Eager for more revenue than organic growth can provide, companies are returning to the merger-and-acquisition market. But they are choosing their targets carefully.
Acquisitions are back. Companies relied on radical cost cutting to restore profitability during the depths of the 2001-2002 downturn, but in 2003 executives realized that higher earnings would have to come from increased revenues, and a new wave of acquisitions began. Today, buyers are paying premium prices for carefully chosen targets, and they have strong expectations for returns. Those expectations, combined with greater shareholder scrutiny and the requirements of the Sarbanes-Oxley Act, are prompting deeper due diligence and tighter risk management.
CFOs and finance departments are more involved than ever before in their organization's merger-and-acquisition (M&A) activities, and they are moving quickly to secure the best targets. Robert K. Shearer, CFO and vice president of finance and global processes with VF Corp., the Greensboro, N.C.-based global apparel giant, completed three acquisitions in 30 days flat this summer, on the heels of a major purchase in August 2003. The company expects these companies to contribute $1 billion in sales to its total revenue of $6 billion for 2004. "Acquisitions are a key component of our growth strategy," says Shearer.
In the first eight months of this year, U.S. corporations announced 6,530 mergers and acquisitions valued at $555.8 billion, up from 5,529 deals worth $278.3 billion for the same period in 2003, according to Mergerstat. In a global survey of more than 100 executives at large companies conducted by Accenture in mid-2004, 70 percent of respondents said that their organization either was already undertaking M&A operations or planned to do so within 12 months. (See Big Players Looking for Targets.)
The fastest growth is in the middle market, among targets valued at less than $500 million. Not since the second quarter of 2001 has this crucial segment of the merger-and-acquisition market been so active. VF operates in this zone, targeting midsize companies with strong growth potential.
Although some multibillion-dollar deals have been announced this year, the megadeal mania of the 1990s shows no signs of reemerging. The Accenture survey found that overall deal size relative to acquirer revenues is shrinking and that executives are skeptical of the value that can be generated though large deals. Only 8 percent of respondents reported that they expect their organization's next M&A transaction to be a merger of equals. Seventy-four percent said they expect it to be an acquisition of a smaller player.
Instead of the huge, headline-grabbing mergers of the pre-recession era, companies are back to the hard work of building growth by buying strategic pieces of the market that infuse the enterprise with new products, customers or distribution systems.
The Growth Imperative
A confluence of factors including global recovery, increased debt availability and a perceived lack of organic growth opportunities is driving the new wave of M&A activity. "Businesses increasingly seek to drive growth through mergers and acquisitions because there are fewer perceived opportunities to increase operating efficiencies or grow organically," says Ravi Chanmugam, a New York City-based partner in Accenture's strategy and business architecture practice.
The Accenture survey found that 77 percent of executives expect mergers and acquisitions to provide less than 20 percent of their company's revenue growth over the next year. But some organizations have set their sights much higher. "We target 6 percent top-line growth per year, with half of that coming from our ongoing core businesses and half from acquisitions," says Shearer.
That top-line target predates the 2001-2002 slowdown, which was "a tough economic climate for apparel overall," Shearer notes. "We exited some businesses and improved the bottom line all along. But for sustained bottom-line growth, we recognized that we needed to grow the top line as well. We continued acquisitions through 2000, and the company looked at opportunities in 2001 and 2002, but we did not make another significant acquisition until we purchased Nautica in August 2003. That's when our acquisitions activity accelerated again."
VF has narrowed its acquisition targets down to lifestyle brands with good growth. "We're not looking for brands or businesses that bulk us up in the same businesses that we're currently in," reports Shearer. "We're looking for brands that address a new consumer group or bring in a new platform or new capabilities."
Best Software, an Irvine, Calif.-based business management products provider, is another organization that's fueling strategic growth through acquisitions. Over the past seven years, the company has completed 14 transactions in the United States valued at more than $1.4 billion in total. "Our focus has been to acquire product offerings that enhance our offerings and acquire customer bases and strategic initiatives in particular market segments," says James Eckstaedt, executive vice president and CFO. "We've built the company through acquisitions."
Best Software made its first acquisition in 1998. Additional purchases followed in 1999 and 2000. During the downturn, the company limited its purchases to smaller, private businesses, but it resumed major acquisition activity in 2003. Its March 2004 purchase of Accpac International Inc. brought Best Software more than 500,000 new customers.
"One of the reasons we've been successful is that we do thorough research before we approach a potential target, and we pursue acquisitions for strategic reasons," Eckstaedt reports. "We measure success by the increased revenue and profitability of the acquired company over time. In some cases where the acquired target is a new area for us, their financial information remains pure, so we can see the growth. In other cases where we buy a product or a technology that enhances our existing portfolio, we can measure our success in our ability to deliver to our customers the products and functionality they want." Best Software attributes a large part of its 21 percent revenue growth in the first half of 2004 to its aggressive acquisitions strategy.
Joel H. Rassman, executive vice president, treasurer, CFO and director of Toll Brothers Inc., a $3 billion-a-year luxury home builder headquartered in Huntingdon Valley, Pa., measures the success of his company's acquisitions by the pipeline of immediate opportunities they provide.
A home builder may decide to acquire another builder to obtain entry into a new market, expertise in a particular product type, access to building lots or an experienced subcontractor base. "The alternative to acquiring a builder is entering into a new market or introducing a new product," Rassman notes. "Generally, acquiring a company allows you to grow faster."
