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The Speculator
5
ways to give acquisitions the inquisition
Sometimes buying other
companies can mean a better bottom line. Sometimes it can mask a
host of problems. We find clear evidence that serial acquirers
underperform those that go it alone.
By Victor
Niederhoffer and Laurel Kenner
Like most transactions in life and markets,
acquisitions can be very good or very bad. For an acquired company,
a good acquisition lets the owner cash in and enjoy a profit -- the
self-interested, wholly appropriate incentive for starting a company
in the first place. For the purchaser, a good acquisition provides
an opportunity to save on costs, to improve marketing or to invest
capital at higher returns than are available internally.
At worst, an
acquisition is a desperate attempt by the seller to unload bad
merchandise based on private information of an adverse nature, or an
effort by the acquiring company to create a facade of enhanced
profitability.
Most acquirers, we hasten to say, would never
in a million years dream of succumbing to the alluring temptations
that come with acquisition accounting. But some find that a steady
stream of purchases much improves their ability to deliver the
consistent quarterly growth so dear to analysts, and they are not
averse to gilding the lily for temporary advantage.
And
nothing improves a corporation’s ability to manipulate earnings like
a series of acquisitions. With a few flourishes of the pencil, a
chief financial officer can find a cornucopia of profits in an
acquired company’s earnings, pension plans, medical plans and assets
held on the balance sheet below market price.
Below, we
attempt a statistical test of what numerous or infrequent
acquisitions signal in a relatively homogenous sample of large
buyers -- companies that make up the S&P 100 index. After
reporting the results, which seem to support the virtue of
abstemiousness on the part of large companies, we’ll share some
insights for acquirers and investors from a highly successful serial
acquirer of privately held companies.
Another signal of hubris
Accountants
have been vigilant for more than 50 years in trying to create rules
that will make acquisition accounting fair. The Financial Accounting
Standard Board’s ban on “pooling of interest” accounting in mergers
last year was only the latest example. (Without pooling, companies
must amortize the premium, or “goodwill,” they paid for the target
company over a period of years, thereby depressing earnings.) But as
in all arms races, acquirers and their consultants and experts are
always vigorous in mounting new attacks and finding new ways to put
the best foot forward.
With investors paying more attention
these days to accounting treatments, we find ourselves fascinated by
the possibility of developing statistical profiles of serial
acquirers vs. abstainers. Might a predilection for acquisitions be a
sign of hubristic overconfidence in the company’s ability to run
other businesses? Are abstainers unusually confident in their
ability to run their businesses without benefit of acquisitions?
Unfortunately, these questions are difficult to test. We therefore
started with a modest preliminary study of the relation of
acquisitions to stock performance.
Taking the companies in
the S&P 100 at the start of 1998, we counted the number of
acquisitions each made over the next four years, through 2001. We
came up with three groupings for comparison: the top 15 acquirers,
companies that made no acquisitions and companies that made one
acquisition. We calculated their stock performance from Jan. 1,
2002, through July 12, 2002. The results appear
below.
Paying the piper for serial acquisitions
| Purchases 1998-2001 vs. performance
Jan. 1-July 12, 2002 |
| Company |
Ticker |
Purchases |
% chg. |
| 15 most acquisitive |
|
|
|
| General Electric |
GE |
66 |
-28.6 |
| Tyco |
TYC |
32 |
-76.7 |
| Clear Channel Communications |
CCU |
31 |
-33.9 |
| Citigroup |
C |
28 |
-28 |
| AES |
AES |
15 |
-79.6 |
| AOL Time Warner |
AOL |
14 |
-59.1 |
| United Technologies |
UTX |
14 |
-2 |
| General Motors |
GM |
13 |
-4.1 |
| American International Group |
AIG |
12 |
-20 |
| Microsoft |
MSFT |
12 |
-21.7 |
| Wells Fargo & Co. |
WFC |
12 |
-13.6 |
| Cisco Systems |
CSCO |
11 |
-62.4 |
| Ford Motor |
F |
11 |
-19.8 |
| Intel |
INTC |
11 |
-40.2 |
| J.P. Morgan |
JPM |
11 |
-16.9 |
| Average % return |
|
|
-33.8 |
| |
|
|
|
| Companies with 1 acquisition |
|
|
|
| Bank of America |
BAC |
1 |
9 |
| Black & Decker |
BDK |
1 |
13.9 |
| EMC |
EMC |
1 |
-36.4 |
| Harrah's Entertainment |
HET |
1 |
19.1 |
| International Paper |
IP |
1 |
1.5 |
| May Department Stores |
MAY |
1 |
-18.2 |
| Medtronic |
MDT |
1 |
-24.5 |
| Medimmune |
MEDI |
1 |
-47.7 |
| 3M |
MMM |
1 |
2.3 |
| Merck |
MRK |
1 |
-22.5 |
| Oracle |
ORCL |
1 |
-29.9 |
| Pfizer |
PFE |
1 |
-19.2 |
| Pharmacia |
PHA |
1 |
-23.6 |
| RadioShack |
RSH |
1 |
-11.1 |
| Sears |
S |
1 |
-2.4 |
| SBC Communications |
SBC |
1 |
-24.3 |
| The Southern Co. |
SO |
1 |
-0.2 |
