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On 25 March, for example, one of The Australian Financial Review’s journalists emphasised that “the move this week by Solution 6 and Sausage Software to combine forces under the one umbrella has created [a $A5.0b] software powerhouse that threatens to make an unprecedented break into the top-20 listed companies.” Another stated that “both [companies’ CEOs] have been successful. In two-and-a-half years, Tyler has driven Solution 6’s share price up from 45c to $12.50, while it has taken Bos just 20 months to push Sausage from 15c to $6.90. The new entity will certainly be a force to be reckoned with – it will become the dominant internet player on the Australian Stock Exchange and the biggest B2B e-commerce specialist in the Asia-Pacific region.” (By 1 May these prices had adjusted modestly to $4.45 and $2.58 respectively). In sharp contrast, announcements of corporate mergers and acquisitions typically say little or nothing in sober and precise – indeed, any – terms about the combined entity’s operations, balance sheet, cash flow and profitability. Executives who make these announcements seem to avoid these matters; and journalists and “analysts” who cover them seldom seem to raise or consider them seriously in their reports. Neither SOH’s nor SAS’s submissions to the ASX about their merger even mentioned the combined entity’s expected earnings. Equally remarkably – astonishingly is perhaps the better adverb – with two honourable exceptions neither did any of the dozen-odd reports about the merger published in The Australian and The Australian Financial Review between Tuesday 21 March and Saturday 25 March.
One exception, an article entitled “Dose of governance seems to have gone by the board,” appeared in the AFR on 21 March. It made three important points. First, although “in a new economy. profits and cash flow matter little. the jury is still out on whether the new entity will be cash-flow positive from day one.” Second, “in the short-term, its bottom line will be slim as it depreciates the huge goodwill associated with the transaction.” Finally, and quite revealingly, it raised concerns for the “small investors whose priority ranks well down on the Solution 6 share register.”
The other exception, The Australian’s Margin Call column of 22 March, stated bluntly: “it’s a shocker, an absolute shocker. We’ve heard all this syrupy rubbish on the Telstra-Solution 6-Sausage deal. We’ve listened to the baffling e-talk and the PR hype. Here’s the reality: this represents a massive transfer of wealth from Telstra shareholders to those of Sausage and Solution 6, and further to [SOH’s CEO Chris Tyler].” Further, with respect to the acquisitions which SOH and SAS have conducted during the past year, “so, we’ve got 25-odd acquisitions. How exactly are those going to be kicked into shape? There’s probably been around three weeks’ due diligence done on each, so you can bet that the vendors are laughing.” Finally, Margin Call noted that “... things are too ‘exciting’ over at Solution 6 for questions of a material answer to be addressed. At the analyst briefing Chris and the crew couldn’t even give a straight answer on whether there would be forecasts in the Part A takeover documents for this prospective glamour deal. Doesn’t really matter when, according to Chris, the ‘e-procurement market will be worth trillions of dollars.’ What’s that mean? No detail to the analysts, just e-rhetoric.”
Berkshire Hathaway’s Chairman, Warren Buffett, included a passage apposite to this point in the company’s 1999 Annual report. He wrote that “at other companies, executives may devote themselves to pursuing acquisition possibilities with investment bankers, utilizing an auction process that has become standardized. In this exercise the bankers prepare a ‘book’ that makes me think of the Superman comics of my youth. In the Wall Street version, a formerly mild-mannered company emerges from the investment banker’s phone booth able to leap over competitors in a single bound and with earnings moving faster than a speeding bullet. What’s particularly entertaining in these books is the precision with which earnings are projected for many years ahead. If you ask the author-banker, however, what [the] firm will earn next month, he will go into a protective crouch and tell you that business and markets are far too uncertain for him to venture a forecast.”
Typical Outcomes of Mergers and Acquisitions
George Santayana said that “those who do not learn from history are doomed to repeat it.” Mark Twain offered with a weaker version of this saw: “history doesn’t repeat itself, but it rhymes.” If so, and given the track record of corporate mergers and acquisitions undertaken during the last 10-20 years, then shareholders of acquisitive companies should be inflating the life rafts. There are strong grounds, in other words, to fear that many of the M&As being undertaken today will prove to be duds – or worse.
Recent academic studies of Australian, New Zealand and North American mergers and acquisitions, despite their myriad differences of scope and method, tend to agree on one startling point: most (up to 75%) M&As fail to benefit the shareholders of the acquiring company. A report conducted by KPMG International and released in December 1999, for example, analysed 700 of the largest M&As undertaken between 1996 and 1998. It found not only that most deals failed to benefit shareholders – slightly more than half (53%) actually harmed them. Similarly, Mark Sirower, author of The Synergy Trap, analysed 168 agreements struck between 1979 and 1990 and concluded that two-thirds failed to fulfil expectations and at least one-third harmed shareholders. Similarly, in 1995 Business Week and Mercer Management Consulting studied 150 M&As conducted between 1990 and 1995. They found not only that half produced negative returns for shareholders: companies which refrained from acquiring other companies performed better in the stock market than acquirers.
Oh Well, Never Mind
A handful of really dreadful M&As (profiled by Nikhil Deogun and Steven Lipin in The Wall Street Journal Interactive Edition on 8 December 1999) disintegrate to the point where the buyer is forced to unload its acquisition at a fire-sale price. These disasters send an unmistakably clear danger signal to investors: some mergers and acquisitions – despite the best-laid plans of top management and the dearest advice that investment bankers, lawyers and management consultants can provide – sour very badly and very quickly.
