The True Cost of Mergers and Acquisitions

“Statistics say that 70% of the time you acquire an asset, you’ve overpaid for it,” says John Williams, the CEO of Domtar Corporation. “After an acquisition, the asset’s performance starts declining. The people tell you, ‘We’re underinvested.’ So, off you go, trying to put another billion dollars or two in the hopes it will solve the performance problem you’ve just purchased for a billion dollars. This happens every single day in the industry.”

We agree wholeheartedly with this observation.  In our twenty-five years of being in trenches side-by-side with our clients’ teams, we find that the vast majority of the time teams underestimate the total capex costs required when they make a new acquisition.

Worse still, some companies don’t even attempt to account for future capex needs. They go solely on the site’s EBITDA multiples—another one of those irrelevant measures. Too many times, we have seen firsthand the dire results from this line of thinking. EBITDA multiples don’t take into account capex needs at all. This is like buying a car for its market price and completely ignoring the fact it needs a new engine. If that weren’t cause for concern enough, EBITDA multiples tend to overvalue older assets and undervalue newer ones; since it’s usually older mills for sale, you can imagine the result.

Most of all, leadership views a potential M&A through an analytical lens, asking the black-or-white question: “Is this a good buy?” In our work with clients, we have proven that it is impossible to gauge whether a strategic decision is good or bad in isolation. It’s only through a systems-thinking lens that an individual site’s true contribution to the portfolio be discovered.

The question is, “How good can our company’s accumulated discounted cash flow possibly be without the acquisition vs. how good can our company’s accumulated discounted cash flow possibly be with the acquisition?” The answer to that question will not be the discounted cash flow from the acquisition target. The exception would be whether the acquisition target is a completely separate business from what you have today—but why would you buy such a business?

The average success of acquisitions can be debated, and different companies have very different track records of succeeding in their acquisition strategies. There is abundant literature on rationale for acquisitions and the potential risks from an intention point of view. There are, however, a few common pitfalls that are rarely debated or understood at all.

Underestimating future capex needs comes from underestimating the replacement costs of new assets by focusing too much on the last few years of capex levels, depreciation, and book value. The last few years’ capex levels rarely give any real indication of the true capex needs going forward to keep assets running. The sellers often “dress the bride” or “put lipstick on the pig” by underinvesting. Also, depreciation levels give no information regarding future investment needs. In fact, the correlation may even be negative. Low depreciation levels often indicate aging assets and large near- term reinvestment and/or consolidation needs. Then there are buyers who sometimes believe that the capital expenditures required do not matter since the capexes that will be made will have a positive NPV. Since the capex will “carry itself,” they don’t believe they need to include those in acquisition analysis at all. This is a terribly costly misunderstanding.

Since the EBITDA in no way reflects future capex needs and the remaining life of the site’s assets, it provides no linear information regarding enterprise value. Using standard industry multiples, even allowing for the accepted spread between attractive and unattractive targets, tends to undervalue new assets and perhaps more dangerously significantly overvalue aging ones—and again, the aging ones are typically the ones for sale.

All capital-intensive industries should assume a continuously deteriorating terms of trade, i.e., the cost of the input goods will have higher cost escalations compared to the finished goods sold; that deterioration must continually be combatted by process, quality, and feature improvements. This means that a significant part of the capex amounts assumed to improve the business actually is used only to defend its current ability to generate cash flow.

Generally, acquisitions accelerate the optimal rate of consolidation of production capacity. In the extreme, a company with only one machine does not need to be able to take the amount of hard decisions regarding closures and technology change compared to a company that runs ten sites with interchangeability. So, at least from a capex strategy point of view, larger companies need to be nimbler and faster compared to their smaller competitors when optimizing the value of capex allocation.

Written by Fredrik Weissenrieder and Daniel Lindén authors of REDESIGNING CAPEX STRATEGY.
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