Think before picking up that bargain

Business Times - 11 Jul 2009

SHOW ME THE MONEY

When it comes to large acquisitions and huge outlays, the odds of such acquisitions succeeding are not great

By TEH HOOI LING
SENIOR CORRESPONDENT

ASSETS are still relatively cheap compared with their pre-crisis levels. And companies with fat cash hoards are no doubt tempted to deploy some of this money in the hope of picking up a bargain. But before embarking on any major acquisition, these companies would do well to read the book Billion Dollar Lessons - What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years by Paul Carroll and Chunka Mui.

Investors, too, will benefit from this book. It will help them work out whether what their investee company is about to do makes strategic sense. They will also have a better understanding of the likelihood of success of the strategy.

In the words of the authors, for executives, 'why spend $500 million and a decade of your life repeating someone else's mistake when you could learn to avoid it by spending a few hours with a $26 book'?

Here is the extent of corporate failures. Between 1981 and 2006, 423 US companies with individual assets of more than US$500 million filed for bankruptcy. Their combined assets at the time of their bankruptcy filings were more than US$1.5 trillion. And their combined annual revenue was almost US$830 billion.

Over those 25 years, the write-offs of 258 publicly traded US companies came to US$380 billion. Sixty-seven companies had combined losses from discontinued operations that totalled almost US$30 billion.

The authors found that the number one cause of failure was misguided strategy - not sloppy execution, poor leadership or bad luck. After eliminating failures that stemmed from poor execution and factors beyond the control of management - such as the 9/11 terrorist attacks - from the remaining cases, the authors identified repeating patterns where failures across multiple industries were variations on a theme. They found the failures tended to be associated with one of seven types of strategy.

One, pursuing non-existent synergy. Companies tend to over-estimate the benefits from a merger. A Bain study found that two-thirds or more of takeovers reduce the value of the acquiring company. And two-thirds of companies routinely fail to achieve all the synergies identified before a takeover. One reason why synergy goals aren't met is that companies don't do detailed work to make sure that the synergies that seem possible can, in fact, be produced.

In 1981, after IBM introduced personal computers to the market, it thought that it would be synergistic to offer software programmes with its hardware. So it started buying small independent software companies. It also hoped that the entrepreneurial spirit of these software companies would rub off on IBM itself. Instead, IBM smothered the software companies. The Big Blue eventually took US$2 billion of losses on software before giving up on the business.

Quaker bought Snapple for US$1.7 billion in 1994. It sold it for $300 million just three years later. In 1996, Union Pacific bought Southern Pacific Rail Corporation because the combined railroads would be the biggest network in the US. But the two railroads' information systems didn't work together. There were so many delays that the federal government declared an emergency and intervened.

Two, aggressive use of financial engineering when structuring deals. Green Tree Financial Corporation, through financial engineering, made trailer-home ownership more accessible to low and middle-income Americans. In 1992, it lent US$1.2 billion. In 1996, it lent four times that amount. The market rewarded Green Tree generously. Its stock jumped 30-fold and its 'profits' surged six-fold between 1991 and 1997. Green Tree's chairman and chief executive took home pay of US$200 million during the boom.

Green Tree's 'financial innovation' was to offer 30-year mortgages instead of the 15-year terms that were standard for trailer homes. The fatal flaw? Trailer homes depreciate and have a life-span of only 10-15 years. On a typical US$50,000 mortgage, after five years the borrower would still owe US$49,000 in principal based on an interest rate of 12-13 per cent. But by then, a trailer home is worth much less than the sum owed. Borrowers are better off defaulting. And many did just that.

But in the intervening years, Green Tree securitised the mortgages, held on to the mortgage-backed securities and booked profits based on its own forecast of defaults and pre-payments. In those earlier years, the more borrowers it found, the higher the profits it recorded. The long-term performance of the loans was of no importance to Green Tree's management. Investment bankers, said the authors, have an acronym for this: IBG YBG, which stands for 'I'll be gone, you'll be gone.' It means that even though there may be long-term problems with a deal, the folks who put it together will have reaped their profits and be long gone.

In 1997, Green Tree's intricate design began to unravel. Defaults and pre-payments started to escalate. In November that year it took a US$190 million pre-tax write-off. Its credit rating was downgraded and it couldn't roll over its short-term debt. Then came a white knight - life and health insurer Conseco. It was attracted by Green Tree's 30 per cent growth rate, and perceived that both companies served and shared the same market and culture.

So Conseco bought Green Tree for US$7.6 billion in 1998 - at US$53 a share, despite the latter's market price of only US$29 a share. To lift sales, Conseco continued to use the Green Tree model, and actually increased the number of loans made after the acquisition. It financed US$6.3 billion in new trailer homes in 1999. The quality of loans was even worse than before the acquisition. Conseco's founding CEO resigned in April 2000. He received a US$72 million severance package. In total, his pay from 1993 to 2000 was US$530 million. Conseco declared bankruptcy in 2002.

Three, buying a string of small companies in a fragmented industry - referred to as roll-ups - to form a behemoth. A Booz Allen study followed 81 roll-ups between 1993 and 2000. Only 11 outperformed the S&P500. 20 were in or near bankruptcy. Many of these failed roll-ups ended in fraud. Part of the problem for roll-ups is that they are searching for efficiencies in the most inhospitable environment imaginable. In the initial years, however, investors do get excited by the perceived rapid growth. Tyco spent US$63 billion acquiring more than 1,000 companies between 1994 and 2001. It tried multiple roll-ups in home-security alarms, special electronic connectors, fire-protection equipment and specialised manufacturing. There was little emphasis on integration. The strategy came apart in 2002. Tyco's market cap sank by $90 billion that year.

Four, stay on a misguided course. This would involve a former dominant player in a declining industry gobbling up its competitors in a bid to increase market share. Paging company Arch Communications bought dozens of paging companies as it tried to achieve scale, even though the writing was on the wall that mobile phones would make pagers obsolete. In mid-1998, Arch paid US$649 million for Mobile Media. From 1999 to 2003, more than two-thirds of people who used pagers gave them up. Arch filed for bankruptcy in December 2001. In another example, Kodak noted the threat of digital cameras but tried hard to protect its fat profit margins in the photo printing business for as long as possible. In the past decade, as digital cameras gained dominance, Kodak lost 75 per cent of its stock market value.

Five, misguided adjacencies. Avon decided its 'culture of caring' qualified it to operate retirement homes. It also bought into a medical equipment rental company. Avon simply did not have the expertise to manage the new acquisitions. In 1988, it took a charge of US$545 million to dismantle its health care business.

Six, investing in a technology without keeping an eye on the alternatives. Motorola's US$5 billion satellite telephone venture Iridium went bankrupt less than a year after it began. Its assets were auctioned for just US$25 million. Motorola had not anticipated the progress that cellular phones would make.

Seven, consolidation in a declining industry. The example of the paging company above would apply here too.

A lot of the cases above involved large acquisitions and huge outlays. The odds of such acquisitions succeeding are not great. Perhaps a viable strategy is the 'string of pearls' approach, as adopted by Olam. With this strategy, acquisition outlay should not exceed 10 per cent of a company's current value. And preferably, acquisitions should be spaced - perhaps one every three years. Yes, growth would be slower. But it is definitely a better alternative than the massive destruction of shareholder value which inevitably will happen when a company tries to acquire many others in a hurry.