Toll Brothers completed two major acquisitions last year. When the company acquired Richard R. Dostie, a major builder based in northeast Florida, it also acquired that company's experience and established reputation in the Jacksonville market, a pipeline of lots, a veteran management team, and valuable relationships with land providers. "Toll Brothers saw an opportunity to enhance the profitability of the combined entities by introducing best practices of both and by expanding the Dostie product lines with the introduction of Toll Brothers products," Rassman says. Toll Brothers' third-quarter 2004 financial statement showed that its revenues were up 46 percent from the same period in 2003, reflecting the best growth and earnings in the company's 36-year history.
Although the Sarbanes-Oxley Act rocked the world of finance, its impact on M&A activity has not been as large as many observers believed it would be. The law puts a new twist on timing the transaction, and it heightens the importance of documenting the due diligence process. But it leaves that process largely unchanged.
"In terms of the overall due diligence process itself, what made a good acquisition pre-Sarbanes makes a good acquisition post-Sarbanes," Shearer says. "The most important factors in the due diligence process remain unchanged. It's about coming to understand a business -- what makes the business good and where the risks and opportunities are."
VF has not made any substantial changes to its due diligence process since the passage of Sarbanes-Oxley, but Shearer notes that the company is "being very careful about the opening balance sheets and making sure that they are properly stated on day one."
Sarbanes-Oxley has also made VF more sensitive to the overall materiality of a potential target. "If it's highly material and it would have a significant impact on our company, we have to evaluate our ability to meet the Section 404 requirements," Shearer says.
"There's a difference here between public and private companies," Shearer adds. "Public companies have the same Sarbanes requirements to meet, and they are generally up-to-date; private companies are not as concerned. If the acquisition target is a material private company, the timing of the acquisition may be affected depending on what we find in the due diligence process. The comfort factor changes with the overall materiality of the target."
Although Sarbanes-Oxley affects timing and presents some additional exposure, "the largest risk always comes down to meeting the projections and financial assumptions we make in every deal," Shearer says. "We make assumptions about sales and sales growth and holding or improving profitability on those sales. The biggest risk -- and where we pay the most attention in the due diligence process -- is in sorting through those assumptions and developing a set of assumptions that we feel we can meet."
Rassman's experience of the post-Sarbanes-Oxley M&A environment parallels Shearer's; the law has not prompted Toll Brothers to make major revisions to its due diligence process. "The biggest change comes as a result of the requirement to document the process," Rassman reports. "Before Sarbanes-Oxley, we could establish our comfort levels without documenting every step that we went through. The requirement for certifications under Sarbanes-Oxley is such that the procedures and controls, as well as the testing, need to be documented. This has probably added some costs and elongated the process to some degree.
"However, both of our recent acquisitions were small enough so that the risks associated with the acquisitions were not deemed material in terms of the total Toll organization," Rassman adds. "This is particularly true since we acquired the assets of the entities rather than the entities themselves."
Best Software is owned by a U.K.-based parent, so it is not bound by Sarbanes-Oxley. But Eckstaedt reports that "we do take a harder look at public company targets because of Sarbanes to ensure that we understand any risks involved and to protect our company. Our due diligence process is very rigorous, with or without Sarbanes, but in the past few years we have adopted a much more focused approach. We tend to work with the same bankers and legal counsel on [all of] our transactions, and we work well with the teams from these outside providers. That's helped us significantly because the outside providers know what we're looking for and what's important to us and what we need in terms of legal documentation for a transaction."
CFOs Lead Due Diligence
VF divides its acquisitions planning between two teams; one considers overall strategy, while the other identifies specific opportunities. "The strategy side is all about looking at the broad scope, evaluating markets, reviewing competitive factors, and identifying the opportunities in new channels of distribution or new product categories," Shearer says. "The M&A side works to specify which brands or companies might be the right ones for VF and then carries through with the acquisition process." VF's strategy group reports to the chairman; the M&A group reports to Shearer.
Shearer's team directs the due diligence process, but VF's operating units are deeply involved and bear primary responsibility. "The M&A group leads the process and gives discipline to it," Shearer reports. The M&A team's tasks also include making the initial contact with potential targets; structuring the deal, including pricing and contract negotiations; and overseeing the integration of the acquired company into VF.
At Best Software, all North American M&A deals are Eckstaedt's responsibility. "I've been involved in all of the larger transactions and played an integral part in negotiating the actual merger agreements," he reports. He also leads the due diligence team, which includes outside attorneys, accountants and investment bankers, as well as internal personnel from the finance, IT and legal departments. "We put together a cross-functional team of people who work with their counterparts at the target or with senior management at the target to obtain the due diligence information that we require," Eckstaedt says.
Toll Brothers also uses a due diligence team that meets with target companies' staff. "We use the meetings to learn about the target companies and the reasons for their success," says Rassman. "It is most important when you acquire an organization to make sure you preserve the value of what you have acquired."
As long as top-line organic growth remains muted across a wide range of sectors in the U.S. economy, M&A activity will continue to expand. Shareholder pressure and Sarbanes-Oxley have added a layer of complexity to deal-making and due diligence, but CFOs' focus remains squarely on new market opportunities and post-acquisition numbers. Companies like VF, Best Software and Toll Brothers demonstrate that substantial rewards come to organizations that choose their purchases wisely.
6 Steps to Effective Due Diligence
Due diligence provides buyers with an opportunity to review targets' books and records, verify the assumptions underlying price and other terms of a deal, identify potential synergies and cost-saving opportunities, assess potential liabilities, identify key employees and customer relationships, and plan post-closing integration.
"Due diligence is an interactive, iterative process that requires focus and energy to maximize results and avoid mistakes," says Arlie R. Nogay, partner and practice group leader, corporate and securities, with Pittsburgh-based law firm Reed Smith LLP. "Preparation and active debriefing are key elements to achieve success." Nogay advises executives to follow these six basic steps: