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For a glimpse of the future, take a look at how investors respond to merger announcements.
Hilary Rosenberg, CFO Magazine
September 1, 1998
To hear the happy couples tell it, all mergers are bound for glory. The synergies, efficiencies, and growth created are sure to enrich shareholders. But as any student of finance knows, mergers seldom live up to expectations, and the question remains, Which mergers will languish and which will flourish? Time will tell, most experts say. But according to a study of major deals struck from 1994 through June 1997, the stock market's initial reaction to a merger often predicts the acquirer's relative market performance a year later.
That is not hopeful news, especially for deals that suffer poor receptions. They face poor odds, according to the study that PricewaterhouseCoopers LLP conducted for CFO magazine. Of 52 companies whose stocks performed worse than their peers in the first five days after a merger was announced, 35 companies were still doing badly 12 months later. On the other hand, nearly two-thirds of the companies that enjoyed an immediate boost outperformed their peers after a year. All told, the market foresaw the future almost two- thirds of the time.
To ensure meaningful results, the study examined only deals that met certain criteria: the acquirer paid more than $500 million; both acquirer and target were public companies; the target's market value was at least 10 percent of that of the acquirer; and the acquirer was involved in no more than one large transaction during the one year under consideration. Using the starting price of five days before announcement, the study measured market returns both five days after and one year after the announcement date.
A shrewd investor might think twice about owning stock in this collection of companies. On average, the acquirer's stock prices were 2 percent lower than the market as a whole, and a year later, they trailed by nearly 9 percent. Furthermore, these acquisitive companies did not keep up with their peers; on an industry-adjusted basis, they lagged by 1.6 percent at announcement and 3.7 percent a year later.
A drop at announcement is consistent with conventional wisdom that any large deal punishes the acquirer, and for most deals, the market was a tough judge right from the start. Overall, when they announced their purchases, 63 percent of the sample companies lost value on a market-adjusted basis.
However, the study also highlights exceptions to the premise that most mergers are doomed. Of the surveyed stocks that tumbled after announcement, more than one snatched victory from the jaws of defeat. Stock in Allegheny Ludlum Corp. fell by 4.6 percent versus peers in April 1996, immediately after the steel producer agreed to rescue Teledyne from the grip of WHX, a hostile bidder. The price tag was $2.1 billion. A year later, however, Allegheny Ludlum's stock performance outpaced its peers' by 68.2 percent.
Similarly, Boston Scientific Corp., in Natick, Massachusetts, turned a mediocre initial response to its $897 million purchase of SciMed Life Systems into a ringing success, outpacing its peers by nearly 63 percent after one year. Boston Scientific CFO Larry Best blames the poor reception on the absence of a track record. "We had never acquired a company before," he says. A year later, however, "SciMed proved to be synergistic in terms of financial results and market leadership." Harrisburg, Pennsylvania-based Rite Aid Corp.'s $2.4 billion acquisition of Thrifty Payless Inc., in Wilsonville, Oregon, also turned the tables after a year, thanks to seamless integration of the two drug retailers that exceeded expectations.
Despite widespread claims that today's so- called strategic mergers are different from the financially driven transactions of the 1980s, the performance of recent mergers closely tracks the performance of '80s mergers, according to Mark Sirower, who helped direct the PricewaterhouseCoopers study. "The '80s were full of deals that were considered strategic--DuPont and Conoco; Baxter and American Hospital Supply; Burroughs and Sperry; Monsanto and G.D. Searle," says Sirower, a professor at New York University's Stern School of Business and author of The Synergy Trap: How Companies Lose the Acquisition Game (Free Press, 1997). He warns that there is no reason to suppose that so- called strategic deals are better for shareholders than financial deals, because companies first have to prove why they are strategic. "If they don't," he adds, "it's too easy to overpay without having valued the strategy."
"We had all heard the stories about mergers that went bad and ended up destroying value instead of creating value," says Richard Osborne, CFO of Duke Energy Corp., in Charlotte, North Carolina, which agreed to pay $7.7 billion for PanEnergy Corp., a Houston- based gas pipeline company, in November 1996. Although the debt Duke assumed in the transaction upended its financial structure, investors stuck with the company. Five days after the announcement, Duke was slightly outperforming its peers. A year later, its stock performance exceeded the electric utility industry by 1.5 percent, a slim margin but still ahead of the pack.
It wasn't experience that made the deal a success. Duke had never before done a major merger or acquisition and, despite the market's approval, management was nervous from the start. The formula for success ultimately rests on whether a deal makes sense. "This industry is consolidating," says securities analyst Edward Tirello of BT Alex. Brown. "And Duke took it a step further, going to power- plant operations and construction. With gas- pipeline operations and its own electric operations, it can mesh the two. Also, Duke is big in power marketing, as is PanEnergy. So there's the power marketing angle."
"We integrated systems and laid out new lines of authority, new management, and financial targets as quickly as we could, so that people could get through the sea of uncertainty as quickly as possible," Osborne says.
What Drives Returns?
Trailing earnings per share (EPS) does not shed much light on why stock prices go up or down. At the end of the four quarters following Duke's announcement of its purchase of PanEnergy, Duke's stock price rose despite EPS that were off by slightly more than 1 percent, according to CFO magazine's analysis of data supplied by Bloomberg LLP. A broader look at earnings per share in the wake of acquisitions in the PricewaterhouseCoopers study suggests that something other than EPS explains changes in the stock price. For example, Tenet Healthcare Corp., in Santa Monica, California, led the positive-to- positive group, with a 53.4 percent increase in stock price after a year, yet its EPS lost 113 percent in the 12 months after Tenet's agreement to buy OrNda HealthCorp, in Nashville. Median change in price for companies in the positive-to-positive category was 32 percent, while the median change in EPS tumbled by 43 percent. "And that is consistent with what we've found," Sirower notes. "Expectations of long-term cash flow-- not a short-term earnings number--drive shareholder returns long term."
