The purpose of this research is to examine the merger of International Dairy Queen and the Orange Julius segment of Orange Julius International. Dairy Queen acquired the Orange Julius segment in 1987. The findings of this research are presented in two parts. Acquisition and merger theory is discussed in the first part, while the acquisition of Orange Julius by Dairy Queen is analyzed in the second part.
ACQUISITION AND MERGER THEORY
Acquisition is a “generic term covering all forms of acquiring another firm, such as consolidation, holding company, merger, or purchase of assets witha cash or stock.” A merger is the combination of two or more firms. In most instances of merger, one corporation acquires the stock of another. The acquiring corporation then either retires the stock of the other corporation and dissolves the acquired corporation, or permits the acquired to continue operating in its own name as a wholly-owned subsidiary. In either case, assets, liabilities, and equities of the two firms are consolidated. In the merger which is analyzed in the following section of this research, International Dairy Queen acquired a segment of Orange Julius International. The segment, Orange Julius, was the original firm from which Orange Julius International derived.
Sensible motives for acquisitions and mergers are found when the positions of each company involved will be improved by the action. There are a number of these sensible motives, including (1) capital requirements by an acquired company, (2) the meshing of distribution systems, (3) complementing customer bases, and (4) similar reasons.
Using Acquisitions an d Mergers
to Increase Net Worth
Often, one firm will acquire another with either low or no earnings, or, possible, tax credits. In these instances, the acquiring firm may be able to reduce its own federal income tax liability. When an acquiring firm is able to reduce its federal income tax liability through acquisition or merger, it also increases its net worth. Secondly, acquisition and merger may permit each of the companies involved to operate more efficiently, and, thus, earn higher consolidated profits than they would earn separately. In this instance, also, net worth would be increased through the process of acquisition or merger. These reasons are the principal ways in which net worth is increased through the
process of acquisition or merger.
Some theorists contend that ” . . . systematic relationships exist between merger and changes in capital structure.” Three of the relevant theories in this context may be summarized as follows:
1. The latent debt capacity (LDC) theory holds that an under-utilization of potential tax subsidies on interest payments by Firm A creates an incentive for that firm’s acquisition by Firm B, which will, in turn, be able to fully utilize Firm A’s debt potential.
2. The increased debt capacity (IDC) theory holds that an incentive for merger may be provided by a decrease in the probability of default, which would occur as a result of a merger. In these cases, the debt capacity of the combined firms subsequent to the merger is presumed to be greater than the sum of the debt capacities of the two firms prior to merger.
3. The coinsurance wealth transfer (CWT) theory holds that the incentive for merger is derived from the fact that one of the two firms involved would have fallen into insolvency in the absence of a merger. In such mergers, the stockholders of the stronger firm are held to be made worse off by the merger, while the bondholders of the weaker firm are held to be made better off by the merger.
A 1984 study found support for two theories–IDC (increased debt capacity) and CWT (coinsurance wealth transfer), as incentives for mergers. The study found no support, in this context, for the LDC (latent debt capacity) theory.
The use of a control group of non-merged firms provided the researchers with a relatively easy way out of a thorny methodological problem–that of attempting to know what the financial condition of merged firms would have been in the absence of a merger. For the non-merged firms, however, the researchers imputed post-merger characteristics through the application of a quantitative model. The procedure appears to introduce supposition, as the imputed values are used as the basis of comparison and evaluation of merger effects.
A better methodological approach for the researchers would have probably been to restrict their investigations to only merged firms. While it is true that the researchers would have been denied certain knowledge as to the financial condition of these firms had no merger occurred, it would have still been possible to compare the combined pre-merger financial characteristics of the firms involved with the post-merger financial characteristics of the surviving firm. This basis of comparison would have enabled the researchers to assess impacts on relevant financial ratios, which, in turn, would have permitted an evaluation of each of the
three theories investigated–LDC, IDC, and CWT. In this event, all data would have been actual, with no need for a reliance on imputed data.
As the study stands, its findings and conclusions do not really provide a test of the three theories investigated, for they compared post-merger financial characteristics of merged firms with imputed post-merger financial characteristics of non-merged firms. What should have been compared were the post-merger financial characteristics of the surviving merged firms with the combined pre-merger financial characteristics of the firms which were merged.
There are no methodological qualms concerning the financial ratios used as bases for comparison and evaluation, or concerning the quantitative procedures employed in the comparisons and evaluations. The methodological weakness in the study involved, instead, a failure to compare the pre- and post-merger financial characteristics of the merged firms, relying instead on a comparison of the post-merger financial characteristics of non-merged firms.
There is another highly relevant factor involved in any assessment of the LDC theory. This factor involves expectations. It is quite possible that an incentive for merger is provided by the under use of potential tax subsidies by a firm, and that this merger is actually consummated on an expectation that debt will be increased to exploit the unused potential tax subsidies. For any number of reasons, the additional debt might not be incurred in
post-merger conditions. Whether the reason that additional debt is not incurred is due to changing financial and economic conditions, actual post-merger conditions, or a determination that the potential tax subsidies are worth less than originally thought, would not change the fact that the incentive leading to the merger in the first place was an anticipated benefit to be derived from unused tax subsidies. A different type of data (from that collected for the study would be required to make such an assessment.
THE DAIRY QUEEN/ORANGE JULIUS MERGER
As noted in the introduction to this research, Dairy Queen
acquired the Orange Julius segment of Orange Julius International in 1987. Dairy Queen paid Orange Julius International $23.5 million for the Orange Julius segment. Of the total sales price, $22.25 million was paid on closing, with the remaining $1.25 million plus interest due to be paid one-year subsequent to closing.
The Orange Julius segment had not been an outstanding performer in the most recent years prior to the acquisition by Dairy Queen. Net losses at Orange Julius, however, were minimal, approximating seven-one-hundredths of one percent. Earnings at Dairy Queen, by contrast, approximated 6.6 percent prior to the acquisition of Orange Julius.
Revenues at Dairy Queen and Orange Julius were far more comparable than would be anticipated by the number of stores in each organization. Orange Julius posted in excess of $125 million in sales, for a 725 store operation. By contrast, Dairy Queen, with 5,268 stores, had over $185 million in pre-merger sales. The difference in per store revenues between the two organizations (approximately $172,500 at Orange Julius, and approximately $35,100 at Dairy Queen) is explained by the fact that Dairy Queen is a licensing and servicing company, while Orange Julius operated its own stores. Total store sales at Dairy Queen stores do not accrue to Dairy Queen International.
In the context that Dairy Queen lacks experience in the actual operation of stores, as opposed to licensing and servicing stores, this merger might be considered to have been unwise. On the other hand, if Dairy Queen can successfully convert the Orange Julius chain to a franchise operation, it is likely that the Orange Julius organization can also be converted to a profitable enterprise.
The capital requirements, together with the poor earnings performance, provided incentives for Orange Julius International to sell the Orange Julius segment to Dairy Queen. The potential for a meshing of distribution systems, commonality of customer bases, and significantly increased revenues provided incentives for Dairy Queen to acquire Orange Julius.
The acquisition of Orange Julius by Dairy Queen was a positive event for the shareholders of Orange Julius International. For the shareholders of Dairy Queen, the acquisition of Orange Julius holds a potential to significantly improve the net worth of their company. At present, however, it is only a potential. It is, thus, incumbent upon the management of Dairy Queen International to fully develop this potential. Certainly, the potential is present in the acquisition to develop consolidated profits for the two firms which are significantly greater than the combined profits of the two independent firms. It is also probable that, in the early years subsequent to the acquisition, Dairy Queen International will accrue some federal income tax advantages from the Orange Julius operation.