Exhibit #1: on 6 May 1991, AT&T purchased NCR for $7.4b in scrip. AT&T’s CEO celebrated the purchase in these terms: “I am absolutely confident that together AT&T and NCR will achieve a level of growth and success that we could not achieve separately. Ours will be a future of promises fulfilled.” On 20 May 1995, however, as part of a major divestiture, AT&T sold NCR for $3.4b (i.e., a 54% loss). AT&T’s CEO rationalised this decision: “the complexity of trying to manage these different businesses began to overwhelm the advantages of integration. The world has changed. Markets have changed.”
Exhibit #2: on 21 March 1994 Novell Corp. bought WordPerfect for $1.4b. WordPerfect’s CEO proudly stated: “[this] combination positions WordPerfect to be central to the next generation of applications. We are helping Novell create a software powerhouse.” On 31 January 1994, however, Novell sold WordPerfect for $124m (i.e., a 91% loss). In announcing this volte-face, Novell’s CEO stated that the sale “allows Novell to focus on what we do best, and that’s [networking software].”
Exhibit #3: on 3 May 1994 Smithkline Beecham purchased Diversified Pharmaceutical Services for $2.3b. The CEO said that “over the past year, we have conducted an exhaustive analysis. and concluded that the unique alliance today positions us to win.” On 9 February 1999, however, SKB sold DPS for $700m (i.e., a 70% loss). Its CEO said: “I am confident that we will deliver accelerated financial performance with a sharper focus.” This time did not set out the analytic basis of this assertion.
Exhibit #4: on 2 November 1994, Quaker Oats bought Snapple for $1.7b. The CEO exulted: “Snapple has tremendous growth potential through increased penetration, broader distribution and international expansion.” On 27 March 1997, however, Quaker Oats sold Snapple for $300m (i.e., an 83% loss). Revising this glowing assessment, the CEO said that “after reviewing all possible options, we decided it was in the shareholders’ interest to remove the financial burdens and risks Snapple brought to the portfolio and better focus on our value-driving businesses.”
As shareholders in AMP Ltd (to name just one company – there are certainly others) are well aware, Australian corporate history is littered with M&A disasters of comparable magnitude. As a distressing but nonetheless illuminating exercise, readers may wish to compare the hubris-laden statements uttered by AMP executives at the announcement of the hostile takeover of GIO Australia Holdings Ltd with statements made later to describe and justify its results.
Leithner & Co. Policy
Like all other aspects of business, corporate mergers and acquisitions are inherently risky propositions. The stark truth is that many and perhaps most fail to achieve what their highly-remunerated creators confidently claim that they will achieve. Disturbingly, corporate deal-makers are seldom in doubt and often in error. In Warren Buffett’s words: “the sad fact is that most major acquisitions display an egregious imbalance: they are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honeypot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent.” Hence my strong preference that the companies in which we have invested are the ones doing the selling rather than the ones doing the buying. And notwithstanding the Ralph Review’s incentives to do otherwise, if and when these companies receive a credible offer of merger or notice of takeover, I will generally sell our shares for cash in the open market (at prices which will usually be inflated well above intrinsic value by the buyer’s offer) rather than swap them for the buyer’s scrip.
More generally, this marked disparity between words and deeds, together with this imbalance between costs and benefits, provide yet another reason why Leithner & Co. seeks to invest in companies which allocate capital rationally. Such companies have track records of real profitability and good prospects of sustainable profitability. They also retain profits (or some portion thereof) only if these profits’ returns, when invested within the company, are likely to exceed the returns which shareholders can obtain if they invest them outside the company. If profits cannot surmount this hurdle then they should be returned to shareholders as dividends or share buybacks (see the circular dated 1 April 2000) – not accumulated in “warchests” or spent acquiring other companies.
If they can overcome this hurdle, good uses of companies’ retained profits can include the expansion of their most profitable (and the contraction of less-profitable or loss-making) operations. They can also include the acquisition on amicable terms of sound businesses at sensible prices. But important caveats apply. First, these acquired business should be much smaller than the acquiring business. Second, no attempt should be made to integrate the two businesses’ operations: apart from the half-yearly transfer of profits to its parent, the subsidiary should operate autonomously. Third, cash rather than debt or scrip should be used to finance acquisitions. Finally, because suitable opportunities do not arise every day, acquisitions should be infrequent.
(Interestingly, these points characterise the acquisitions made by Berkshire Hathaway, Inc., since the 1960s one of America’s best-managed and most-profitable corporations. Through these and other means, BRK has served its shareholders better than virtually any other corporation. Equally interestingly, BRK has no acquisitions department or corporate planning unit, and is a management consultant-, corporate banker- and lawyer-free zone.)
Conversely, poor uses of companies’ retained profits can include hostile takeovers of other businesses; the use of shares or debt (or both) to finance acquisitions; purchases of other businesses in rapid succession; acquisitions for the sake of growth rather than profitability; and mergers with or buyouts of companies of equal or larger size. These attributes, unfortunately, characterise the majority of M&As which have recently been and are currently being undertaken in Australia, the United States and other countries. If owners of common shares wish to assign primary blame for the damage to their well-being which is conducted in their name then they should take a good, long, hard look in the mirror. (“The fault, dear Brutus, is not in our stars but in ourselves” said the protagonist in Shakespeare’s Julius Caesar). But corporate executives, together with the management consultants, bankers and lawyers who advise them, are playing their part too.
 
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