FREE online courses on Financial Management and Creating Value - Chapter 1 -
Beware of Mergers
One of the most popular forms of corporate restructurings is
the merger. A merger is when a bidding company negotiates to acquire another
company. Payment is often made in the form of stock. The buyer is usually a
larger mature company with surplus cash and wants to grow externally by
acquiring another company that has strong growth. The merging of the two
companies is suppose to result in higher values, commonly referred to as
"synergy" values. However, the reality is that mergers do not necessarily lead
to higher values.
A study of 150 mergers over a five-year period (1990 to 1995)
found that one-third of all mergers "substantially eroded shareholder value." A
comparison of acquiring companies with non-acquiring companies showed that
non-acquiring companies (companies that grow internally) outperformed the
acquiring companies. As Tom Peters (author of In Search of Excellence) has
pointed out - "mergers are a snare and an illusion."
One reason mergers fail to provide higher values is due to
the fact that the price paid for the acquired company exceeds the value of the
company. Good target companies are hard to find and larger companies are unable
to grow internally. This drives the price of target companies up. Additionally,
investment bankers are eager to arrange mergers regardless if value is enhanced.
There is no such thing as a bad merger in the eyes of an investment banker.
Some other reasons why mergers don't work include:
- Increased Earnings: Mergers are sometimes
undertaken to improve earnings. However, the mere purpose of increased earnings
is no guarantee of higher values since the new combined company may fail to
earn positive returns on capital invested.
- Competitive Advantage: Trying to beat the
competition through a merger is a temporary quick fix. It does not address the
fundamental reasons for failure to compete. You still have to outperform your
competition on the total capital invested. If you are unable to generate higher
returns, investors will move funds to competing companies that offer higher
returns for the same level of risk.
- Bargain Purchase: Buying a company simply because
it is undervalued should raise a red flag. You are guessing against the
marketplace when it comes to valuation. Additionally, undervalued companies
sell at a discount for a very good reason - they are not worth much because
their prospects for future recovery are doubtful. Trying to turnaround an
under-performing company is not easy.
- Cash Flow Cow: Buying a company just to acquire a
strong cash flow is costly. The very reasons for the strong cash flow soon
evaporate after the merger and long-term values fail to materialize.