| Average % return |
|
|
-12.6 |
| |
|
|
|
| Companies with no acquisitions |
|
|
|
| Allegheny Technologies |
ATI |
0 |
-14.1 |
| Ltd Brands |
LTD |
0 |
11.4 |
| Anheuser-Busch |
BUD |
0 |
8.8 |
| Avon Products |
AVP |
0 |
3 |
| Baker Hughes |
BHI |
0 |
-19.1 |
| Burlington Northern Santa Fe |
BNI |
0 |
0.2 |
| Cigna |
CI |
0 |
-3.7 |
| Norfolk Southern |
NSC |
0 |
17.1 |
| Campbell Soup |
CPB |
0 |
-19.4 |
| Nortel Networks |
NT |
0 |
-95.5 |
| Colgate-Palmolive |
CL |
0 |
-23.3 |
| Philip Morris |
MO |
0 |
-6.4 |
| Delta Air Lines |
DAL |
0 |
-65.3 |
| Raytheon |
RTN |
0 |
7.3 |
| FedEx |
FDX |
0 |
-3.8 |
| Toys R Us |
TOY |
0 |
-10.4 |
| Gillette |
G |
0 |
-13.5 |
| Xerox |
XRX |
0 |
-38.1 |
| Average % return |
|
|
-14.7 |
| |
|
|
|
| S&P 100 |
|
|
-21.5 | |
As
the above table shows, serial acquirers underperformed abstainers by
19.1 percentage points this year, and they underperformed the
S&P 100 by 12.8 percentage points. Abstainers beat the S&P
100 by 6.8 percentage points.
The urge to merge can be good
or bad, and each acquisition must be judged on its merits. However,
during the most recent four years, the urge has been inversely
related to year-to-date 2002 performance.
From long
experience on all vantage points of the acquisition arena -- Vic
founded and for 25 years spearheaded a very active
mergers-and-acquisition brokerage -- we would suggest that in
certain types of markets, an acquisition might offer the temptation
to overstate earnings. If the truth comes out, the stock may be
hammered.
Making mischief with the
books
We have no knowledge of the accounting probity of
any of the companies in the news today. But we can say that in
general, most mischief begins with assets held on the books of
acquired companies at original cost. If the acquired company bought
the assets many years before, or if the assets are worth much more
than they cost (as must be assumed if they were bought at a
premium), then there is great potential for an acquiring company to
sell off these assets at the market price for a nice
profit.
A second source of temptation is the potential boost
to the acquiring company’s earnings from the acquisition. When a
company’s stock is selling at 20 times earnings and it buys
something at 10 times earnings, there is an immediate pickup that
can be calculated based on the number of shares and earnings
involved.
A third major line of misstatements is the prospect
of writing certain items up or down to advantage. The common
practices of writing up goodwill for tax purposes, or writing down
pension obligations and medical plans of the acquired firms, are
treasure chests in this regard.
We must emphasize that we
have no reason to believe that serial acquirers are any more prone
to such temptations than those that acquire less frequently.
Multiple acquisitions are merely a possible signal, an area of
concern in certain kinds of markets.
To assist our readers in
evaluating acquisitions, we are pleased to present insights from a
friend who is among the world’s leading experts in the subject:
Vic’s partner of 35 years, Dan Grossman. Grossman has managed and
bought a wide variety of businesses, and through his law practice
has been instrumental in forming and developing many companies,
including the drug maker Syntex. Dan recently sold a number of his
businesses profitably and is writing a book about his adventures in
the M&A business.
Advice on
acquisitions from Dan Grossman
Avoid businesses requiring exquisite management. Buy a company
that regular people can run.
When evaluating an acquisition, picture what it will be like
trying to sell it. Look for the type of business that buyers,
especially public companies, will want to acquire.
Avoid mixing acquisition analysis with some other need in your
life. Don't look to acquire a company because it will get you
involved with golf or sailing, or because it is in a glamorous
location, or because you have been laid off and need a place to
work. It is hard enough to be objective analyzing an acquisition on
its own merits without throwing in all kinds of personal needs and
desires.
Have a good accountant explain to you how inventory can be used
to juggle earnings, and why, for some companies, it is almost
impossible for a buyer to determine the accuracy of reported
earnings for a given year.
Time is the friend of a growth company, and the enemy of the
bargain or value company. The longer you are going to own, the more
important to pay up for growth.
Final
note
The results of our preliminary study on acquisitions
may unduly reflect the unusual pessimism of the current stock
market. Yet given the sad fates of serial acquirers over the past
few decades -- the conglomerates, the rollups and all the companies
that became marquee names in the market value rankings by paying
princely sums of their own soaring stock for tiny, unprofitable
companies -- it does not seem inappropriate to conclude that both
acquirer and investor should be on guard when reaching for the
stars.
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