Synergies

Synergy is a catch-all term used to describe the financial consequences of two business-units belonging to the same corporate parent as opposed to being two independent companies.

Business unit 1  +  Business unit 2  +  Synergy   =  Combined value


The term synergy is commonly used to justify mergers or acquisitions, but it is equally suitable for describing the consequences of having multiple business-units in exiting companies.

At least since the 1960s, companies have put out press releases describing how their company will gain synergies after a proposed acquisition. Often the synergies were only described in vague terms, and very often the synergies failed to materialise after the acquisition. The poor track record of past acquisitions is the key reason why the term synergy has a bad reputation. Corporate press releases today often try to quantify the potential synergies, but the track record of achieving synergies has not improved that much.

Synergies have an impact on the profit & loss statement and the balance sheet. Anything that influences the profit & loss statement above the EBIT line (earnings before interest and tax) is called operating synergy. Anything that influence below the EBIT line is called financial synergy.

Operating synergies. Operating synergies can be of different types. The most straightforward type is economies of scope. By combining two related business-units under the same corporate parent some fixed costs can be shared between the two units. It is generally possible to calculate the size of potential cost savings before an acquisition, even though it often is difficult to implement the changes after the acquisition. Some examples:

• Coca-Cola's sales force can be used more efficiently if they are able to sell sports drinks, bottled water, and fruit juice in addition to carbonated soft drinks.
• Back-office operations can often be rationalised when two companies merge. Office space can be consolidated to one location. Fixed investment in IT can be spread over a larger volume.

Another type of operating synergy is focused on enhancing revenue. This is a more elusive type because it normally takes longer time to come into being. Examples:

• Facebook's acquisition of Whatsapp is not going to generate any revenue in the short term, but it might generate more advertising revenue in the future. There would be a synergy between Facebook's efficient system of targeted advertising and advertising revenue on Whatsapp. If Whatsapp were to introduce advertising as a free-standing company it would not have the required customer information to target the advertisements. This would result in lower advertising revenue. The combined entity enables Whatsapp to charge higher advertising rates.

Especially when analysing revenue enhancing synergies, it is easy to forget that synergies are in addition. The fact that Whatsapp has a large number of customers is not a synergy for Facebook. The synergy is that Whatsapp does not have (and will not get) as efficient system of targeted advertising.

Example Walt Disney Corporation. The company has five different business units. It actually has more than five business units, but they present the financial data in five industry categories. (In fact, Walt Disney breaks revenue into 13 categories, which could have been used for a more fine-grained analysis.) By making a pairwise comparison to assess the realised synergies, it is possible to understand the coherence of the corporate strategy. Figure 1 describes the amount of realised synergies. The analysis shows that it would be possible to consider Walt Disney Corporation as consisting of "old" Disney (yellow) and Media Networks (blue). There are in fact only small realised synergies between the two Disneys. This means that it could make sense to split Disney into two companies. Each new top management team could then focus on the core business. Almost 70% of Disney's profit is coming from Media Networks and there is a risk that top management does not spend enough attention and resources on its cash cow. In the recent past "old" Disney has made expensive acquisitions (e.g. Pixar, Marvel, Lucasfilm) probably at the expense of growth opportunities in Media Networks or return of profit to the shareholders. The small amount of synergies that might exist between the two Disneys could probably be regulated in a long term contract. 

Figure 1. Assessment of realised synergies between the industry segments in which Walt Disney is present. Colour-coding refers to a possible break-up of Walt Disney.

Financial synergies. Financial synergies can also be of different types. It is for instance likely that the cost of capital is lower for a larger company. There might also be tax benefits if one business-unit has accumulate losses and another business-unit is profitable. The profitable business-unit can normally deduct the accumulated losses of the other business-unit.

Synergies have to be larger than additional costs. Adding a corporate management layer over previously independent business-units adds operating costs. It is important that the synergies are larger than the costs associated with having a corporate level management. This is especially true for acquisition of companies listed in a stock market. If one assumes that the pre-acquisition price is correct and the acquiring company pays a 20% premium, the synergies will have to be larger than 20% to be positive.