Many mergers and acquisitions are undertaken with the promise of significant cost savings through workforce reduction. However, the issue of whether the projected synergies are achievable is often left for integration teams to tackle. Companies could benefit from using a practical framework that not only validates the workforce synergies available at the pre-deal stage but also highlights the operational risks associated with closing this type of transaction.
“If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked.”
– Letter to Stockholders (1998) from Warren Buffett, chairman of Berkshire Hathaway
During 2005, a strong focus on free cash flow and profitable growth continued to be a critical direction for corporate Canada. Despite the high volume of growth-oriented mergers and acquisitions activity over the past year, operational excellence and cost reduction remain an executive priority for Canadian companies. In fact, while most companies purport that increased market share and revenue growth were prime motivators in making their deals, they also agreed that a substantial component of the valuation resided in the operational synergies expected from integration.
Operational synergies in the context of business combinations can take many forms, ranging from the cross-selling of products to the rationalization of product portfolios. However, pure head-count reduction continues to be one of the most direct approaches in delivering efficiency targets (see Figure 1 below). Removing any duplication through the consolidation of functional areas, re-alignment of resources and optimization of technology can drive immediate improvements to operating margins, with subsequent restructuring costs being recognized below the all-important EBITDA line. For industries that are labour-intensive, significant cuts in the workforce would decrease not only the direct salaries and benefits costs but also other head-count-driven expenses such as travel, training, motor vehicles and offices and computers, all of which can add an additional 10 to 20 per cent to the projected annual cost savings.
Recent examples of this rationale would include the $16 billion (U.S.) AT&T and SBC merger, completed in November 2005, in which the carriers are expected to achieve annual operating synergies of about $2 billion (U.S.) by cutting back on redundant departments and functions. (All amounts are expressed in U.S. dollars). SBC has stated that it expects a workforce reduction of 13,000 through this merger. Similarly, Verizon’s $8.6 billion acquisition of MCI, completed in January 2006, is predicated on annual operating synergies of about $1 billion through the reduction of 7,000 jobs from the companies’ combined workforce of about 250,000 employees.
At a one-dimensional level, the more you cut, certainly the more costs you save. Nevertheless, the underlying premise behind efficiency through consolidation is that the combined entity can achieve economic results that outstrip the sum of its parts Â¯ in short, it can achieve more with less people. It is important, therefore, to test this notion by assessing any proposed workforce reduction in the context of appropriate operational metrics, to ensure that the reduction is indeed achievable from a business perspective. Moreover, there are potential non-financial implications associated with this type of efficiency programs that may have a significantly adverse impact on the overall M&A business case.
In the following pages, we will use a hypothetical example to present a framework for analysis and to explore key issues inherent in M&As that depend on significant workforce reduction synergies.
Operational Synergies Through Workforce Reduction – Analysis
In our example detailed in Figure 2, the Acquirer is contemplating the extent of the synergies possible through the integration of its functional groups with Target Co. In particular, the combined entity, New Co, can achieve different levels of annual savings through various degrees of integration, ranging from no layoff/no savings in the conservative Status Quo scenario, to $40 million annual savings in the aggressive Option 3 scenario, in which a 30-per-cent head-count reduction is attained.
As expected, the greater the workforce consolidation, the more attractive the economic results. For example, with a 30-per-cent workforce reduction in Option 3, economic measures such as the payback period and annual operating savings are far more prominent than in Option 1. Most notably, with a 30-per-cent versus a 10-per-cent staff reduction, the EBITDA margin improves by 500 basis points.
In principle, cost savings arising from workforce reduction are easy to calculate. However, acquirers often underestimate the practical challenges in capturing these savings. For instance, certain positions could easily be eliminated by the stroke of a pen, but the people in those jobs may be moved to other departments due to their continuing value to the merged entity. Consequently, head count remains largely unchanged, so the merger does not deliver the targeted cost savings.
Despite the favourable financial metrics in Option 3, careful regard must also be given to the operational pressures that would be created on the business because of the substantial decrease in head count. Namely, relevant operational Key Performance Indicators (KPIs) resulting from the reduction need to be assessed in order to conclude whether the degree of reduction contemplated in Option 3 is reasonable or too aggressive.
Operating impact analysis
Somewhat ominously, when synergies from workforce elimination are considered in view of the implied operational KPIs, a vastly different picture may emerge. Referring to Figure 3 below, while Option 3 presents better economics on paper, the following fundamental issues need to be examined:
1. Comparison to benchmarks – How do the implied operating metrics compare with industry benchmarks? Are they notably more optimistic than industry leaders? For example, the top 5 competitors for the business above have, on average, $1.75 million of revenue/sales staff and 16,000 customers/operations staff (similar to Option 1).
In light of this, a 30-per-cent workforce reduction aggressively driving $2.38 million of revenue per sales staff and 22,750 customers per operations staff may in fact be “too much too soon.”
In undertaking this analysis, acquirers should be cautioned against comparing the cost of apples to the cost of oranges. For example, if New Co outsources more of its operations than the benchmarked companies, or if New Co assigns some cost to marketing that others assign to sales, it may skew the analysis in a consequential way.
2. Existing capabilities – Can the current capabilities of New Co support the implied operational KPIs? For example, is 230,000 units/production staff attainable without compromising quality levels or delivery times given the current distribution infrastructure, capacity constraints and technological capabilities? If not, can business process improvements or investments in technology close the gap? For New Co to achieve the level of centralized production implied by the projected synergies, it may have to restructure its supply chain to incorporate more in-region storage facilities.
