball shareholders because of the anticipated high earning growth rate of the combined firms. Negotiations ensued, and the stock-for-stock offer contained a significant premium, which was well received. Fotoball is a very young company and many of its investors were looking to make their profits through the growth of the stock. The offer would allow Fotoball shareholders to defer taxes until they decided to sell their stocks and be taxed at the capital gains rate. An earn-out was also included in the deal to give management incentives to run the company effectively and meet deadlines in a timely order. Valuations for both K2 and Fotoball reflected anticipated synergies due to economies of scale and scope, namely, reductions in selling expenses of approximately $1 million per year, in distribution expenses of approximately $500,000 per year, and in annual G&A expenses of approximately $470,000. The combined market value of the two firms was estimated at $909 million – an increase of $82.7 million over the sum of the standalone values of the two firms. Based on Fotoball’s outstanding common stock of 3.6 million shares, and the stock price of $4.02 at that time, a minimum offer price was determined by multiplying the stock price by the number of shares outstanding. The minimum offer price was $14.5 million. Were K2 to concede 100 percent of the value of synergy to Fotoball, the value of the firm would be $97.2 million. However, sharing more than 45 percent of synergy with Fotoball would have caused a serious dilution of earnings. To determine the amount of synergy to share with Fotoball’s shareholders, K2 looked at what portion of the combined firms revenues would be contributed by each of the players and then applied that proportion to the synergy. Since 96 percent of the projected combined firms revenues in fiscal year 2004 were expected to come from K2, only 4 percent of the synergy value was added to the minimum offer price to come up with an initial offer price of $17.8 million, or $4.94 per share. That represented a premium of 23 percent over the market value of Fotoball’s stock at the time. The synergies and the Fotoball’s relatively small size compared to K2 made it unlikely that the merger would endanger K2’s credit worthiness or near-term profitability. Although the contribution to earnings would be relatively small, the addition of Fotoball would help diversify and smooth K2’s revenue stream, which had been subject to seasonality in the past. Organizationally, the integration of Fotoball into K2 would be achieved by operating Fotoball as a wholly owned subsidiary of K2, with current Fotoball management remaining in place. All key employees would receive retention bonuses as a condition of closing. Integration teams consisting of employees from both firms were set to move expeditiously according to a schedule established prior to closing the deal. The objective would be to implement the best practices of both firms. On January 26, 2004, K2 Inc. completed the purchase of Fotoball USA in an all-stock transaction. Immediately after, senior K2 managers communicated (on-site, where possible) with Fotoball customers, suppliers, and employees to allay any immediate concerns. -What was the role of "strategic controls" in implementing the K2 business plan?

Due diligence is the process of validating assumptions underlying the initial valuation of the target firm as well as the uncovering of factors that had not previously been considered that could enhance or detract from the value of the target firm.

A data room is a method commonly used by sellers to limit buyer due diligence.

McKesson HBOC Restates Revenue McKesson Corporation, the nation’s largest drug wholesaler, acquired medical software provider HBO & Co. in a $14.1 billion stock deal in early 1999. The transaction was touted as having created the country’s largest comprehensive health care services company. McKesson had annual sales of $18.1 billion in fiscal year 1998, and HBO & Co. had fiscal 1998 revenue of $1.2 billion. HBO & Co. makes information systems that include clinical, financial, billing, physician practice, and medical records software. Charles W. McCall, the chair, president, and chief executive of HBO & Co., was named the new chair of McKesson HBOC. As one of the decade’s hottest stocks, it had soared 38-fold since early 1992. McKesson’s first attempt to acquire HBO in mid-1998 collapsed following a news leak. However, McKesson’s persistence culminated in a completed transaction in January 1999. In its haste, McKesson closed the deal even before an in-depth audit of HBO’s books had been completed. In fact, the audit did not begin until after the close of the 1999 fiscal year. McKesson was so confident that its auditing firm, Deloitte & Touche, would not find anything that it released unaudited results that included the impact of HBO shortly after the close of the 1999 fiscal year on March 31, 1999. Within days, indications that contracts had been backdated began to surface. By May, McKesson hired forensic accountants skilled at reconstructing computer records. By early June, the accountants were able to reconstruct deleted computer files, which revealed a list of improperly recorded contracts. This evidence underscored HBO’s efforts to deliberately accelerate revenues by backdating contracts that were not final. Moreover, HBO shipped software to customers that they had not ordered, while knowing that it would be returned. In doing so, they were able to boost reported earnings, the company’s share price, and ultimately the purchase price paid by McKesson. In mid-July, McKesson announced that it would have to reduce revenue by $327 million and net income by $191.5 million for the past 3 fiscal years to correct for accounting irregularities. The company’s stock had fallen by 48% since late April when it first announced that it would have to restate earnings. McKesson’s senior management had to contend with rebuilding McKesson’s reputation, resolving more than 50 lawsuits, and attempting to recover $9.5 billion in market value lost since the need to restate earnings was first announced. When asked how such a thing could happen, McKesson spokespeople said they were intentionally kept from the due diligence process before the transaction closed. Despite not having adequate access to HBO’s records, McKesson decided to close the transaction anyway. -McKesson, a drug wholesaler, acquired HBO, a software firm. How do you think the fact that the two firms were in different businesses may have contributed to what happened?