As a shareholder, you do well to place more emphasis on risk than on reward. Corporate management usually does the opposite, and this is why most large acquisitions fail.
In fact, I assume from the start that an acquisition will fail — or at least will turn out not nearly as profitable as the picture management paints.
For starters, a buyer typically pays too much. An old Wall Street adage comes to mind: “Price is what you pay; value is what you get.” It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the latest trade. When a company is acquired, though, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.
How much higher? Acquisitions have the elements of a zero-sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince the company’ s board and its shareholders that the sale price is high (unfairly good). The buyer in turn needs to convince his constituents that they are getting a bargain. Remember, both are talking about the same asset.
This is where a magic word — which must have been invented by Wall Street banks’ research labs — comes into play: “synergy.” The only way this acquisitions dance can work is if the buyer convinces his constituents that combining the two companies will create additional revenues otherwise not available, and/or it will eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.
If you examine why General Electric Co., for example, has been a subpar investment over the last two decades, you’ll find that it’s because of poor capital allocation. The company lost a lot of value in making destructive acquisitions — buying businesses at high prices, relying on false or unfulfilled synergies, and selling (divesting) at reasonable (or low) prices.
There are also a lot of “dis-synergies” (a term you’ll never see in an acquisition press release). The two corporate cultures may simply be incompatible. One company may have a strong founder-led culture, while in the other company decisions are made by consensus. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.
A case in point: Silicon Valley pioneer HP Inc. has been substantially gutted by large acquisitions. When the company acquired Compaq in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. The same happened with EDS (acquired in 2008), which had a service culture, and again with Autonomy (in 2011) — a software company that ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.
Acquisitions can also lead to an employee morale problem. The day before the acquisition, people at the acquired company came to work as usual. They were not particularly worried about the future. After the acquisition announcement, though, their job security is perceived as being at risk, and they are now on LinkedIn updating their profiles and networking. Now they worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new, more profitable organization that may be about to let them go.
Finally, integrating businesses is difficult. Aside from the culture problems, companies must realign global supply chains, move or combine headquarters, and merge software systems. In large companies, this task is like merging two complex nervous systems.
So while the acquisition press releases may tout synergies, they don’t talk about the price tags and dis-synergies (risks) that come with the deal, too.
Here’s a good example of the right approach: Gilead Sciences’s management has a terrific, but small, acquisition record. In 2011, it paid $11 billion for Pharmasset, a company that had no revenues and a molecule a few years out of (maybe) being approved: a cure for hepatitis C. Well, cure hepatitis C it did. It was an incredible success, generating $20 billion in revenues in just the first year of sales. It is incredibly difficult to judge this transaction, though, because we don’t really know the role that luck played here.
Wall Street sees Gilead’s October purchase of Kite Pharma as Pharmasset 2.0. Gilead is paying $11.9 billion for a company that has just $20 million in revenues but also has a possibly revolutionary medicine to treat cancer — and potentially reap billions in profits. We own shares of Gilead and would love to believe that this acquisition will be a success, but we don’t know — and neither does Wall Street.
Yet from a risk perspective, even if the Kite acquisition doesn’t work out, it will not weaken Gilead. It will the cost the company one year of earnings. Gilead generates significant, stable cash flow, has a great balance sheet and management that is great at running the business, and is a rational, patient capital allocator. Indeed, our upbeat view on the company has not really changed, except that now we also hold a $12 billion lottery ticket that may cure cancer. Moreover, this acquisition doesn’t have most of the dis-synergy risks we discussed above — Gilead is buying research and scientists. Science and luck will decide whether the deal is successful. If Kite’s drug is as good as Gilead’s management thinks it is, then we’ll have Pharmasset 2.0. If not, we lost a year of earnings.
To be sure, acquisitions can create value. But when a company grows through acquisitions, its management needs to have a highly specialized skill set that is often different from that used in running a company’s day-to-day operations.
Accordingly, it’s important to examine the motivations of management when it makes an acquisition. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” desperation to them — and a corresponding price tag.
Article by Vitaliy Katsenelson, Contrarian Edge
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).