Yesterday, we learned the details of a huge deal: Smurfit Kappa plans to merge with WestRock. Should shareholders approve, Smurfit WestRock would be the biggest packaging company in the world. And it would be headquartered in Dublin. 

Every time a big deal gets announced, I say similar things about how mega deals are risky, and how the average deal destroys shareholder value. 

The reason M&A often goes wrong is that corporate executives and shareholders don’t want exactly the same thing. Shareholders want to maximise the present value of future cashflows. Executives want this (their pay is linked to the share price), but they also want other things like power and influence. Big deals are fun, and they put executives in control of big institutions. So there’s a bias towards doing them, over and above their strict value to shareholders. 

A certain amount of scepticism is fine. But of course, many deals are a huge success, including mega-deals. How are we to say which are good and bad?

The investment guru Michael Mauboussin has an M&A checklist. Today I’d like to use the checklist to vet the Smurfit deal. 

Money at risk

Firstly, how big is the deal? What happens if it goes wrong?

With any merger, the combined company should be worth more than the sum of its parts. That’s the whole point. 

“More than the sum of its parts” in the context of a merger means synergies. Synergies is a word that makes people’s skin crawl but it’s a useful term. It refers to the extra economies of scale that result from M&A. 

There are two types of synergy. The ones that result in more sales are called growth synergies. An example would be Smurfit WestRock cross-selling its newly-expanded product range to its newly expanded customer base. 

The ones that result in lower costs, and bigger profit margins, are cost synergies. An example of cost synergies would be letting go of staff where there are duplicate functions at the combined company. 

A company pondering a merger will estimate how big the synergies are likely to be. Then it’ll have to offer the acquired company a premium over and above its market price to get acquired. The premium compensates the acquired company for the loss of control. For the acquirer, the art is in maximising synergies relative to the premium paid for them.

Synergies don’t always show up. That’s the risk with M&A. A company might pay a premium to acquire another one, and learn that the combined companies wasn’t more valuable than the sum of its parts.

Mauboussin refers to a concept of shareholder value at risk (SVAR). That is, how much are shareholders on the hook for if the deal flops?

SVAR depends on two numbers: the premium being offered; and the way the deal is being funded. 

Obviously the bigger the premium, the bigger the shareholder value at risk. The point about funding relates to how the risk is allocated. If the acquiring company (Smurfit Kappa in this case) offers cash for WestRock, then the risk is entirely with Smurfit Kappa. In the event that the synergies don’t show up, WestRock shareholders have already been paid in cash and are off spending their money.

The other way to fund a merger is with shares. In this setup, the shareholders of the acquired company get shares in the new, bigger company. The difference here is that the shareholders of the acquired company bear some of the risk of things going wrong. If the synergies don’t show up, their shares will be worth less.

In the proposed Smurfit WestRock deal, WestRock shareholders are being offered a $2.4 billion, or 28 per cent, premium over the company’s market value.

WestRock shareholders are being paid in a mixture of cash and shares. Of the $2.44 billion premium, $1.28 billion is being paid to WestRock shareholders in cash. The remaining $1.16 billion is being paid in shares.

For all-cash deals, the calculation for SVAR is (premium) / (market cap of buyer). 

For all-share deals, the calculation is (premium) / (market cap of buyer plus market cap of seller plus premium).

In the case of this deal, the SVAR for the cash portion is 12.8 per cent. For the share portion, it’s 5.4 per cent. The total SVAR is 18.2 per cent.

How does that measure up? Well, in a 2017 Credit Suisse research note, Mauboussin ran the SVAR numbers for a sample of recent deals and found the average SVAR was 5.5 per cent. The largest SVAR was 13.1 per cent. By this benchmark — admittedly six years old — the Smurfit WestRock deal is very big indeed and comes with a lot of risk for Smurfit Kappa shareholders.

The prize

Why is Smurfit Kappa taking such a big risk? It’s doing it because it sees a huge potential upside. 

Smurfit Kappa is forecasting synergies in excess of $400 million per year. For reference, the combined companies made $1.8 billion in profit in 2022. $400 million per year would be very material. 

To know what $400 million of extra profit is worth in today's money, you simply divide it by the company's cost of capital. According to data from Aswath Damodoran, the average cost of capital for US packaging companies in 2022 was 7.25 per cent. That would imply the deal will create $5.5 billion of value — more than double the premium that's being paid.

This goes some way to clarifying why Smurfit Kappa are taking all this risk, and why they're willing to offer roughly half of the premium up front in cash. If they can pull this off the combined business will be worth much more than the sum of its parts. A world leader in its industry, based in Clonskeagh.