Estimating synergies

Operational Synergies

When estimating operational synergies, Koller et. al. (2005) suggests developing an industry specific business system followed by an analysis of the cost base of the target company. The size of the synergistic benefits should preferably be estimated using expertise from experienced line managers (Koller et. al. 2005).

Since this thesis solely rely on publicly available information, this is not possible and creates a significant restraint to the precision of the estimates. However, the authors argue that benchmarking against industry peers to reveal if industry economics support the suggested synergistic benefits will serve as the best approximation. Further, the quality of the estimated benefits depend on the extent to which costs can be assigned to specific functions. In this case, Volvo does not offer such information but merely assign cost according to the income statement items (see appendix 4). Thus, the proportional impact of a specific synergistic benefit on income and balance sheet items will also rely on industry economics.

Mellen and Evans (2010) stress the importance of timing as future synergistic benefits are worth less than current benefits. Cultural differences are identified as a key factor that potentially delay the timing of benefit, whereas a clear power structure can act to ease these difficulties. This is supported by Teerikangas and Very (2006), who find that national cultural differences matter, but that organisational culture is a greater determinant of the success of M&As. However, despite the importance of incorporating cultural aspects when estimating the timing of synergies, the outside perspective of this thesis hinders a useful and trustworthy comparison of organisational culture. Thus, in order to account for the fact that synergies seldom appear instantaneously, as highlighted by scholars, this thesis estimates that it takes two years before the estimated synergies are realised. The synergistic benefits are identified as follows:

R&D: As the R&D intensity is expected to increase this becomes a major source of economies of scale. By being able to spread the cost as well as utilising the benefits of R&D over more vehicles, the R&D budget is expected to increase in absolute terms whilst decreasing per unit under Renault’s ownership. This is evident considering that the R&D trend in the industry is homogenous, as described in the strategic analysis.

Further, by combining the two entities, the elimination of duplicate functions is estimated to yield additional benefits. Volvo is currently spending a relatively small proportion of revenues on R&D relative to peers and though economies of scale can be realised, industry economics limit it to a modest decrease. The synergistic benefit is estimated to impact both the income statement and balance sheet through both decreased expenses and capitalisation. As a percentage of revenue, expenses are estimated to decrease by 0,2% and intangible assets by 0,5%. In addition, the increased R&D budget in absolute terms is expected to have a positive effect on Volvo’s chance of remaining competitive throughout the technological shift. As such, this

100 affects the expected growth of the company. However, as stated by Mellen and Evans (2010), revenue enhancement synergies should be estimated with caution as they are dependent on a number of factors external to the deal, such as customer and competitor response. The revenue synergistic benefits are thus estimated to increase revenue growth by 0,2%.

Manufacturing and Procurement: Critical to the auto industry is the ability to spread overhead costs, as described in previous sections. Volvo and Renault have both independently embraced this aspect through the development of platforms that can be applied to several models, all in order to realise this benefit. With regard common platforms, the Renault-Nissan alliance claim to benefit a 40% decrease in engineering costs and a 30% reduction in purchasing costs through higher volume purchases (Renault Nissan, 2015). The benefits of combined purchases will likely affect, not just the benefits of using a common platform, but the entire procurement process. This suggest a decrease in both cost of sales and SG&A as material costs will decrease, as well as shared product and process engineering will yield a decrease in overhead costs. There are no expected synergistic benefits through decreasing overcapacity through joint production, since Volvo is currently expanding its manufacturing network in order to facilitate its expansion. Meanwhile Volvo already has a low cost of sales relative to industry peers, industry economics suggest a modest decrease.

However, the analysis of Volvo showed that the company has a relatively high SG&A costs, which indicates that Volvo have from relatively high overhead costs. Thus, the benefits are estimated to a 0,5% decrease in both cost of sales and SG&A as a proportion of revenue.

