Question - Ford anticipates substantial synergies from acquiring Volvo. What are these potential synergies? As a consultant hired to value Volvo, what additional information would you need to estimate the value of potential synergy from each of these areas?

CASE INFO

Ford Acquires Volvo's Passenger Car Operations

This case illustrates how the dynamically changing worldwide automotive market is spurring a move toward consolidation among automotive manufacturers. The Volvo financials used in the valuation are for illustration only they include revenue and costs for all of the firm's product lines. For purposes of exposition, we shall assume that Ford's acquisition strategy with respect to Volvo was to acquire all of Volvo's operations and later to divest all but the passenger car and possibly the truck operations. Note that synergy in this business case is determined by valuing projected cash flows generated by combining the Ford and Volvo businesses rather than by subtracting the standalone values for the Ford and Volvo passenger car operations from their combined value including the effects of synergy. This was done because of the difficulty in obtaining sufficient data on the Ford passenger car operations.

Background

By the late 1990s, excess global automotive production capacity totaled 20 million vehicles, and three-fourths of the auto manufacturers worldwide were losing money. Consumers continued to demand more technological innovations, while expecting to pay lower prices. Continuing mandates from regulators for new, cleaner engines and more safety measures added to manufacturing costs. With the cost of designing a new car estimated at $1.5 billion to $3 billion, companies were finding mergers and joint ventures an attractive means to distribute risk and maintain market share in this highly competitive environment.

By acquiring Volvo, Ford hoped to expand its 10% worldwide market share with a broader line of near-luxury Volvo sedans and station wagons as well as to strengthen its presence in Europe. Ford saw Volvo as a means of improving its product weaknesses, expanding distribution channels, entering new markets, reducing development and vehicle production costs, and capturing premiums from niche markets. Volvo Cars is now part of Ford's Premier Automotive Group, which also includes Aston Martin, Jaguar, and Lincoln. Between 1987 and 1998, Volvo posted operating profits amounting to 3.7% of sales. Excluding the passenger car group, operating margins would have been 5.3%. To stay competitive, Volvo would have to introduce a variety of new passenger cars over the next decade. Volvo viewed the capital expenditures required to develop new cars as overwhelming for a company its size.

Historical and Projected Data

The initial review of Volvo's historical data suggests that cash flow is highly volatile. However, by removing nonrecurring events, it is apparent that Volvo's cash flow is steadily trending downward from its high in 1997. Table 9-10 displays a common-sized, normalized income statement, balance sheet, and cash-flow statement for Volvo, including both the historical period from 1993 through 1999 and a forecast period from 2000 through 2004. Although Volvo has managed to stabilize its cost of goods sold as a percentage of net sales, operating expenses as a percentage of net revenue have escalated in recent years. Operating margins have been declining since 1996. To regain market share in the passenger car market, Volvo would have to increase substantially its capital outlays. The primary reason valuation cash flow turns negative by 2004 is the sharp increase in capital outlays during the forecast period. Ford's acquisition of Volvo will enable volume discounts from vendors, reduced development costs as a result of platform sharing, access to wider distribution networks, and increased penetration in selected market niches because of the Volvo brand name. Savings from synergies are phased in slowly over time, and they will not be fully realized until 2004. There is no attempt to quantify the increased cash flow that might result from increased market penetration.

Table 9-10. Volvo Common-Size Normalized Income Statement, Balance Sheet, and Cash-Flow Statement (Percentage of Net Sales)

1993 19941995199619971998199920002001200220032004

Income Statement

Net Sales1.0001.0001.0001.0001.0001.0001.0001.0001.0001.0001.0001.000

Cost of Goods Sold.772.738.749.777.757.757.757.757.757.757.757.757

Operation Expense.167.101.120.077.119.133.132.131.129.128.127.126

Depreciation.034.033.033.034.029.038.038.039.040.040.041.042

EBIT.027.128.098.112.088.073.073.074.074.074.075.075

Interest on Debt.050.023.022.021.015.023.023.022.021.021.020.020

Earnings Before Taxes .024.017.076.091.072.049.051.052.053.054.055.056

Income Taxes.004.018.022.012.015.014.014.015.015.015.015.016

Net Income.028.087.054.079.057.035.036.037.038.039.040.040

Balance Sheet

Current Assets .632.503.444.524.497.500.500.500.500.500.500.500

Current Liabilities.596.400.283.298.304.350.350.350.350.350.350.350

Working Capital.036.103.161.226.192.150 .150.150.150.150.150.150

Total Assets1.21.889.809.905.889.906.880.858.839.822.808.795

Long-Term Debt.371.211.227.236.256.234.215.196.180.165.151.307

Equity.244.278.299.371.329.321.316.312.309.308.307.307

Selected Valuation Cash-Flow Items

EBIT (1 - t).022.150.126.126.105.093.094.094.095.095.096.096

Capital Expenditures .031.027.033.053.054.061.069.078.088.099.112.126

D Working Capital .025.077.068.049.000.017.020.020.020.020.020.020

Free Cash Flow.047.079.053.059.088.087.044.036.027.017.005(.008)

to the Firm (FCFF)

Determining the Initial Offer Price

Volvo's estimated value on a standalone basis is $15 billion. The present value of anticipated synergy is $1.1 billion, suggesting that the purchase price for Volvo should lie within a range of $15 million to about $16 billion. Although potential synergies appear to be substantial, savings due to synergies will be phased in gradually between 2000 and 2004. The absence of other current bidders for the entire company and Volvo's urgent need to fund future capital expenditures in the passenger car business enabled Ford to set the initial offer price at the lower end of the range. Thus, the initial offer price could be conservatively set at about $15.25 billion, reflecting only about one-fourth of the total potential synergy resulting from combining the two businesses. Other valuation methodologies tended to confirm this purchase price estimate. The market value of Volvo was $11.9 billion on January 29, 1999. To gain a controlling interest, Ford had to pay a premium to the market value on January 29, 1999. Applying the 26% premium Ford paid for Jaguar, the estimated purchase price including the premium is $15 billion, or $34 per share. This compares to $34.50 per share estimated by dividing the initial offer price of $15.25 billion by Volvo's total common shares outstanding of 442 million.

Determining the Appropriate Financing Structure

Ford had $23 billion in cash and marketable securities on hand at the end of 1998 (Naughton, 1999). This amount of cash is well in excess of its normal cash operating requirements. The opportunity cost associated with this excess cash is equal to Ford's cost of capital, which is estimated to be 11.5%about three times the prevailing interest on short-term marketable securities at that time. By reinvesting some portion of these excess balances to acquire Volvo, Ford would be adding to shareholder value, because the expected return, including the effects of synergy, exceeds the cost of capital. Moreover, by using this excess cash, Ford also is making itself less attractive as a potential acquisition target. The acquisition is expected to increase Ford's EPS. The loss of interest earnings on the excess cash balances would be more than offset by the addition of Volvo's pretax earnings.

Epilogue

Seven months after the megamerger between Chrysler and Daimler-Benz in 1998, Ford Motor Company announced that it was acquiring only Volvo's passenger-car operations. Ford acquired Volvo's passenger car operations on March 29, 1999, for $6.45 billion. At $16,000 per production unit, Ford's offer price was considered generous when compared with the $13,400 per vehicle that Daimler-Benz AG paid for Chrysler Corporation in 1998. The sale of the passenger car business allows Volvo to concentrate fully on its truck, bus, construction equipment, marine engine, and aerospace equipment businesses. (Note that the standalone value of Volvo in the case was estimated to be $15 billion. This included Volvo's trucking operations.)