Tuesday, April 12, 2011

Rising Corporate Mergers: A Good or Bad Omen?

News of company acquisitions recently has enlivened otherwise dull trading days for the stock market.  Corporate acquisition announcements tend to give a boost not only to the stock prices of the companies involved, but to the stock market overall.  While the result is usually a substantial jump in the target company’s stock price, the result for the acquirer and the market over time, however, is substantially negative.

The main reason for the poor results for the acquiring company and for the overall stock market is the same reason for investment success or failure overall—the price that is paid.  Merger and acquisition activity tends to be at its most frenzied near stock market tops.  For the Standard & Poor’s 500 Index, cycle peaks in merger and acquisition activity occurred in 2000 and 2007, both years of historic market tops.  The S & P 500 Index has fallen 12% since the top in September 2000, nearly eleven years ago.  It also has fallen 14% since the more recent top in October 2007.  And this is after a doubling in stock prices in the last two years!  Conversely, the cycle lows in merger and acquisition activity occurred at historic lows in the stock market, in the early 1990’s, 2004, and 2009.

What might explain the proclivity of CEOs to seek acquisitions near market tops?  Market tops tend to occur when business conditions are favorable, enthusiasm is widespread, and credit is available.  Such conditions also lead CEOs to convince themselves of the likelihood of “synergies” from the combined entity.  Synergy potential usually is a combination of cost savings from eliminating redundant operations as well as from economies of scale and cross-marketing opportunities. 

But things rarely turn out that way.  The record of corporate acquisitions is generally poor, as acquiring companies pay too much for the target company, resulting in “goodwill” added to the asset side of the balance sheet to account for the premium price paid.  In subsequent years, much of this goodwill is written down to reflect a more accurate value of the assets acquired, and a large charge-off to earnings follows.  As a result, there is little, if any, growth in book value per share, a measure of the effectiveness of a company’s management. 

One of most egregious examples of this was AOL’s purchase of Time Warner for $164 billion at the height of the Internet mania and near the peak of the stock market.  It remains the largest corporate merger in American history.  When the business value of AOL plummeted, the company was forced to take a massive writedown of goodwill that resulted in a loss of $99 billion in 2002.  By late 2005, the combined company’s market capitalization—which was $350 billion at the time of the merger--had fallen to just $20 billion.  When Time Warner spun off AOL as a freestanding company in 2009, AOL’s market cap. was just $2.6 billion, or less then 1% of the market value of the combined company at the time of the merger.

There are, of course, counter examples of successful corporate acquisitions.  Berkshire Hathaway, Danaher, and Emerson Electric have fine records of integrating numerous acquisitions over the years.  Many of these tend to be smaller, “bolt on” acquisitions that aren’t too disruptive to the existing company.  The major drug companies, on the other hand, have spent hundreds of billions over the last decade on major acquisitions with little benefit to shareholders.  The overall record of corporate acquisitions is mixed at best.

For these reasons, takeover announcements are indeed to be cheered by holders of the target company’s shares.  For the acquirer in most cases, and for the stock market overall, they should receive a Bronx cheer.

Steve Lehman

S & P 500:  1314
Russell 2000: 825

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