3. Implied pre-merger utilization rate – The pre-merger utilization rates for each functional group that are implied by the Option 3 KPIs must be reviewed for reasonableness. For example, to successfully realize a 230,000-units/production-staff metric would imply a pre-merger utilization rate for the production group of as low as 54.9 per cent. Was that the case?
This type of data-driven analysis not only serves to validate the workforce synergies available but also flags key operational issues that may need attention if the deal is to move forward.
When evaluating New Co’s workforce reduction synergies, a number of qualitative issues also need to be considered.
The Yo-Yo Diet: Short-term gain for long-term strategic positioning
To win the war in an increasingly competitive market context, it is important to distinguish between trimming “fat” and permanently shearing away organizational “muscle.” Certainly, finding the balance between realizing synergies to meet short-term financial targets and maintaining the level of resources that New Co strategically needs to be successful in the long term is essential.
While it is beyond the scope of this article, a long-term staffing strategy that considers future skills requirements and aligns with New Co’s future objectives needs to be in place prior to the merger.
If the long-term expectation of New Co is growth, then a rehire situation will eventually occur in the future. There is a Chinese proverb that states “Feed an army for a thousand days, only to use them in a second.” Is it better to train and develop your staff organically and be prepared to seize rising opportunities in a changing market, or to reactively rehire when pressed in an “employees market” in which costs become a premium?
Furthermore, if New Co consolidates and cuts its workforce without making the necessary improvements and changes to its work practices processes and technologies, then a smaller department is being asked to do the same amount of work. Unfortunately, working harder is not necessarily working smarter. Invariably, staffing levels will in due course creep back up, sometimes to a point that exceeds the pre-merger level.
Pitfalls of the “peanut butter” approach
Great care should be taken prior to implementing a “peanut butter” approach to workforce reduction. In New Co’s case, a targeted percentage reduction “spread evenly” across all functional areas (e.g., 30 per cent in Option 3) will mean that those departments that are already managed efficiently will be cut too deeply while those that have substantial slack will not be cut enough. This is too often played out in mergers within the tech sector, when a New Co’s new marketing direction requires more staff in the emerging technology department than in the legacy department. However, by using the “peanut butter” approach to achieving synergies, the emerging technology department is reduced by the same amount as a legacy department and, consequently, the new marketing strategies cannot be realized.
Although cutting the workforce may facilitate the economies of scale and scope that come with sharing resources, it is important that the right people are cut and that the more productive, high-performing staff members are retained. Not surprisingly, mergers often trigger unwanted turnover in the top-quartile of performers, as these employees in the Target Co tend to assume that they would be a part of the layoff, or that they are not compatible with New Co’s organizational direction. On this basis, the most valuable employeesÂ¯those that New Co can least afford to loseÂ¯tend to be the first to leave the organization, and they often move to the competition.
In the end, large workforce reductions should be carefully planned, with a clear key-employee retention strategy in place. This is particularly important for the period shortly after the acquisition when too much change can be seriously disruptive to productivity and morale.
One company that has tried to address the retention issue proactively is Sprint Corp. Shortly after announcing, in December 2004, its $35-billion acquisition of Nextel CommunicationsÂ¯a business combination that is expected to yield $14 billion net present value in operating and capital synergiesÂ¯Sprint unveiled a retention plan tied to the deal. The plan will pay all executives down to the director level a cash incentive equal to 100 per cent of their salary to stay on after the merger. Fifty per cent of the incentive payment will be paid once the merger is complete, with the balance awarded on the one-year anniversary of the deal. At that point, the executives would receive an additional incentive bonus based on a formula that the company did not disclose. Sprint acknowledged that this program will provide it with “optimal leadership and continuity.”
You Can’t KPI Culture
While operational KPIs are useful in evaluating synergies, they fall short when it comes to assessing perhaps the most important determinant of M&A success: organizational culture. Therefore, regardless how good a deal looks on paper, crunching only the numbers is often insufficient in and by itself.
Take, for example, Walt Disney Co’s proposed $7.4 billion acquisition of Pixar Animation Studios, announced in January 2006. The mutual benefit of this acquisition is obvious: Disney improves its competitive position in the growing feature-animation business, while Pixar gets the distribution capabilities of one of the world’s leading media companies. There are likely to be additional operating synergies in this combination as well. However, a true hallmark of success in this combination will be whether Disney, reputed for having a highly regimented culture, can integrate Pixar into its family of businesses without altering the latter’s unique, free-spirited, independent work dynamic, which has made it so successful.
Any attempt by Disney to squeeze efficiencies out of Pixar, either through increasing its output (from one to two feature animations per year) or eliminating overlapping support positions, may affect the work environment and cause skilled employees to leave. Quite often, companies let people go because of skill gap, particularly in the technology and high knowledge-based sectors like communications and animation. Ironically, highly skilled people in those same sectors frequently leave companies because of culture gap. In evaluating an acquisition candidate, companies need to look beyond the financial and operational gauges and consider whether the culture of the target firm would meld well into the new combined entity.
Cost savings through workforce reduction are critical to New Co’s M&A business case. However, estimating synergies is difficult because time for due diligence is often short and the acquisition target is loath to give unrestricted access to confidential data in case the deal founders. While our framework will not eliminate the risk of overestimating workforce savings, it does provide New Co with a basis for assessing key merger assumptions. Only with a clear understanding of both the magnitude of synergies available and the associated operational risks can New Co’s integration team formulate a realistic plan to extract value from the business combination.