TESTS OF MERGER THEORY

Three major types of merger motivations were identified by Berkovitch and Narayanan (1993): synergy, hubris, and agency problems. In the Exxon-Mobil merger, synergy and efficiency objectives were promised and achieved. The initial synergies were estimated at $2.8 billion. As a result of rapid and effective integration of the two companies, Chairman Lee Raymond announced within 7 months of the completion of the merger that synergies of $4.6 billion had been achieved. Analysts’ reports were projecting a further increase in synergies to the $7 billion level.

Synergies can result from cost reductions or revenue increases. ExxonMobil benefited from sales of duplicate facilities and employment reductions. Costs were reduced by adoptions of best practices from both companies, particularly in combining advanced technologies. Revenue increases can come from strengthening the market positions of each. In addition, joint ventures with major oil-producing countries such as Saudi Arabia were facilitated by strengthening Exxon’s position as one of the three largest international oil companies.

Hubris can be reflected in overpaying for the target. Exxon paid a premium of $15.5 billion. The equity market cap of the combined firm increased from $234 billion to actual values of $280 billion by the end of 1999 and to $301 billion by the end of 2000. Thus, the capitalized value of the synergies was $46 billion to $67 billion. In his news release of August 1, 2000, Raymond stated that an improvement of at least 3 points above the historic Exxon level of return on capital employed (ROCE) was being achieved. These results are inconsistent with agency problems.

Other motives for mergers discussed in the literature include tax savings, monopoly, and redistribution. Tax aspects were not a major factor. Regulatory agencies found no antitrust problems in the upstream activities (exploration and development). However, divestitures were required in downstream activities (distribution and marketing). Redistribution from bondholders did not occur. Redistribution from labor took place in the sense that employment reshuffling occurred and reductions were made.

In their review of merger activity, Holmstrom and Kaplan (2001) described the positive influence of a number of developments in the 1990s. These included an increase in equity-based compensation, an increased emphasis on shareholder value, a rise in shareholder activism, improved and more active boards of directors, increased CEO turnover, and an increase in the role of capital markets. The goal of improving through the Exxon-Mobil merger reflected these general developments.

In their companion review, Andrade, Mitchell, and Stafford (2001) further developed the earlier Mitchell and Mulherin (1996) emphasis on the role of shocks in causing mergers. Their analysis is applicable to the oil industry mergers. However, the pressures have been more than periodic shocks. Price instability has been a continuing problem for oil firms. Large price changes in downward as well as upward directions have been destabilizing. Price drops reduce profit margins and investment returns. Price rises increase margins and returns, but stimulate production expansion and new entrants. Hence, price uncertainty created strong continuing pressures for improved efficiency to reduce oil finding and production costs.

Another oil industry characteristic is high sensitivity to changes in overall economic activity. The East Asian financial problems in 1997 and 1998 led to reduced demand, resulting in a decline in world oil prices to less than $10 per barrel in late 1998. The decline in growth in the U.S. economy beginning in 2000 contributed to the drop in oil prices from $37 to less than $20 per barrel during 2001. By February 2003 the threat of war with Iraq moved oil prices to over $38 per barrel.

The rise of 15 government-connected national oil companies created increased competitive pressures. The increased application of technological advances in exploration, production, refining methods, and transportation logistics created new competitive opportunities and threats. Price instabilities (like persistent overcapacity in the steel, auto, and chemical industries) caused continuing pressures for M&A activities to reduce costs and increase revenues. In addition, the $2 billion synergy in the BP acquisition of Amoco stimulated competitive responses resulting in other mergers, alliances, and joint ventures. The oil industry M&A activities during the period 1998 to 2001 are consistent with the industry shocks theory, an industry structural problems theory, and a theory of competitive responses.

REVIEW

The Exxon-Mobil combination is an archetype of a successful merger. Fundamentally, the reasons, structures, and implementation of the transaction reflected the characteristics of the oil and gas industry. The industry increasingly utilizes advanced technology in exploration, production, and refining, and in the logistics of its operations. It is international in scope. World demand is sensitive to economic conditions. The weakness in the Asian economies pushed prices below $10 per barrel at the end of 1998. The U.S. recession, which began in March 2001, helped push oil prices from $32 per barrel down to $17 per barrel by November 2001. During the Middle East crisis in April 2002, oil prices had moved up to the $37-per-barrel level.

Critics of merger activities have argued that the likelihood of successful mergers is small. In addition, they argue that purchase prices include substantial premiums requiring increases in values of acquired firms that are not likely to be achieved. The Exxon-Mobil combination provides counterevidence. Synergies include improvements in the performance of all the parties in the transaction. Premiums usually are expressed as a percentage of the premerger market cap of the target. These percentages can run high; however, more relevant is the amount of the premium in relation to the size of the combined firm. The $15.5 billion premium to Mobil was 26.4% of its market cap but represented only 6.6% of the combined premerger market cap. The $2.8 billion premerger synergy estimate ($7 billion postmerger) required only a modest valuation multiple to recover the $15.5 billion premium. More generally, Table 10.11 demonstrates that in total, the nine major oil transactions were value increasing for acquirers as well as targets.

This chapter develops a framework for an analysis of how M&As can perform a positive role in aiding firms as they adjust to changing environments. We emphasize a multiple approach. Critical factors are the economics of the industry, the business logic of the combination within the framework of the industry and the economy, the behavior of the value drivers in the financial analysis of the merger, regulatory factors, and competitive interactions.

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