Mergers & Acquistions (M&A) Explained: Economies Of Scale & Reacting To Competition

Welcome back to The Deal Room. And before I begin, Stephen did share a slight script with me where I was gonna give this fantastic opening, but then whilst discussing what we are gonna discuss, Stephen, you just said it way better than, than, than the script about why are we gonna do this mini-series about explaining M&A about case studies, about how that could be useful for applications that are ongoing. You just said it to me literally 2 minutes ago off air. That was so perfect as to the rationale behind a new kind of using the Deal Room for a mini-series. So, so what was that rationale?

Yeah. So over the next, over the next 4 episodes, we're going to spend a bunch of time going through why companies acquire other companies. It's a standard. If you were to read the M&A textbook in your undergraduate course, you would probably get your 6 or 7 reasons why one company might want to acquire another company, and maybe a couple of reasons why a company might want to be sold. But we're going to put this into a mini-series, partly because as you get interviews and as you prepare for assessment centres, it's fantastic to have— to be armed with this information. And to be armed with it in a couple of relatively short podcast episodes. Secondly, because we spend all— we spend all of our time teaching this, uh, discussing it in the deal, the deal of the week, putting it in the podcast. So just, just to add a bit of structure to what we already do in order to help you become slightly better with regards to your application process and your interview process and your assessment center process, it makes sense And hopefully it's gonna be a really, a really fun couple of episodes.

Okay, cool. So look, to give you a bit of insight as to what we're gonna cover in this first episode of the 4-part series, we're gonna look at economies of scale and reacting to competition. Gonna use Shein's acquisition of Missguided and also gonna look at Google's $2 billion investment in the AI company anthropic. So we'll also take a look at some other things. We've had this recent wave of mega deals in the oil and gas sector, so we'll talk a little bit about how the weight of cold hard cash acts as a reason to go out and find some acquisitions. And finally, in this episode, we're going to be using Intel and BlackBerry— BlackBerry is still knocking about, still exists— to discuss the logic of spin-offs and the rationale behind selling the family silver. So perhaps we could kick it off then, being the fashionista that you are, Stephen, with the story about SHEIN and Misguided.

Yeah, I have to confess, I've, I've never bought anything from SHEIN. I, I don't really know what it is, but I have been doing some research, so I'm better informed than I used to be. Uh, so yeah, so in these podcasts, we're going to give 3 rational— deal rationales, and then one reason for selling. So the first one we're going to talk about is economies of scale. And I like this one because it is straight out of an economics textbook. Whenever I ask audiences, students, why does one company buy another company, someone always says economies of scale. And to an extent, it is true. Economies of scale, the textbook definition, is the decreasing of unit costs as you grow as a company, which means that your gross margins, your revenue minus cost of goods sold, is increased. You are becoming more efficient. You are being able to drive down prices from your suppliers. You are benefiting from the scale that you are generating as an organization. Now, this is a really good textbook example when looking at Shein and misguided. So we put this on our Deal of the Week because I think it's a really, really interesting deal. So Shein, doing a little bit of digging, my gosh, it's a behemoth. It's valued at nearly $100 billion. It's looking, looking at an IPO probably at some point next year depending on the market. It's got 150 million users and its revenue growth rates, uh, over 100% year on year. So it is an amazing fast fashion on-demand network of manufacturers that provide clothing to users. Pretty, pretty fascinating company. And they have— they've been going out and buying basically failing brands and failing fashion companies. Forever 21 was something— it was a joint venture that they participated in last year. And a couple of days ago, it was announced that they had just bought Missguided. The UK, again, fast fashion, but female-focused fast fashion online retailer. Basically, the deal rationale behind this acquisition was, hey, look, we're Shein, we've got the most extensive customer directory. We have 150 million people that use us. We have unbelievable data on these customers. So you've got amazing customer targeting. This is what, what we would call marketing economies of scale from a textbook definition, but also we are going to insert you misguided into our supplier network and our manufacturing network. Because what Shein does is they say, look, we're almost an intermediary between the, the buyer and the manufacturer, and we are offering, you know, $50 million contracts, $100 million contracts to the manufacturing base, often in China. To go and develop these clothes at a very, very low unit cost. So Missguided just gets to insert themselves into both the marketing economies of scale and also what we call the supplier economies of scale, which should drive down unit costs for the Missguided label whilst also giving them access to a far wider audience of potential customers. So it's a pretty neat Again, textbook rationale for a particular deal.