Sales and Marketing: Marketing is identified as a key tool and capability to create differentiation in the marketplace. Given the recent success of the company, of which is likely attributed to the “Volvo Way to Market” to a large extent, and that brand management is identified as one of the company’s key strengths, the potential benefit of Renault’s contribution in the area is limited. However, marketing skills are arguably transferrable and independent of targeted customer segment, since it is human capital it is expected that duplicate functions can be removed. This is estimated to yield a decrease in SG&A of 0,2% as a percentage of revenues.

Administration: Both firms have corporate functions supporting the core business such as finance, HR, IT and investor relations. Several of these would arguably be redundant under Renault’s ownership as only one investor relations and finance department is needed, as well as implementing common HR and IT practices would likely reduce the need for personnel. The cost of these overhead functions is assumed to be captured by a decrease in SG&A. The synergistic benefit is estimated to a 0,2% decrease in SG&A as a percentage of revenue.

A summary of the key profitability measures under Renault’s ownership are presented in table 25. The table show that Volvo is expected to deliver profit margins closer to those of the peer group companies in the growth period, but that these are expected to deteriorate as the company matures.

101 Table 25. M&A: Pro forma profitability measures

Source: Own construction Financial Synergies

Working capital management is not reasoned an area of improvement, since Volvo by far has the lowest working capital compared to the peers, including Renault. Thus, potential synergistic benefits are most likely to come in the form of a reduced cost of capital. Evans and Mellen (2010) highlight that these benefits generally come through risk reduction by a reduced customer concentration and an improved position relative to peers. However, according to Damodaran (2005a), diversification is not a source of synergies as investors can diversify on their own. Instead, Damodaran (2005a) emphasises the possibility of decreasing the cost of debt through an increased debt capacity of the combined entity by having more stable and predictable earnings. The implications of Renault’s ownership on cost of capital are as follows:

Cost of Debt: Cost of debt for Volvo as a stand-alone entity was derived using the BB positive and Ba2 stable ratings issued by S&P and Moody’s, and Renault is barely reaching an investment grade from the rating institutions with BBB- and Baa3 ratings. Thus, even though more geographically dispersed and potentially more stable earnings would imply a decreased cost of debt, Renault’s ability to facilitate debt as implied by the ratings does not differ significantly from Volvo’s. Further, since source of financing the acquisition is outside the scope of this thesis, it is not possible to include the effect of potential debt financing in estimating the cost of debt. Consequently, the cost of debt is expected to be unaffected by Renault’s ownership and remains at 2,64% after tax.

Cost of Equity: The cost of equity derived in the stand-alone valuation takes both overall industry and peer group beta into account. It is seen as the most appropriate estimate of Volvo’s future risk (or required rate of return for equity providers) and is thus independent of ownership. Renault is a large publicly traded company by European standards and is included, amongst other indices, in the Euronext 100 index comprising Europe’s 100 largest and most traded stocks (Euronext, 2017). Thus, as in the case of Volvo as a stand-alone entity, a liquidity premium is not necessary as the liquidity risk in the stock is likely low.

Therefore, the cost of equity for Volvo of 12,2% remains unchanged and considered appropriate under Renault’s ownership as well.

Average Peer Group E2017 E2018 E2019 E2020 E2021 E2022 E2023 E2024 E2025 E2026 2016 Gross Profit 25,0% 25,0% 24,5% 24,5% 23,5% 22,5% 22,5% 22,5% 22,5% 22,5% 19,6%

EBITDA Margin 12,3% 12,3% 13,4% 13,4% 12,4% 11,7% 11,7% 11,7% 11,7% 11,7% 13,0%

EBIT Margin 7,3% 7,3% 8,4% 8,4% 7,2% 6,8% 6,7% 6,6% 6,6% 6,6% 7,7%

NOPLAT Margin 5,6% 5,6% 6,4% 6,4% 5,5% 5,2% 5,1% 5,0% 5,0% 5,0% 5,9%

ROIC 32,7% 32,8% 36,3% 35,8% 28,5% 23,3% 20,8% 20,0% 17,9% 17,9% 8,9%

Financial Value Drivers Under Renault's Ownership

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