After it acquired Skokie, Illinois-based U.S. Robotics Inc., in 1997 for $6.5 billion, 3Com Corp., a Santa Clara, California, supplier of computer networking gear, ended up in the negative-to-negative column. Subsequent to the announcement, 3Com uncovered shortfalls in inventory that had to be fixed before the company had any realistic chance to grow. Deals on the negative-to-negative list also include Hartford-based Aetna Life & Casualty's purchase of US Healthcare Inc., in Blue Bell, Pennsylvania, which required huge cultural and financial adjustments to compete in the cost- burdened health-care industry. PacifiCare Health Systems Inc., based in Cypress, California, was among the deals that enjoyed a positive reaction at first but stumbled afterwards. The health maintenance organization ran into problems after its acquisition of FHP International Corp., in Fountain Valley, California. The deal was announced in August 1996 before discrepancies in FHP's claims processing surfaced.
A Provident Plan
A consistent policy of effective communications served Provident Cos. well when the Chattanooga-based insurance company announced its acquisition of Worcester, Massachusetts-based competitor The Paul Revere Corp. in April 1996. A few years earlier, Provident had unveiled a strategic plan, making it the theme of its communications with all constituencies, says vice chairman and CFO Thomas Watjen. The essence of that plan was to focus on disability insurance and related products in which Provident was the market leader. "It is a simple strategic vision that's guided all of our actions, from divestitures and acquisitions to internal reorganizations," Watjen says. "So, we have credibility at the point of announcement."
In making the announcement, Watjen and Thomas White, vice president of corporate relations, explained that in the context of the strategic plan, the acquisition was more than just an exercise in cost savings through consolidation. It also presented growth opportunities that neither company could have pursued on its own. The stock rose 12.5 percent, industry-adjusted, just after announcement.
The stock continued to perform well over the following months as the company integrated Paul Revere and met its goals for savings. At the same time, Provident was preparing for growth by merging the two companies' product lines and field sales offices. By the one-year mark, the stock was up more than 43 percent, industry-adjusted.
Certainly, the market was then anticipating growth. As it turned out, though, it was a bit optimistic.
The reconfiguration of Provident's product line involved moving to a product with a lower premium, which, at least for a while, dampened overall sales totals. In the spring of 1998, the stock took a breather, slipping to the low 30s, a 17 percent industry-adjusted return since announcement. "The market moved quickly, maybe too quickly, from just looking at expenses to holding us accountable for increased growth," says White. "What it is looking for now is a resumption in sales growth from the combined companies." By June, however, the total number of policy applications were starting to grow.
The First Nine Months
Some consultants claim a year is not enough time in which to judge a major acquisition either a complete success or a failure. It's common, some argue, for an acquisition to undergo two stages of development. In the first nine months or so, the new organization settles in and, when problems arise, there needs to be a midcourse correction. In some cases, the market needs more than a year just to understand an acquisition.
For an acquisition that leads a company into a new industry, the market's show-me attitude might last longer than a year. But PricewaterhouseCoopers and other consultants agree that for most deals, a year is a sufficient length of time for judging success. What's more, going out any further would complicate the analysis. By then, many other factors figure into an acquirer's earnings and stock value.
Take the case of Tyco International Ltd.'s July 1994 acquisition of Kendall International Inc., a maker of disposable medical products in Mansfield, Massachusetts. Upon announcement, the stock of the Exeter, New Hampshirebased diversified manufacturer fell 6 percent on an industry-adjusted basis. A year later, the price was off 14 percent. On a market-adjusted basis--which may be more accurate because of the difficulty of finding an industry index to compare with a diversified manufacturer-- Tyco's stock was off 7 percent at the start but only 5 percent a year later. It should be noted that several days after that first anniversary, the stock was even with the market. In any event, the stock wasn't exactly going like gangbusters when the deal was a year old.
Tyco International CFO Mark Swartz admits that initially the market had some problems with this acquisition. Congress was still weighing President Clinton's national health care bill, and there were concerns that the proposed program would place pricing pressures on the medical industry. Moreover, Kendall was the largest acquisition Tyco had ever made, and it represented a major diversification from its basic fire-protection business. "There was some skepticism," concedes Swartz. But at no point did the acquisition itself falter. The integration of back-office functions, elimination of duplicative costs, and closure of five manufacturing facilities in the first year helped contribute to an increase in Tyco's earnings. In each year of a three-year plan, Kendall exceeded its stated goals in both revenues and earnings, Swartz says. In the second year after the announcement, ending in July 1996, the stock performed about 20 percent better than the market. "Our investors became more comfortable with how good an acquisition it was," Swartz asserts.
For about one deal in three that gets off to a bad start, according to the survey, its fate is not yet sealed. "Thirty percent of the time, the negatives turn around," says Kersten Lanes, a partner at Pricewaterhouse-Coopers. The bottom chart on page 109 lists 17 companies that did just that, on an industry- adjusted basis. Among them: Boston Scientific in its 1994 purchase of SciMed Life Systems, and Rite Aid in its 1996 acquisition of Thrifty Payless. "Get damage control right away," Lanes advises. "Focus on how the deal is going to impact shareholder value."