Yeah, it's really well explained. If only economics module that I studied at uni had it explained to me in that way, it would have made a lot more sense. It would have been a lot faster, for sure.

Yeah, absolutely. And it makes a lot more sense when there's a real deal on the table. So often I was thinking about how you would teach it without a deal on the table, and the textbook would say, look, imagine a manufacturing facility, imagine a small manufacturer, um, they can't produce things as cheaply as a large manufacturer because you've got the automation in the warehouse. I would have probably given Tesla as the example, right? Their initial Roadster was $150,000 because they couldn't get the cost of production down, but now you can pick up a Model Y for $50,000. That's, that is kind of textbook economies of scale. But there are other types, especially when it comes to these types of acquisitions. And, and I, and, and I think it makes sense, uh, for Shein. Again, another reason they probably picked it up on the cheap. It's another deal rationale because it was insolvent just a year ago. So there's all money that, you know, as we've always said, a deal is either good or bad value depending on how much you pay. Um, but yeah, there's a couple of reasons there.

Well, look, before we, we move on to the, the next part, perhaps I can ask you and the listeners a quick quiz question. Which brand do you think has the longest average duration of a user being on their website? So when it comes to fashion retail, so a user landing on a website and you know what, I don't know what the average for any global website, but we're talking what, seconds normally, isn't it? For before you get a bounce off. So what do you think is the most sticky website where people come on and stay the longest?

It's— I guess it's interesting because you've got— you've got— you've probably— it's probably something that leverages that kind of addictive scrollability. Uh, so I immediately think of Vinted, uh, as something that you can scroll through for hours just looking and trying to get a cheap, you know, a decent deal. Uh, I don't think it is Vinted. I, I, you know, it could be SHEIN because you've— because you've suggested this quiz in this— in this part of the podcast. But I don't know, I'm gonna give SHEIN. Why not?

Well, you've obviously done your research then. You are obviously looking at the Shein hauls on TikTok, and that must have landed in the right place. So yeah, Nike is actually number 2, and I think the— I think it's— I can't remember the exact second, but it's something like 3 and a half minutes the average session, whereas Shein by far and away is the highest. It's more like 7 minutes. Which is insane. But, um, but yeah, and there was H&M, Zara, they all comprise of the other sort of top 5. But yeah, but there you go. So, okay, economies of scale, tick. Yeah, nice. So yeah, reacting to competition.

Yeah, I think this is a really interesting one just in the context of, of, of remembering— I always say this— remembering that what we talk about when we talk about deals and we talk about M&A and we talk about careers in finance it's all a human-based industry. We're all humans and we all look at our next-door neighbors from a company perspective. We're constantly thinking, what are they doing? Should we be doing that or should we be doing something totally different? So, so reacting to competition is such an important driver of doing deals. And we've got a couple of examples here actually kind of the inverse of each other. The first one again is Shein. So again, Shein acquisition of Missguided. Some people say that this, this bringing in of brands— Forever 21, Missguided— is a slight reaction to the growth of its Chinese competitor Temu, which is an offshoot of the Chinese company Pinduoduo. And Temu, who acts as a marketplace rather than a own brand retailer. They act as a marketplace and they have grown much quicker than Shein in the US and they have been number one in the app, the iOS app downloads every single week for the last 6 months in the US. So they are growing incredibly quickly. They are, you know, it becomes a bit of a lowest common denominator when it comes to these fast fashion companies. If Shein can sell a dress for $10, Can we find a supplier that will sell one for $8? And that's what it's looking like going. So Shein, instead of going, can we compete on unit costs and on sales? Well, no, maybe we can look at our competition and differentiate. So reacting to competition, I'm going to go out and buy established brands. I'm going to go out and buy Forever 21, going to get them onto the Shein ecosystem. I'm going to go out and buy Missguided, get them onto the Shein ecosystem and start to become a little bit different from this upstart rival in order to protect the valuation, which is, as we said, you know, upwards of $100 billion, in order to further create that story when it comes to the IPO. So again, reacting to competition by differentiating is a really, really important one. The flip side, the flip side is, is the fear of missing out. And we've spoken both on this podcast and on the Friday podcast a lot about this AI hype cycle, or generative AI hype cycle. And I'm not sure whether you covered it on Friday. Did you cover— did you cover the Google earnings on Friday?

Yeah, we were talking about Microsoft and, uh, and Google, so we did talk AI. Yes, it's brilliant.

