Last week we spoke about the impact of interest rates on consolidation. While a low rate environment certainly provides incentive to companies to grow through mergers and acquisitions, good deals are good deals in both high and low interest rate environments. There is a financial component that drives consolidation but there is a strategic component as well. Consolidation in the entire automotive aftermarket industry will likely continue due to both components. Prolonged increases in interest rates may have an impact on valuations over the medium term but likely not a significant impact immediately.
When considering growth by acquisition, a lot of time is spent identifying and quantifying synergies. Synergies are advantages that come about through the integration of two companies that, individually, the two companies would be unable to achieve. There are three common types of synergies: revenue, cost, and financial.
A revenue synergy is when, as a result of an acquisition, the combined company is able to generate more sales than the two companies would be able to separately. For example, consider LKQ and Keystone. Prior to LKQ’s acquisition of Keystone, LKQ sold primarily used parts. Keystone sold primarily aftermarket parts. However, in the combined company, LKQ could leverage its existing distribution network and sales force to sell more aftermarket parts into the industry than Keystone could sell as a stand-alone organization. Similarly, when a major consolidator acquires a smaller competitor, the consolidator often is able to leverage existing client relations to drive more sales into the new location than the stand-alone operator was able to on its own.
Revenue synergies can create very attractive economics for both buyer and seller. A savvy seller can command a substantial premium when the revenue synergy that the selling company provides is unique to the buyer. Conversely, a savvy buyer can often easily justify paying a substantial premium confident that the increase in revenues post close will offset the additional consideration provided to the seller.
Cost synergies refer to the opportunity, as a result of an acquisition, for the combined company to reduce costs more than the two companies would be able to do individually. Again, take the LKQ – Keystone deal as an example. When LKQ acquired Keystone, LKQ could distribute aftermarket parts through its existing distribution network. LKQ was able to eliminate significant costs associated with delivery trucks, fuel, insurance and delivery drivers. LKQ was also able combine warehouses and eliminate redundant storage expenses. Redundant management overhead was eliminated as well, further reducing expenses. As a result of the LKQ – Keystone acquisition, LKQ’s overall cost of doing business dropped while its sales increased. This is often referred to as developing economies of scale. In collision repair another example of cost synergies is when a larger group is able to negotiate lower prices or improved payment terms with vendors such as paint companies because they buying more products and services.
In some cases, combining companies can result in financial advantages the stand-alone companies would be otherwise unable to achieve individually. For example, smaller companies generally have to pay a premium when borrowing money relative to larger companies. However, two mid-sized companies can merge and lower their combined cost of capital more than they could individually. There may also be unique tax benefits and possibly an increased debt capacity as a result of merging that would otherwise be unavailable.
Be cautious when evaluating financial synergies, however, as studies have demonstrated that these synergies tend to be illusive. However, in certain situations they are worth considering.
Identifying Synergies and “Pro Formas”
Synergies can be tricky to nail down. But without clearly identified and quantified synergies, most acquisitions simply do not make financial sense. Accurately articulating the financial value of specific synergies is a must for both buyers and sellers.
For sellers it is important to understand the synergistic opportunities your company provides to the acquiring company. A detailed description of these synergies likely will increase the value of your company in the eyes of an acquirer. Even experienced buyers may not readily see all of the potential synergies in acquiring your business. You are well served to present a compelling case to your buyer of all the areas they can benefit by acquiring your business.
For buyers it is even more important to clearly understand the potential synergistic benefits of an acquisition prior to a close. Clear insight into both revenue and cost synergies drives a conversation around valuation. Understanding how and when these synergies will be realized is important in developing a deal structure that helps ensure that the synergies are captured appropriately.
Whether you are evaluating an acquisition, or have been approached by a consolidator and are considering a sale, the importance of developing a “pro forma” financial model cannot be understated. A pro forma is a financial model, typically built in Excel, that projects the performance of a business and is the foundation for creating a business valuation (something which both buyers and sellers should have before commencing a deal). For a seller a pro forma tells a story and illustrates an opportunity. For a buyer, it serves as a roadmap and holds the management team accountable post close.
Synergies and Consolidation
Synergies play a substantial role in driving valuation. The ability of a management team to identify and extract the expected synergies plays a major role in the success or failure of an acquisition. Consolidation in the industry will continue, even in the face of increasing rates, because the financial opportunities far outweigh increased borrowing costs in the short term. A very richly-valued acquisition can appear moderately priced after taking into account the impact of revenue and cost synergies post close.
Whether you are considering an acquisition or have been approached by a consolidator to sell your business, it is important to have a comprehensive understanding of the opportunities to build and recognize synergies in a transaction. Building a pro forma is an important way to tell your story and set a road map. If you want to know more about the potential synergies present in your company, get in contact with me (subscribers email me direct). And if you think all this talk about synergies is overrated – share that with me too and tell me why. I read all the emails and respond to most so don’t be shy. I enjoy chatting with others in an industry I’m passionate about.