Yes, most mergers are misguided. But savvy investors shouldn't overlook those few companies that get them right.
As we continue to examine the flaws in our financial markets -- and figure out what to do about them -- Enron and WorldCom begin to look like the easy cases. The people who ran those companies swindled their shareholders, betrayed their employees, and trashed our economy. Those are offenses properly addressed by judges, juries, and prison wardens.
But what are we investors to make of General Electric? The giant's slide from highly respected to vaguely suspected is harder to fathom. In the first six months of this year the company that spent the 1990s as an icon of management prowess saw its shares sink 27% -- nearly twice as much as the 14% falloff in the S&P 500. Could investors really be pining that much for retired CEO Jack Welch? Unlikely. For the second quarter of this year Welch's successor, Jeffrey Immelt, reported strong revenue and profitability growth in several of the conglomerate's biggest businesses. Profits were up 14% from a year earlier. No, GE has been distrusted largely because of something it used to be celebrated for: its habit of making dozens of acquisitions a year.
How our moods change. Nearly as amazing as the way investors embraced profitless dot-coms in the late 1990s was their enthusiasm for companies that bought other companies. Mergers, a hallmark of every bull market, reached an all-time peak of more than $1.8 trillion in the United States in 2000. Even though studies have long shown that mergers are more likely to destroy shareholder value than increase it, we somehow got comfortable with the idea that a majority of those acquirers were above average -- and that the most active acquirers, such as WorldCom and Tyco International (a "scandal of the week" in early June, in case you forgot), deserved the highest multiples.
We sure don't think that way anymore. Mergers are far fewer in a bear market, and even a company with a proven acquisition record is likely to see its stock hammered when it announces a deal. Pfizer shares fell 11% on the July day the drug giant announced its $60-billion purchase of Pharmacia. Now acquisitions are automatically associated with executive hubris or, worse, accounting games and phony growth. Is that view reasonable? For the most part, yes. Acquirers nearly always pay a substantial premium over the stock-market price for the shares they're buying, and their justification for doing so nearly always boils down to the notion that they can run the acquired company better than the incumbent management can. You don't have to run a company yourself to see how implausible that usually is -- but it helps, doesn't it?
Still, companies will keep making acquisitions, sometimes even for good reasons. The trick for investors is to put the burden of proof where it belongs -- on the acquirer. To identify mergers that have a better-than-even chance of turning out well, look for these commonsense criteria:
A purchase price that is low enough -- say, a 10% premium over the market price, as opposed to 50% -- that the buyer needn't count on heroic synergies to make the deal work. Auctions never produce such prices. Avoid companies that participate in such contests.
A buyer who pays in cash. In a bull market, the favorite acquisition currency is pumped-up stock (witness Tyco's 700 purchases between 1999 and 2002 , which were paid for mostly with stock), and discipline goes by the boards. "Using stock to fund acquisitions has the same effect as using chips in casinos," says Lawrence Cunningham, author of the recently published Outsmarting the Smart Money. "It's the first emotional step toward separating people from their money."
A target that's significantly smaller than the buyer -- and that's in a business that the buyer understands well. The more "transformational" the deal (think of AT&T's ill-fated foray into cable TV), the greater the risk.
The list goes on: you also want to see some evidence that the deal isn't purely the brainchild of a dominant CEO. Attention to postmerger integration is vital, too. Not all successful acquirers will meet every prerequisite. But they will exhibit the most important quality a company can bring to a merger, which is, simply, humility.
Who is appropriately humble? GE once was and, with some prodding from a distrustful market, may even be again. A good model is sensible Johnson Controls, which has steadily prospered in the consolidating auto-supply business even as its rivals have stumbled on their own acquisitions. (See "One Stock," below.)
Mergers are tough, folks -- culturally, commercially, logistically, and every other which way. When you find that rare acquirer with a healthy appreciation of that reality, you've found something special.
Done well, acquisitions can enable a company to thrive in a changing industry. A case in point is Milwaukee's Johnson Controls (ticker symbol: JCI), which -- thanks in large part to five key deals dating back to 1985 -- has become one of the globe's two predominant suppliers of auto interiors, selling to automakers from Ford to Toyota to Renault. Johnson likes to pay cash and follows conservative accounting practices. Its successful strategic acquisitions help to explain the stock's 16% compound annual growth rate in the five years ending in March -- compared with 3% for its industry and 7% for the S&P 500.