So it's fantastic. So, so, you know, obviously Alphabet had a big earnings— well, it's going to say I had a big earnings miss. It didn't really have an earnings miss. You know, let's be honest about it. How was that? How was such a successful quarter, uh, you know, reacted with a 10% drop in share price?

Well, yeah, I mean, the summary of that is when you are in the collective of the Magnificent Seven, anything short of magnificent is just not good enough as far as Wall Street is concerned these days.

Absolutely insane. Um, so Alphabet had a cloud computing earnings miss on the 25th of October. Microsoft had a massive, uh, win, revenue 30% up, as you spoke about on Friday, uh, and the share price of Google went down almost 10% in reaction. So what happened, uh, a couple of days ago? Well, Google announced, or Alphabet announced, that it had, uh, further— it, it had invested a further $2 billion in a generative AI startup Anthropic, off the back of Amazon investing $4 billion in the same company, and obviously Microsoft with OpenAI as well. So this is a jumping on the bandwagon. This is reacting to competition by doing what they're doing. Right. So this is everyone in this, you know, Magnificent Seven, everyone trying to jump on this bandwagon because they have seen the massive, massive, massive share price increase related to this boom in generative AI. So sometimes you look at your competition and you go, I want to be different. Sometimes you look at your competition and you say, I want to buy a company so that I can be the same, or I can be more like my rival that seems to be getting a little bit of a, bit of a head start over me. So reacting to competition is a very, a very interesting deal rationale.

Yeah, and looking at the Anthropic founding members, they were the founding members of OpenAI, so it literally doesn't get more interbred in terms of the sharing of knowledge in that space. So yeah, super interesting actually.

Yeah. And who knows? And who knows what will happen? You know, just taking a step back, who knows whether the kind of valuation wheels will come off once we realize that the use cases may well be limited. However, I don't know if you've been— I mean, OpenAI's growth rate in terms of revenue is quite staggering from a standing start of almost nothing. Um, it's, it's, it's quite remarkable. So maybe we've got a few, a few months and years left to run on that. Cool.

All right, well, let's, let's discuss a little bit on using capital. Now, we've discussed quite a bit on recent podcast episodes about the actual deal mechanics themselves, but maybe how it plays into the context of this conversation with Exxon and Chevron.

Yeah, so using capital isn't, isn't necessarily the most textbook, most textbook explanation as to why someone would go out and do a deal. But it stands to reason that if I've got a load of cash on my balance sheet and that cash is growing and growing and growing, I am going to be under pressure from my shareholders to do something with that cash. Obviously, you can do 3 things with that cash. You can reinvest it in the business. It's what, you know, what we call organic growth— quite slow, quite steady, often quite hard to find things to spend that money on within the business. Especially if you're an established business. The second is to return it to shareholders, which obviously shareholders love, uh, in the form of dividends or share buybacks. And the third is to go out hunting, go out and buy another company. And often when there is a lot of cash on the balance sheet, shareholders will start asking the question, what are you going to do with that money? Because remember, if I'm investing in a company, I don't want them to just hoard cash because I can hoard cash. Yeah, I want them to go out and do something with it that's going to make my investments in, you know, increase, right? So Exxon acquiring Pioneer, Chevron with its latest acquisition that we covered in Deal of the Week— this is— these are two representations of companies that have had bumper years, bumper recent years due to the spike in oil prices, uh, hoarding cash and then spending some of it. Now, especially in the case of Exxon acquiring Pioneer, Exxon has $30 billion of cash on its balance sheet. It needs to use some of it, otherwise it will start getting— feeling the pressure. Actually, Chevron's was slightly different because it was an all-share transaction. So Chevron's recent $59 billion acquisition was an all-share transaction, and that's partly because the share price from March 2020, Chevron share price rose from $59 to $165 a share, which means that you have more— your shares go further, you're a more valuable company. So when you're looking at an all-share transaction, which means that the, uh, target's shares get converted into a number of the new owner's shares, means that I have more leverage because I'm a more valuable company. So using capital and leveraging valuation, leveraging increases in share price is a very common deal rationale. And obviously when you're riding the upswing of a cyclical surge, as Exxon and Chevron has been doing, it's that again, it stands to reason that they should be going out and hunting and entering in this new era of oil and gas consolidation that we've spoken quite a lot about. So I always say, you know, if you want to, if you want to find out who might be doing the next wave of acquisitions, just go to the balance sheets and go to the, go to the increase in share price, because you know that those two factors will contribute to an urgency of finding a suitable acquisition.

