Energy Transfer Equity just showed why the so-called synergies promised by corporate dealmakers need to be taken with barrels of salt. The U.S. pipeline partnership in September said it would be able to squeeze an extra $2 billion a year of earnings before interest, tax, depreciation and amortization by 2020 from its agreed purchase of Williams Companies. Amid the oil price slump, the two firms just revised their base case to $170 million. Wall Street uses synergies to justify the premium an acquirer pays, so it matters when benefits don’t materialize.
ETE-Williams may be a special case, with optimistic top-line improvements and expense cuts evaporating even before the deal is finalized. But overall, consulting firm McKinsey has suggested that 70 percent of mergers don’t deliver hoped-for revenue gains from cross-selling and other supposed opportunities. The record on achieving cost savings is better, though far from perfect. According to Bain & Co, overdone synergy estimates cause disappointment in more than half of all deals.
In analyzing mergers and acquisitions Breakingviews, like many investors, tends to attach no value to promises of enhanced revenue from transactions – though sometimes they are credible enough to represent a potential post-merger fillip, even if it’s not easily quantifiable. But it’s also necessary to be cautious valuing expected cost savings.
When Honeywell International was meeting resistance in its courtship of United Technologies last month, it published its case for what could have been a $160 billion merger. Among the listed benefits were an estimated $3.5 billion of annual synergies. Taxed and valued at Honeywell’s roughly 16 times price-to-earnings (PE) multiple, they were worth more than $40 billion to shareholders by the company’s calculation.
United Technologies, in turn talking its own book, argued that Honeywell’s figure for savings was too high, that any expense cuts should be valued on a lower multiple, and that there would be substantial outlays involved in achieving them. The unwilling target also pointed to divestitures that could be required by antitrust watchdogs and concluded that in the end there would be essentially no value created at all.
That’s an overly pessimistic conclusion, but United Technologies neatly set out why merger watchers need to be skeptical. Breakingviews generally values reasonable-looking cost synergies, net of tax, on a multiple of 10. That’s lower than typical PE ratios, but there are two solid reasons for that. For one, they may not be achieved in full. Second, while cost savings once achieved may persist, they don’t offer the growth that justifies higher multiples.