Mergers and Acquisitions is one of the most common methods firms use to expand. When a firm announces an acquisition, the market usually reacts favorably to the stock of both the acquirer and acquiree. Mr. Market is thus already discounting the so called “synergies” from the future in the stock price. But do these synergies come to fruition?
Reasons For Acquisitions
Companies have plenty of reasons for Mergers and acquisitions (M&A). Here’s a few.
- To Gain Market Share
A larger firm has increased potential for economies of scale. This boosts the company’s competitive positioning, and gives flexibility to pricing strategies. M&A activity is also usually justified from the cost savings that can be implemented. - Cultural Synergies
If two companies have similar corporate cultures and operate in the same industry, on paper it makes sense to merge. Ironically, many mergers fail specifically due to corporate culture differences. - Access To New Markets
If a firm wants to expand to new markets but doesn’t have the infrastructure, M&A can aid the efforts. - Buying The Competition
If you can’t beat them, buy them.
When M&A is announced, what you read from the news seems great. The future is bright, and it’s the right thing to do. Sometimes these synergies work, but more often than not, they fail.
Most Synergies Fail
Research indicates that most acquisitions fail. Why is this? Here’s a few reasons.
- Over-payment
The acquiree wants to be paid as much as possible (obviously). The acquiring company’s management usually has incentives to buy. If you find out that management is incentivized to “increase market share” through the proxy statement’s, chances are they are not acquiring for the right reasons. - Cultures Don’t Merge
Corporate culture may usually be behind a firm’s success (or failure). Soft factors such as power distances, working methods and leadership all play a role in the success of M&A. Unfortunately these cultural “synergies” remind you more of conquistadors entering South America than harmonious cooperation. - Branching Outside The Industry
If a company starts acquiring businesses outside its core industry, chances are it will not succeed. Its the business equivalent of apples and oranges. If you think about it logically, what are the chances of M&A “synergies” if the firm’s are in different industries?
Beware the gluttonous acquirer. The firm may be gaining market capitalization, but at what cost? A massive red flag is if the company is using debt in its acquisitions. As we know the failure rate of M&A, the use of debt is most likely a double whammy.
Don’t be fooled by a “stronger” balance sheet following M&A. There is a new line item now, ironically listed as an “asset”: Goodwill. Goodwill is the premium the firm has paid for an acquisition, which is depreciated for a set amount annually. Remember, most firms overpay, meaning Goodwill is most likely not a true asset.
When Acquisitions Make Sense
Since M&A is so commonplace, even though failure rates are high, does it ever make sense to acquire? Yes it does in certain cases, and successful acquisitions are usually made under the following conditions:
- The Price Is Right
Since the biggest culprit to M&A failure is over-payment, great acquisitions are made the same way as great investments: Paying less for the company than what it’s worth.
“Investment is most intelligent when it’s most businesslike” -Warren Buffett.
The flip-side is that business is most intelligent when its approached as intelligent investing. M&A is most active during economic booms when prices are high, and low during recessions when prices are low. Obviously, economic downturns provide the best opportunities for price-conscious acquisitions. Unfortunately M&A activity reflects the stock market: Most people buy high and sell low. - Capital Allocation – Last Alternative
Capital Allocation is one of the most important management responsibilities. Usually these are the alternatives:
Pay a dividend, repurchase own stock, retain earnings, make an acquisition.
I would argue that acquisitions should be looked into if the first three alternatives have been ruled out. Also, acquisitions should be made if target companies are available for bargain prices. Debt should not be used, but if this is the case, it should be payable within a few years. If the company can compound the intrinsic value per-share through organic growth and projects, it’s usually more valuable than M&A.
I’ve come across firms that make intelligent acquisitions. Usually these are made price-consciously, within the industry and other alternatives have been considered proceeding M&A. Always remember to find out the incentives behind acquisition decisions.
You can read more on some famous M&A failures here.
What are your thoughts on M&A? Feel free to leave a comment and I’ll catch up with you!
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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