Yeah, and it seems like at the moment a bit of a return to reality for some of these oil majors, because we've had all the earnings started to come out. And BP this morning, so they made a Q3 net— Q3 net income, this figure is, which makes it even more like huge. It came in at 3.29 billion for the quarter, net income. Now that sounds like a, a giant figure, but actually it was short. Analysts were looking for 4 billion. And remember A year ago, a year earlier, Q3, they were clocking in at $8.15 billion net income. So yeah, they're, they're, they were kind of building up the war chest, so to speak, and that money's still coming in, um, evidently at this point, but has dropped off quite dramatically.

And, and, and look, these big oil majors, they, they, they, uh, they have a very, very consistent dividend policy. Uh, which is the main— which is the fundamental reason why a lot of, a lot of, a lot of people own shares in these, in these companies. But $8 billion in a quarter, there's going to be some room for maneuver. And, and there have been calls actually recently for BP to get active in the market. Again, is there this kind of fear of missing out? Well, your competitors are doing deals. What, what are you doing? Are you just going to sit tight? So we'll wait and see whether BP and Shell, uh, start making some moves as well.

Maybe a, a deal between each other, perhaps. Could that even be possible? There's been— there's— you often get every now and again, don't you, a little bit of murmuring around the supermajors coming together?

Yeah, I mean, so ExxonMobil was a, was a pretty big, uh, transaction, right? A pretty big merger. And, and I mean, Shell and BP are so large and so competitive with each other as the Europeans, or two of the European supermajors. Anything's possible, but that would be, that would be quite remarkable.

Well, now's the time for Shell. BP's a bit of a, uh, without a captain, so to speak, interim CEO right now. So we should see. But, um, okay, so we've covered A couple of things: economies of scale, reacting to competition, we just discussed there using capital. Now, spin-offs, something which you often hear a lot of. So how does that fit into the picture?

Yeah, so I, I like, I like to do one reason why a company would sell, uh, or why an organization would consider, uh, receiving offers for its company. So there are obviously two sides to every transaction, and working in M&A, you will have a bank that acts on behalf of the buyer and a bank that acts on behalf of the seller, and it's got to be a deal works for both parties. I just thought I'd talk very quickly about spin-offs. Now, spin-offs are where a larger company decides to sell or spin off a division of its particular company in order potentially to unlock value that is not being realized because that particular unit is being weighed down by the rest of the company or doesn't make strategic sense. I'm just going to link this to a very a little bit of theory. So as an analyst, as an M&A analyst, you are likely to do, to conduct quite a few sum-of-the-parts valuations. So how do we value a particular company? Let's think about Alphabet. How do I value Alphabet? Well, I can do my traditional discounted cash flow, or I can do my trading and transaction comps analysis, but I can also do I can also value the individual parts of the business to see whether the sum of the parts is more valuable than the whole. And in Google's case, well, maybe it is because you've got one of the most valuable social media companies or social media content companies in YouTube. You've got the cloud, you've got the search. Pretty remarkable set of businesses that if they are unleashed, if they are spun off, maybe will create even more value. Just going back to our economies of scale argument, the reason why you might acquire a company, this is more of a diseconomies of scale argument, right? Maybe you've got, you've got a little bit big for your boots as a company, and you've gone out and acquired a bunch of other companies, and you suddenly become a bit of a mess. You become a bit of a strategic mess with all sorts of different units doing different things. The share price gets weighed down because you tend to get valued closer to your least productive business unit relative to your most productive business, business unit. So what you do, you consider spinning off a chunk or spinning off a business unit. And that is what Intel has recently announced that they are going to do with their programmable chip division and BlackBerry with its Internet of Things division as well.

So let me give you, um, let me, let me, I was just add a question. I was frantically typing away because something came to mind as you were describing, uh, spinoffs. So just given the spirit of talking a little bit on this episode about Alphabet or Google, um, and obviously YouTube revenues, there was a US analyst that back in 2019, this is a few years old, mind, um, that, or forecasted how much YouTube would be valued if it was spun off into its individual entity. What do you reckon would be as a valuation standalone YouTube?

Well, back in 2019? Yeah. Oh yeah, it's a, it's a really good question. I, I, I think it's an incredible, incredible company and probably should be valued at more than Meta is valued at the moment. I'm trying to think back to 2019. Look, 800 billion, a trillion. How are we doing?

