Hubris: “We can do it better than [the target company]. With additional scale, we will be able to gain operating efficiencies and marketing opportunities. We will be a big company in our industry, and we will control our own destiny.”
So some CEOs think. It is easy to propose large mergers, wave your hands at the details, and the deal takes on a life of its own. But large deals:
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- Attract competition. If a large piece of market share is up for grabs, many will try to grab it. Premiums to get a large deal are often uneconomic, akin to the guy who shows of a jar of nickels in a crowded room, and invites people to bid for it. He never clears less than a 20% profit on the jar.
- Have to meld two different cultures. This is not trivial.
- Have to meld two different information technology departments. Also not trivial.
- Have synergies and cost savings that are often overestimated.
- Face greater scrutiny from the government, which slows things down, and results in greater restrictions on the combined enterprise.
- Have a CEO that will be severed, and he will require handsome compensation to go. Sadly, the remaining CEO will get a pay boost, after all, he is running a bigger company.
- Run into the problem of Too Big To Manage. This may not apply to large energy companies, because they are relatively simple, but with most other companies with market caps over $100 billion, performance deteriorates. It is difficult to keep incentives sharp for employees and managers.
- Have a buyer who may not appreciate some strengths of the target company. In two insurance acquisitions, I saw the acquirer throw away valuable divisions that they could not understand, firing people more talented than the acquirer was. At least they should have sold the division to someone else.
- Generates goodwill, which makes the company harder to analyze, an lowering its valuation versus book.
That’s why I don’t buy companies that do scale acquisitions. They tend to flounder and lose money.
But I do buy companies that do tuck-in acquisitions. Tuck-in acquisitions are buying a little company that adds:
- A new technology
- A new marketing channel
- A new product or service
Which is complementary to their existing business, and they will grow it organically. With a tuck-in, the competition is less, integration issues are less, almost every difficulty versus large acquisitions are less. Prices are low.
One use of free cash flow is acquisitions. Companies that focus on small acquisitions and organic growth use free cash flow wisely. Large acquisitions overpay to buy a trophy asset that the acquirer may unintentionally destroy. Avoid such acquisitive companies. The company may grow, but the stock price likely will not.
By David Merkel, CFA of Aleph Blog