Industrials have been my favorite sector for the fourth quarter of this year; my latest recommendati...
Can CEOs destroy shareholder value in an acquisition? Just watch them
02/26/2010 8:30 am EST
Forget the synergies, the cost-savings, the cross-selling that CEOs tout when they announce one of these deals.
Too many of the huge merger and acquisition (M&A) deals struck in the second half of 2009 and that are still being struck will take money out of shareholder pockets this year and for years to come.
But some CEOs are so desperate for growth and so pessimistic that their company can produce growth internally--you know by doing things like developing new drugs, marketing new products in new markets or finding new reserves of oil or natural gas, for example—that they’re willing to mortgage the future for a deal that makes them look good now. Or that allows them to disguise how bad things actually are with accounting tricks for long enough to walk out door and cash out those options. (For more on how hard it will be to find profits in this recovery see my post http://jubakpicks.com/2010/01/19/get-your-portfolio-ready-for-the-profitless-global-economic-recovery/ )
Money can’t buy you love but it can buy a CEO the semblance of revenue and earnings growth.
Not every deal in 2009 and 2010 will destroy shareholder value. I’d give you a few at the end of this post that might actually work out well for shareholders and discuss how to tell the difference between the good and the bad. But a high percentage of the deals that have earned the headlines and moved the stock market in the last year or so need to be seen for what they are: admissions of weakness in sectors desperate for growth.
ExxonMobil (XOM) buys XTO Energy (XTO) for $41 billion. Kraft Foods (KFT) buys Cadbury (CBY) for $20 billion. Xerox (XRX) buys Affiliated Computer Services for $5.6 billion. Comcast ($37 billion) buys NBC Universal for $37 billion. Merck (MRK) buys Schering-Plough for $41 billion.
What’s striking about each one of these deals?
They’re in sectors that are desperately seeking growth.
Let’s just take the most obvious growth problem child, the biotech and pharmaceuticals sector. 2009 started off with Pfizer (PFE) buying Wyeth in January. And it culminated in the fourth quarter of 2009 with 78 deals.
The impetus for the Wyeth deal was the expiration of Pfizer’s patent on Lipitor, the world’s best selling drop, in November 2011. Pfizer got $11.4 billion of its $50 billion in sales for that one drug in 2009. Wyeth’s products and pipeline of future products was purchased to help fill the gap that the expiration of the Lipitor patent would leave in Pfizer’s top and bottom lines.
So a year after the Wyeth deal what’s Pfizer telling Wall Street about growth? The company reported 2009 earnings per share of $2.02. In 2010, the company projects, earnings per share will increase to $2.10 to $2.20 a share. That’s earnings growth of between 4% and 8%.
And after that? Well in 2011, the company told analysts, it expects earnings per share of $2.25 to $2.35. That’s at worst a decline in earnings of 2% from 2010 and at best growth of 12%. The Wall Street consensus pegs growth at a little less than 6% for 2011.
For that you pay $68 billion? Well, I guess so when you have no idea of how to generate growth internally and the alternative is seeing the company flush billions in shareholder money down the drain on your watch.
Or look at the energy sector. After a two-year slowdown in acquisitions, deal-making is heating up again. The big deal has been ExxonMobil’s purchase of XTO Energy for $41 billion (including assumed debt) but there have been plenty of smaller deals too. Although small is a relative term in the energy business. Schlumberger (SLB), for instance, just signed a deal to acquire Smith International (SII) for $11 billion.
Oil producers, especially the big international oil producers, have been locked out of the most promising opportunities for finding new oil and natural gas. They don’t have much alternative to acquiring.
You can judge how tight a spot they’re in by the nature of recent deals. ExxonMobil, Total (OT), BP (BP), Royal Dutch Shell (RDS), and Statoil (STO) have all spent big recently to buy U.S. natural gas or oil reserves. A decade ago many of these companies couldn’t get out of the U.S. exploration and development market fast enough.
For oil producers these deals are an attempt to lock up natural resources for the future when there will be even fewer places to explore and demand will be even higher. Nothing here that different from the drive by China and other developing economies to buy stakes of the natural resources they’ll need.
ExxonMobil? China? What’s the difference except one is somewhat larger. Both the corporate and the natural economy have the same world view and strategy.
For oil service companies the drive to acquire is not that different from that in the drug sector (minus the expiring patent problem). Competition and pricing are getting tougher. Growth is harder to come by. And companies are looking to buy products that fill in existing product lines. The hope if that 1+1=3, of course, and that the acquiring company will get not just the existing product revenue at the company that it’s buying, but a boost in overall sales from filling in its product line and gaining an edge on competitors.
That’s certainly the logic behind Schlumberger’s acquisition of Smith International’s drill bit business.
I think the Schlumberger acquisition is a decent one (even though the price was steep.) I also like Yara International’s (YARIY) recent offer for Terra Industries (TRA) and Bucyrus International’s (BUCY) move to acquire Terex (X).
On the other hand, I don’t like Xerox’s (XRX) acquisition of Affiliated Computer Services and I’m not all that fond of PepsiCo’s (PEP) very expensive acquisition of its big North American bottlers.
How do I figure out which deals are good and which are bad?
I start with a number called Return on Invested Capital (ROIC). It’s a measure of how profitable a company’s investment of shareholder capital and its own re-invested profits have been. Long-term shareholders want to see a high number here because it means that the company has lots of very profitable opportunities for re-investing its profits so long-term shareholders will see company earnings turn into future earnings at a high rate of compound growth. All shareholders want to see a higher number here because it means management is good at finding profitable growth strategies and then effectively executing them.
ROIC is one of the reasons that I don’t like the Xerox deal. On average over the last five years Xerox has managed to earn a return of just 4% on invested capital. That’s below the 4.7% for the business equipment industry as a whole and less than half the 8.5% for the Standard & Poor’s 500 companies.
With that track record it’s unlikely that Xerox is going to get much mileage out of its $5.6 billion investment in Affiliated. Management just isn’t good at extracting value from the shareholder money it invests.
On the other hand, Schlumberger shows an average 21.7% ROIC over the last five years. That’s above its industry at 15.3%) and the S&P 500 companies. In addition, that ROIC is above the 5.6% ROIC at Smith International. On that record, there’s a good chance that Schlumberger will be able to increase the returns that Smith has been earnings on its own capital.
This shouldn’t be the end of how you analyze a deal and it only begins to scratch the usefulness of ROIC. In fact I’d argue that for long-term investors this measure is the single most important number to look at in analyzing a company.
In my post on Tuesday March 2 I’ll show you more of what ROIC can show you and why it’s so important, especially in a global stock market so short on profits.
Full disclosure: I own shares of Schlumberger, Statoil, and Yara International in my personal portfolio.
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