300 billion. So it's, so, uh, it's still a very big number, but in fact that would at the time— so context, 2019— if YouTube was valued at 300 billion, that would put it as the 15th biggest company, or one of the biggest 15 in the S&P 500. So yeah, that doesn't—

again, it, it just doesn't surprise me. It's such an amazing company. And I just wonder whether it would— by, again, I don't think that there's any discussion going on about, you know, splitting up Google apart from if you're in the, uh, in the FTC, part of the antitrust discussions. But yeah, an independent YouTube as an attractive investment is an attract— it probably would be one of the top 10 in the S&P for sure.

A question from a strategy point of view then: if I was Zuckerberg, is there any way I could use some sort of spin-off or shareholding, um, way of managing the virtual reality labs, which is just like leaking money but does hold a future key source of technology that could be distributed, redistributed across the business. Is there any way I can kind of off, like put that away somewhere on the balance sheet to have it away? Or is this more just the CFO doing good job engineering on conference calls?

Yeah, it's really, it's really interesting. It's kind of what, it's why Facebook's now called Meta and it's now, it's why Google's called Alphabet, right? And Alphabet is a, is a collection of different companies. The most important is their search, is Google. But within that, they've got DeepMind, which is their AI research company, let's call it. And they've got— previously they had their kind of moonshot labs where there was a huge budget for doing moonshot-type businesses that could fail. but could also become the next trillion-dollar business. They're kind of incubator. Now, that's a really exciting thing to think about, and that's probably what Meta's done with its metaverse and, you know, put it in that separate section. When the economic going gets tough, this start— this division, the moonshots division or the metaverse division, that starts to become strategically a little less palatable. You're like, ah, where's the money here? Like, you know, the search business is amazing for Google. The marketing and advertising business for Facebook is amazing. Just focus on that. We just want to see your EPS grow. We don't really care that much about moonshots now. During the next kind of hype cycle, maybe we could get back into it. So strategically, that's kind of what Meta is doing at the moment. But I might want to— yeah, I'm just going to end on one point about these spinoffs. We don't need to go into too much detail about Intel and BlackBerry. It's worth, it's worth just looking them up yourself. But the, the, the stock market reaction, the investor reaction to both of these spin-off announcements— Intel spinning off their Programmable Solutions Group, which is what they're going to be calling it, uh, and hopefully IPOing it next year, and BlackBerry spinning off its IoT, Internet of Things, division and maybe IPOing next year, the share prices of both Intel and BlackBerry went up. Now, Intel went up 3.5%, BlackBerry went up 5%. Think about that in the context of many of the episodes that we've spoken about in the last few months. Usually on the announcement of an acquisition, the acquirer share price goes down because investors would rather see that money return to them in the form of dividends or buybacks or whatever, and, and tend to think that big acquisitions may well be dilutive as opposed to accretive to their, to, to, to their earnings per share. Whereas in a spin-off, the typical stock market reaction is that share prices go up of the company that's spinning off, because suddenly they're like, all right, well, maybe there could be a liquidity event, a kind of a cash event that could get returned to us. Maybe this company's going from being quite flabby to being quite focused. We quite like that. So it's quite interesting just to see the typical stock market investor reactions to these different strategic moves, whether it's an acquisition or a spin-off.

Cool. Well, look, Stephen, this is part of a 4-part series, so I'm gonna plug for people to Make sure, if you're not already, that you subscribe to the channel because you don't want to miss those other episodes. But what can people expect from the rest of the series?

Well, look, I've got a very, very long list of rationale for deals, and I'm going to try and pattern— well, I'm going to try and match that list with things that have been going on in the news over the preceding week. So I can't tell you what's going to come up next week because I'm going to try and make it relatively flexible and live. But by the end of this little series, you're going to have a pretty strong compendium of strategies and rationales for why companies do deals.

Cool. And just a final shout out as well, um, I understand you've got another M&A Finance Accelerator session happening this week. Is that right?

Yeah, we're going, we are going this Thursday, 4 PM UK time till 6 PM. Uh, these things usually sell out, quote unquote, they get booked up. It doesn't cost any money. Uh, they get booked up really, really quickly. So follow the, follow the socials, follow LinkedIn for, for the next, for the next session. But the next one is coming up this coming Thursday at 4 PM.

Cool. The link you'll be able to find in the show notes. So just go there. There's probably a few spaces left because we'll drop this episode, uh, and then there'll be a day or so until the event. But yeah, hopefully you can get in on that action. But yeah, thanks Stephen, thanks everyone for listening, and see you for the next episode.

Thank you, man.