Today the market has been up and sideways basically, perhaps a little more defensive this afternoon,...
Merger for Them, Less Money for You?
02/26/2010 10:26 am EST
Recent news of mergers and acquisitions could be a sign of weakness in sectors desperate to expand. And a CEO's bold move can prove costly to investors.
I call it destruction by acquisition.
Forget the synergies, the cost savings, and the cross selling that CEOs tout when they announce one of these deals.
Too many of the huge merger and acquisition deals struck in 2009—and that continue to be struck—will take money out of shareholder pockets for years to come.
But some CEOs are so desperate for growth and so pessimistic that their companies can produce growth internally that they're willing to mortgage the future for a deal that makes them look good now—or at least allows them to disguise how bad things are. Those accounting tricks might work long enough for them to walk out the doors and cash out those options.
Money can't buy you love, but it can buy a CEO the semblance of revenue and earnings growth. (For a look at how hard it will be to find profits in this recovery, see this recent post.)
Not every deal of 2009 and 2010 will destroy shareholder value. I'll give you a few at the end of this column 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 past year or so need to be seen for what they are: Admissions of weakness in sectors desperate for growth.
Exxon Mobil (NYSE: XOM) is buying XTO Energy (NYSE: XTO) for $41 billion, including assumed debt. Kraft Foods (NYSE: KFT) buys Cadbury (NYSE: CBY) for $20 billion. Xerox (NYSE: XRX) buys Affiliated Computer Services for $5.6 billion. Comcast (Nasdaq: CMCSA) agrees to buy NBC Universal for $37 billion. Merck & Co (NYSE: 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.
Whither Go Pfizer-Wyeth?
Let's just take the most obvious growth problem child, the biotech and pharmaceuticals sector. 2009 started off with Pfizer (NYSE: PFE) buying Wyeth in January for $68 billion. 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 cholesterol medication Lipitor, the world's best-selling drug, in November 2011. In 2009, Pfizer got $11.4 billion of its $50 billion in sales from that one drug. Wyeth's products and pipeline of future products were 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 was announced, 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 9%.
And after that? Well, in 2011, the company told analysts, it expects earnings per share of $2.25 to $2.35. That is, at worst, an increase 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.
Deals Big and Small in the Energy Sector
Or look at the energy sector. After a two-year slowdown in acquisitions, deal making is heating up again. The big deal has been Exxon Mobil's purchase of XTO Energy, but there have been plenty of smaller deals, too—although small is a relative term in the energy business. Schlumberger (NYSE: SLB), for instance, just signed a deal to acquire Smith International (NYSE: SII) for $11 billion.
Oil producers, especially the big international oil producers, have been locked out of the most promising opportunities for finding 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. Exxon Mobil, Total (NYSE: TOT), BP (NYSE: BP), Royal Dutch Shell (NYSE: RDS.A), and Statoil (NYSE: STO) have all spent big recently to buy US natural gas or oil reserves. A decade ago, many of these companies couldn't get out of the US exploration and development market fast enough.|pagebreak|
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 is that different from the drive by China and other developing economies to buy stakes of the natural resources they'll need.
Exxon Mobil? China? What's the difference except one is somewhat larger. Both the corporate and the national economies 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 is that 1+1=3 and that the acquiring company will get not just the existing product revenue at the company that it's buying, but also a boost in overall sales from filling in its product line, and gain 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 (OTC: YARIY) recent offer for Terra Industries (NYSE: TRA) and Bucyrus International's (Nasdaq: BUCY) move to acquire Terex (NYSE: TEX).
On the other hand, I don't like Xerox's acquisition of Affiliated Computer Services, and I'm not all that fond of PepsiCo's (NYSE: 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, or ROIC. It's a measure of how profitable a company's investment of shareholder capital and its own reinvested profits have been. Long-term shareholders want to see a high number here because it means the company has lots of very profitable opportunities for reinvesting its profits. That means 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. Over the past five years, on average, Xerox has earned 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 Standard & Poor's 500 companies combined.
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 annual average 21.7% ROIC over the past five years. The average in its industry is 15.3%.
In addition, Schlumberger's ROIC is above the 15.8% return at Smith International, the company it's acquiring. On that record, there's a good chance that Schlumberger will be able to increase the returns that Smith has been earning 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 March 2 column, 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.
At the time of publication, Jim Jubak owned shares of the following companies mentioned in this column: Schlumberger, Statoil, and Yara International.
More from Jim Jubak:
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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