Chapter 3 of 5 · 11 min

Synergies: phasing and costs to achieve

The announced synergy number is a run-rate. Year one gets a fraction of it, less the cost of getting there.

By the end of this chapter you can

Phase run-rate synergies and subtract the costs to achieve them, year by year
Explain why year one can show a net cost
Work back from year-one net synergies to the run-rate management is implying
Value the run-rate and compare it with the one-off cost

The intuition

Two supermarket chains merge and say they will save $100 million a year by closing overlapping warehouses. That $100 million is the run-rate: the yearly saving once every warehouse is closed. It will not all arrive on day one.

Closing a warehouse takes time, and it costs money: redundancy pay, lease exit fees, moving stock. So the first year might capture a quarter of the savings while paying most of those one-off costs to achieve, and show a loss. The savings only outrun the costs later.

The key idea

The market values the run-rate. The accretion model uses each year's phased synergies, less that year's costs to achieve, after tax.

Why it works

Gross synergies in a year = run-rate × that year's phasing percentage.
Costs to achieve are one-off: severance, systems migration, lease exits. For cost synergies they commonly run around one times the run-rate, and most land early.
Net synergies = gross − that year's costs. After tax: × (1 − t), since both are tax-deductible operating items.
Cost synergies versus revenue synergies. Cost savings are within management's control and are usually credited. Revenue synergies, such as cross-selling, depend on customers and are routinely discounted by investors.
Capitalized value. A permanent saving is worth the after-tax run-rate × the acquirer's P/E. That is often what justifies the premium, and what the seller wants a share of.

$100M run-rate, phased 25% / 60% / 100%; $100M of costs, 70% / 30% / 0%; tax 25%

Year 1: 25 − 70	−45 (−33.75 after tax)
Year 2: 60 − 30	+30 (+22.5 after tax)
Year 3: 100 − 0	+100 (+75 after tax)
Cumulative net: −45, −15, +85	positive in year 3
Capitalized at 15x: 100 × (1 − 25%) × 15	1,125, 11.25x the costs

The formulas

Gross synergies (year i) = run-rate × phasing i

The share of the saving achieved that year.

Net synergies (year i) = gross i − costs to achieve i

Less that year's one-off costs.

After-tax net (year i) = net i × (1 − t)

What reaches net income.

Run-rate implied = (net 1 + costs 1) ÷ phasing 1

Add the costs back and scale up to a full year.

Capitalized value = run-rate × (1 − t) × acquirer P/E

A permanent saving, valued like earnings.

Worked example

Year one only. Phase the run-rate, then subtract the costs that land in the same year.

Drawing the numbers…

See it move

Same deal. Change the run-rate, how fast it is achieved, and how big and how early the costs are.

Drawing the numbers…

Try this

Raise the costs to achieve. Every year that carries costs shows lower net synergies, while the run-rate and its capitalized value do not move.
Switch between phasing schedules. The bigger the year-one share, the higher year-one net synergies, with the costs unchanged.
Put all the costs in year one. Year one gets worse and the later years get better by the same total, because the costs are only moved in time.
Raise the run-rate. Gross synergies grow, and so do the costs, because the costs here are set as a multiple of the run-rate.

Run it backwards

Same deal, reversed: management gives you year-one net synergies, the year-one costs and the phasing. What run-rate are they implying?

Drawing the numbers…

Net synergies are gross synergies less costs, so add the costs back to get gross year-one synergies. Those are the run-rate × the year-one phasing, so divide by the phasing.

Analysts do this to test guidance: a small year-one number with a low phasing can hide a very large run-rate promise. Trace that run-rate to named savings before believing it.

Traps

Putting the full run-rate into year-one EPS.

Year one gets only the phased share, less the costs to achieve that land that year.

Forgetting the costs to achieve.

They are real cash and real expense, and they land early. Year one can be a net cost.

Leaving synergies pre-tax in the EPS calculation.

Net income is after tax: multiply net synergies by (1 − t).

Treating revenue synergies like cost synergies.

Revenue synergies depend on customers and are far less certain. Investors usually give them little credit.

Not knowing whether the presented accretion includes the one-off costs.

Bankers often show accretion excluding them and list them separately. Check which version you are looking at.

Say it in the interview

The interviewer asks

“A company announces $100 million of synergies. How do they show up in the accretion model?”

Say yours out loud first, then compare.

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4

Drawing your questions…

Remember

Announced synergies are a run-rate, not a year-one number.
Net synergies = run-rate × phasing − that year's costs to achieve.
After tax before they go into EPS.
Run-rate × (1 − t) × P/E is what the market values.