Cost Synergies in M&A Deals and Merger Models: Full Tutorial and Sample Excel Model
In this tutorial, you’ll learn what Cost Synergies mean, how to estimate them in merger models, and how to compare them to the equity purchase premium in M&A deals.
Cost Synergies Definition: In mergers and acquisitions, Cost Synergies refer to cases in which the combined company’s expenses are less than the Buyer’s expenses plus the Seller’s expenses due to a reduction in the employee count, more favorable supplier contracts, consolidated buildings, and other initiatives.
People often argue for mergers and acquisitions because of “synergies” – but they rarely take the time to understand what this term means and the implications in financial models.
We’ll focus on Cost Synergies in this article, but let’s start by explaining all types of synergies:
What Are Synergies, and Why Do They Matter in M&A Deals?
Put simply, synergies are cases in which 1 + 1 = 3 in mergers and acquisitions.
For example, the Buyer has Revenue of $100, and the Seller has Revenue of $50.
But as a combined company, the Total Revenue is $175 rather than $150 because:
- The Buyer can sell more products to the Seller’s customers, or vice versa.
- The Buyer can add features from the Seller’s technology to its products and services, and customers are now willing to pay more.
- The Seller can use the Buyer’s larger distribution network and geographic presence to sell its products to new customers.
These examples all refer to Revenue Synergies, and in real life, they might look like this in a merger model:
In this case, we’ve assumed that the Seller – BMC Stock Holdings – will be able to sell more lumber, windows, doors, and millwork because of its acquisition by Builders FirstSource, a larger company in the building materials industry.
We modeled these Revenue Synergies as simple percentage increases in sales within these segments, along with corresponding increases in the Cost of Sales and Operating Expenses (there’s no such thing as a free lunch!).
Synergies matter in M&A deals because Buyers tend to pay premiums for Sellers, and if the market fairly values a Seller, synergies may be required to justify the premium.
For example, let’s say that a Seller’s Market Cap or Equity Value is currently $100.
To win approval from the Seller’s shareholders to acquire the Seller, the Buyer offers $125, which is a 25% premium.
If the Seller’s fair value as an independent, publicly traded entity is only $100, then the Buyer can justify this higher price of $125 only if it realizes significant synergies in the deal.
You can estimate the value of these synergies by projecting their after-tax cash flows, assigning them a Terminal Value, and discounting everything at an appropriate Discount Rate (normally the Weighted Average Cost of Capital for the Buyer):
Here, for example, we estimate the synergies’ value at ~$1.2 billion, and Builders FirstSource is paying an equity premium of only ~$300 million for BMC (NOTE: In this screenshot, we’re valuing both Revenue Synergies and Cost Synergies; the section below explains Cost Synergies).
Therefore, it seems like the premium the Buyer is paying is more than justified by the synergies it will realize – assuming the numbers are even close to correct.
Cost Synergies 101: Got Realism?
While Revenue Synergies are important in some deals, they are also highly speculative because no one can “predict” how sales will change when two companies merge.
It’s possible that Company B will sell more of its product to Company A’s customers, but until the deal closes, no one knows for sure.
Therefore, Cost Synergies are often taken more seriously in M&A deals.
They’re more grounded in reality because they’re based on the current spending levels of the Buyer and Seller.
For example, if the Buyer and Seller both have human resources (HR), information technology (IT), and accounting teams, they probably don’t need to maintain these separate teams at their current sizes after a merger.
They can probably form one consolidated team for the combined company with fewer employees.
Besides a “reduction in force” (RIF), AKA laying off employees, Cost Synergies could also come from:
- Renegotiated supplier agreements that result in the combined company paying less for Inventory because of larger order sizes.
- Building consolidation because the combined company probably won’t need as many buildings as the companies did separately. A lower building count means fewer leases, a lower rental expense, and, under IFRS, less in lease interest and lease depreciation.
- Information Technology (IT) because if one company has more efficient systems or software, it might get the entire, combined business to use that setup and save money.
- Reduced sales & marketing (S&M) spending because the combined company may not have to spend as much on marketing as the separate companies did; it may also get better advertising rates due to higher volume.
The concept of Cost Synergies is nice, but their implementation in models is equally important.
When building Cost Synergies into merger models, the following points are critical:
1) Granularity of Estimates – Where do the numbers come from? Are these simple percentage reductions, or are you basing them on employee counts, rental rates from lease agreements, and so on?
2) Time Required – Even if two companies can become more efficient as a combined entity, it will take time to realize these efficiencies. The combined company will transition to new buildings, employee organizations, and supplier relationships over several years.
3) Implementation Costs – Reshuffling an organization also requires money due to employee severance costs, lease-break fees, and the implementation of new systems and processes within IT.
How to Estimate Cost Synergies in Merger Models
A good starting point in any M&A deal is to review the investor presentation issued by the Buyer or Seller; these presentations usually have estimates for the expected synergies.
For example, here are the estimates directly from Builders FirstSource and BMC in this deal:
We can then “foot” these numbers by looking at the average employee cost within the SG&A (Selling, General & Administrative) category for both companies and estimating how many employees might be cut:
The “merger & integration costs” associated with these Cost Synergies are typically a percentage of the fully realized annual cost savings.
We might conservatively estimate that these costs represent 100% of the fully realized annual Cost Synergies, matching the company’s expectations:
It will also take time to restructure the company and realize these cost savings, and we assume that these integration costs are front-loaded, with 2/3 in Year 1 and 1/3 in Year 2, as shown above.
Here’s what they look like relative to the Cost Synergies:
We can now estimate the Present Value of these Synergies, compare it to the Equity Purchase Premium in the deal, and link everything in the full merger model.
We demonstrated the Present Value calculation above, but here are the links and impact on the Combined Income Statement:
The Realistic Impact of Cost Synergies
If you properly factor in the time and expenses required to realize the Cost Synergies, the Buyer’s EPS accretion will almost always decrease in the first 1-2 years but increase after that.
The Buyer incurs most of the merger and integration costs early in the combined period but reaps the full benefits later.
So, Cost Synergies often make deals look worse in the short term, even if they improve the long-term cash flows associated with deals.
To get around this issue, you could do one of the following:
1) Calculate “Pro-Forma” EPS Accretion/Dilution – This metric reverses the non-cash effects of an acquisition and usually adds back the merger and integration costs:
2) Calculate the Long-Term Benefits of the Synergies – We used this approach above when comparing the Present Value of the Synergies to the Equity Purchase Premium.
We prefer the second approach here because “Pro-Forma” numbers are subjective, and there’s no universally accepted way to calculate them.
By themselves, Cost Synergies rarely make or break an M&A deal.
But they often make or break the justification for an M&A deal, which is why they’re so important in transaction discussions.
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