COME TOGETHER / THE ECONOMIST BUTTONWOOD COLUMN

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Come together

Don’t just sit there, bid for something

Feb 23rd 2013
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SPRING is almost here and many of nature’s species are planning to mate. In the corporate sector, too, all kinds of couplings are being attempted—from management buy-outs (Dell) and all-share mergers (American Airlines and US Airways) to a ménage à trois in the form of a bid for Heinz from Warren Buffett and a Brazilian private-equity group.

Does this flurry of activity signal the revival of the merger boom which imploded (along with the banking sector and the world economy) in 2007-08? KPMG, an accountancy group, has a global M&A predictor based on the prospective price-earnings ratio of the stockmarket. A higher ratio means companies will be more confident about making acquisitions. Because the prospective p/e has risen by 15% over the past six months, and because companies have the ability to borrow cheaply, KPMG thinks M&A activity will pick up further this year.

 

But low interest rates and a rising stockmarket cannot be the only reasons why activity is picking up. Both conditions have been in place since the spring of 2009. Many bosses now expect sluggish growth in the developed world, and believe they have milked all the possible gains from cost-cutting in their internal operations. A big deal is the best hope for driving the business forward, some think.

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The merger as cost-saving programme is one of the hoariest justifications for doing deals. Two businesses operating in the same industry may be able to make substantial savings: they will not need two sets of accounts or sales departments, for example. Merger announcements often trumpet such “synergies” but fail to mention the disruption that can be caused when employees of both companies are uncertain of their job prospects or the clash of cultures that can result from blending two groups together.

Other acquisitions can be disguised research-and-development programmes. These usually occur in industries like technology and pharmaceuticals. Big firms buy smaller ones that have a promising product but lack the muscle to develop it. This approach suits both parties. Large firms often struggle to develop new products in-house; small companies often struggle to monetise their ideas.

Acquisitions can also be a form of financial engineering. This was a favourite game of the conglomerates of the 1970s and 1980s. A company with highly rated shares would bid for a group with poorly rated equity. Say Acme has 100m shares, earnings of $10m (earnings per share of 10 cents) and a share price of $2 (a price-earnings ratio of 20). Grotco has the same earnings and number of shares but its share price is just $1 (a p/e of 10). If Acme makes an all-share bid valuing Grotco at $1.20, it will need to issue 60m new shares. The combined group will have $20m of earnings, 160m shares and earnings per share of 12.5 cents. With the help of nothing more than maths, Acme’s earnings per share will have jumped by 25%.

The “brilliance” of Acme’s managers may well be rewarded with an even higher share price and a better rating, allowing it to make further deals. All is well until Acme makes a duff purchase and the market loses faith. At that point conglomerates often disintegrate.

In the modern era financial engineering is more likely to be pursued by replacing equity with tax-advantaged debt, paying down the latter with the odd strategic disposal. It is a neat trick provided the predator gets its timing right and does not borrow too much at the top of the market.

Finally, some mergers and acquisitions may be done out of desperation. Executives feel under pressure if their profits disappoint. An acquisition shows shareholders that something is being done, just as a beleaguered football manager may buy a new striker to appease disgruntled fans. Executives may also feel a merger with a friendly rival (with juicy severance packages for departing managers) is preferable to a hostile takeover. That fear seems to have spurred Office Depot and OfficeMax, two purveyors of paper clips, to announce a merger on February 20th.

Merger booms usually peak with the kind of deal that resembles a Las Vegas wedding after an alcohol-fuelled night: both parties regret it in the morning. (Think AOL and Time Warner in 2000.) Indeed, an awful lot of M&A turns out badly. Biennial KPMG surveys of transactions have never found more than 34% of deals adding value.

 

 

Many acquirers are subject to the “winner’s curse”. In their eagerness to make a deal, they end up overpaying. Then again, bitter experience does not stop people from embarking on their third or fourth marriages.