The Wonderful World of Mergers

Two heads are better than one, and in business, that adage often holds true. By merging or through acquisitions, two companies can group their resources in order to increase market share, beat a particularly difficult competitor, or create a more efficient business model. But such joining of forces doesn't happen overnight; companies must undergo a very long and often frustrating process first.

Mergers vs. Acquisitions

The term mergers and acquisitions (M&As) is often used to describe various corporate restructuring strategies, but it is important to note that these words usually refer to different types of business activities. Mergers take place when two relatively equal-sized companies mutually decide to pool their interests to form a single corporation.

Acquisitions, on the other hand, occur when companies purchase one another—sometimes under hostile circumstances—eliminating the existence of the target as an independent corporate entity. In certain situations, a company that is undergoing an acquisition may still call the deal a merger in order to eliminate negative connotations, even though it is technically an acquisition.

Let's take a closer look at the most common forms of mergers:

Horizontal Merger

When two companies offer similar products or services, they may join together in an attempt to lower costs and increase efficiency. This type of transaction is called a horizontal merger, and because the deal reduces competition in the marketplace, such transactions are heavily regulated by antitrust legislation.

The 2002 merger of Hewlett-Packard (HPE) and Compaq Computer was a horizontal merger, and although there was concern about reduced competition in the high-end computer market, the Federal Trade Commission (FTC) unanimously approved the transaction.

Vertical Merger

In contrast to a horizontal merger, a vertical merger occurs when two companies representing different steps in the buyer-seller relationship or production process join forces. One of the most well-known examples of a vertical merger took place in 2000 when internet provider America Online combined with media conglomerate Time Warner.

The merger is considered a vertical one because Time Warner supplied content to consumers through properties like CNN and Time Magazine, while AOL distributed such information via its Internet service.

Congeneric Merger

Companies that are in the same industry but do not have a competitive supplier or customer relationship may choose to pursue a congeneric merger, which could allow the resultant company to be able to provide more products or services to its customers.

One widely cited example of this type of deal is the 1981 merger between Prudential Financial (PRU) and stock brokerage company Bache & Co. Although both companies were involved in the financial services sector, prior to the deal, Prudential was focused primarily on insurance while Bache dealt with the stock market.

Conglomerate Merger

When two companies have no common business but decide to pool resources for some other reason, the deal is called a conglomerate merger. Procter & Gamble (PG), a consumer goods company, engaged in just such a transaction with its 2005 merger with Gillette.

At the time, Procter & Gamble was largely absent from the men's personal care market, a sector led by Gillette. The companies' product portfolios were complimentary, however, and the merger created one of the world's biggest consumer product companies.

Reverse Merger

A reverse merger—also called a reverse acquisition or reverse takeover—allows a private company to go public while avoiding the high costs and lengthy regulations associated with an initial public offering (IPO).

To do this, a private company purchases or merges with an existing public company, which may be a "shell company," installs its own management, and takes all the necessary measures to maintain the public listing. For example, portable digital device-maker Handheld Entertainment did this when it purchased Vika Corp in 2006, creating the company known as ZVUE.

Accretive Merger

When one company acquires another company and the transaction increases the first company's earnings per share, the deal is called an accretive merger. Another way to calculate this is to note the price-earnings ratio (the ratio between the company's price per share compared to its per-share earnings per year) between the acquiring firm and the target firm.

If the price-earning ratio of the acquiring firm is higher than that of the target firm, the merger is accretive. In other words, the earnings of the target company add market value to the acquiring company. Whether or not a transaction is accretive can change over time, based on changes in the two companies' stock prices and earnings.

For example, Hewlett-Packard announced a merger with services company EDS in 2008 but said that the deal would become non-GAAP accretive in 2009 and GAAP accretive in fiscal year 2010.

Dilutive Merger

The opposite of an accretive merger is a dilutive one, in which a merger decreases the acquiring company's earnings per share. Entering into a dilutive merger is not necessarily bad; in certain circumstances, transactions that are initially dilutive may create value over time, such as when a low-growth company purchases a high-growth company.

If the price-earnings ratio of the target firm is greater than that of the acquiring firm, the merger is dilutive. Copper mining company Phelps Dodge entered a dilutive merger with Canadian nickel miners Inco and Falconbridge in 2006.

The Bottom Line

When two companies merge resources, the resulting transaction can be known by many names. Whether a company calls a deal a merger or an acquisition is largely a function of how the management chooses to present the transaction to its own employees and to the public.

Mergers can take place between many different types of companies such as competitors, industry partners, or corporations with an input-output relationship, and may serve to either increase or decrease earnings per share.

Regardless of how the companies are characterized, one thing remains the same: mergers are always friendly in nature, while acquisitions can be either friendly or hostile.