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Mergers & Acquisitions

The Weak-Meet-Weak Approach to M&A

Combining two weak companies may result in one that is very successful

By CHUCK BENJAMIN, Benjamin Capital Advisors
January 27, 2012

Minus one plus minus one equals minus two, at least when it comes to basic math. Doubling a negative always yields twice as negative of an outcome. Or does it? Not necessarily.

Combining two weak companies may result in one that is very successful when it comes to dealmaking, but the equation does not always hold true when attempting to save two troubled companies. Sometimes two companies that are operating in the red can merge and collectively turn their negative results into a positive outcome. Combining two weak companies may result in one that is very successful. This may seem contrary to popular belief and the countless acquisitions in which strong companies have successfully acquired weak ones. To be sure, the strong-takes-weak acquisition strategy is often effective for both parties, and has a long history of success. But there's a case to be made for weak-meets-week too.

An example of two financially stressed companies uniting is Kmart Holdings Corporation's acquisition of Sears, Roebuck and Co., a deal that closed on March 24, 2005. The two companies cited several reasons for combining forces:

* Sears had begun investing in new, larger, off-mall stores, called Sears Grand. Earlier in the year, Sears had purchased dozens of current Super Kmart locations; the merger permitted the combined company to accelerate that process.

* Proprietary brands held by both companies could be made more accessible to their target demographics by leveraging their combined real estate holdings. This was estimated to be an expected $200 million a year in revenue synergies.

* At least $300 million a year in cost savings was expected annually, particularly in the supply chain and in administrative overhead.

* The establishment of a shared customer-focused culture between the two companies was estimated to yield improvements in revenue per unit area.

* Preservation of two brands post-merger allowed Sears Holdings to focus on different customer demographics, without alienating either group.

Another example is the merger of XM and Sirius. According to their balance sheets, both were operating unprofitably and saddled with debt before forming Sirius XM Radio Inc. The combined company now has more than 18.5 million subscribers, making it the second-largest radio company, based on revenue, in the country. These examples demonstrate how weak-meets-weak mergers can be very lucrative-especially when the two companies stand to share fixed costs and target audiences.

As a result, mergers and acquisitions are most prevalent within sectors that are home to businesses with large fixed costs and diminishing revenues, such as chain stores and manufacturers. Below is a look at a typical company within these sectors:

* Chain Stores - Chain stores have numerous categories of fixed costs. These can include multiple store leases; the cost of one or more warehouse distribution centers; a corporate headquarters; and a myriad of fixed personnel costs required to manage the tasks in various departments ranging from finance, accounting, the supply chain and inventory to marketing, merchandising, human resources and advertising. These fixed overhead costs and expenses, along with all variable costs, must be covered by the gross margin dollars created on sales from the retail stores.

* Manufacturers - Likewise, manufacturers have high fixed cost components, related to property, plant and equipment. When not operating a manufacturing plant at maximum efficiency, the actual hourly price of these cost components rises dramatically. Factories operating fewer than three shifts (and certainly less than two) face skyrocketing per-unit manufacturing costs.

Faced with stagnant or diminishing sales due to a down economy, many retailers and manufacturers have fallen into continual loss positions over the past three years, forcing them to reduce their variable costs. As fixed costs, such as rent, taxes, insurance and payroll, remain the same, often this is not enough, and losses continue. As the balance sheet weakens and credit becomes less available, the company continues to deteriorate. This is a difficult position to be in-and one that is unattractive to most acquirers.

However, when certain business conditions exist, the opportunity to merge with another underperforming company may be the best solution for both entities, as they face the same challenges. Recognizing these conditions may lead management to seek a merger with another poorly performing company rather than declare bankruptcy. Examples of conditions that are conducive to a weak-meets-weak merger include:

* Where the Overall Market is Shrinking. In these difficult economic times, combining two companies in an industry that is rapidly shrinking may make sense. After a merger, the new entity realizes both the benefits of greater market share and the synergy of lower operating costs. These results represent a true win-win for both companies. Housing and many related product categories in home furnishings are examples of industries currently experiencing significant overall revenue reductions. Chain stores are increasingly losing retail sales to online sales. Similarly, U.S. manufacturers continue to lose market share to overseas manufacturers, as domestic labor costs rise and efficiency diminishes.

* Where Competition is Limited. In local markets or industries in which only a few competitors-sometimes just two-have driven prices to virtual loss levels, combining such entities often increases prices and profit margins, in addition to consolidating costs.

* Where Products or Services Overlap. When combined, companies that have diverse but related products can become a one-stop shop for customers, driving increased sales for all products. Agglomerating product categories can prove very profitable. A fabric and furnishing company may add lighting or rugs; a drugstore may add a mini supermarket; or a boutique specializing in dresses may add similarly-priced casual clothing and accessories.

Since the economic downturn began in 2008, numerous middle market and lower middle market companies have been barely hanging on. They have used their borrowing capacities to the limit and are now facing more stringent bank lending standards. Many have maxed out their borrowing capacity on their revolving credit lines. Perhaps the worst part is that if these businesses begin to grow out of their current downturn and their sales expand, they will require even more capital-either contributed or borrowed. So what must they do to survive and prosper? Here are steps to follow that may save not just one, but two, troubled companies by concluding a successful merger:

* Conduct a Detailed Audit - Prepare a formal overall business diagnosis and seek the "real reasons" for the diminishing company's performance. Be meticulously honest in understanding the actual circumstances that the company is experiencing and carefully examine both the industry and company's realistic prospects. Seek the opinions of knowledgeable insiders at all management levels, as well as those of industry leaders. The difficulties may be external factors and not internally-generated or controlled.

* Project Sales with Caution - Conservatively assume that sales may continue downward and evaluate, in detail, how the fixed costs facing the company may impact future cash flow.

* Prepare a Competitive Analysis - Prepare a competitive analysis and evaluate how the competition is faring. Make note of competitors that may be potential merger partners, and which might offer the most synergistic benefits. In addition to the financial analysis, it is important to look at the corporate culture of the two companies and how the management skills and approaches align.

* Consider a Liquidation Analysis - Prepare a liquidation analysis as a test of the downside and the effect of continued losses. Most middle market companies today do not fare well in Chapter 11 bankruptcies due to the high cost, company disruption, and probability that the owners will lose their shareholder positions.

* Seek Independent Counsel - Seek help from independent, third-party professionals to evaluate and help negotiate the best merger possible. In many cases, the elimination of one complete set of overhead fixed costs and many variable duplicative costs will be realized in the newly combined and very profitable company.

Merging such entities may create the additional cash flow and greater security necessary to obtain bank credit. By careful planning and sound business combinations, the management of two poorly performing enterprises can make a strong and robust whole greater than the sum of their weak, individual parts.

Chuck Benjamin is the founder of Benjamin Capital Advisors.