Article by Robert Currie for Brunswick News

You’re sitting at your kitchen tablethis time eating an open-face egg sandwich on a beautiful winter morningYou’re sifting through the news while you drink your coffee and find that instead of one of the companies in your portfolio making an acquisitionthey are being acquiredfor a 40% premium

LBI Facebook Link Post 3This is obviously a great outcome for you and your portfolio, but you have to ask yourself, how does anyone justify paying you40% premiumto what people were willing to pay for the stock yesterday? You feel like the winner, so doesn’t that make them the loser?

When one company acquires another, it is possible that the combined entity is more valuable than the two 
companies individually. This additional value is often referred to as synergies, which can take the form of cost cutting and/or increasing revenue.

Cost Synergies come from costs that the acquiring company can remove from the acquired company’s business once they are combinedGetting rid of real estate overlap, leveraging the same sales team, eliminating third parties, and increased purchasing power are all commonly named examples of cost synergies 

Revenue Synergies, on the other hand, are opportunities to make sales you couldn’t otherwise make. For example, enterprise software companies often use a “land-and-expand” strategy, where they try to win as many customers as possible to create a valuable sales pipeline. This allows them to buy other enterprise software companies that fit well with their current offerings and push the acquired products into their sales pipeline“expanding” their wallet-share of the customers they’ve already “landed”.  

RealPage (RP: Nasdaq)an enterprise software company whose core product is a property management system for real estate managerscancreate a lot of synergies when making acquisitions. While real estate managers look to consume more software as they automate their back-office operations, RP continuously buys adjacent software companies making thema one-stop-shop for their customers (real estate marketingutility payment processing, asset management analyticsetc…). Furthermore, they cut costs fairly easily because they use the same sales force and management team 

Couche-Tard (ATD.B: TSX), known for their Circle K branded convenience stores, is also a great example. In an industry dominated by independent owner/operators, Couche-Tard is able to leverage its size to negotiate very attractive agreements with suppliers for their stores. When they make acquisitions, they are able to bring the acquired stores on to these better supply agreements, increasing profit margins (reducing costs) while bringing prices lower so they gain market share (increasing revenue) 

However, many acquiring companies don’t have the same opportunity to cut costs or grow revenue, making it harder to benefit from paying big premiums for acquisitions. Pipeline companies, for example, have largely fixed costs that cannot be removed (maintenance and depreciation), with limited ability to increase revenue (pipelines have fixed capacity) 

Therefore, the highest price a company should be willing to pay for an acquisition is the value of the company they are buying “plus” the synergies created by putting the two companies together. The size of the premium in relation to the size of the synergies depicts who benefits most from the acquisition. The best acquisitions are those for whom the synergies from the acquisition are much larger than the premium paid.