As the US economy plods through the “Great Recession”, corporations are recording solid profits in the face of weak revenues. These profit gains have been achieved thorough efficiency improvements which all too often have meant fewer jobs. The ironic result is that in this weak economy many companies are flush with cash and have to decide what to do with it. Excluding cash at financial institutions, such as deposits at banks, liquid assets at US corporations are as high as $1.7 trillion.
In light of the anemic returns equity holders have enjoyed since the subprime crisis, the obvious argument would be to give the money to shareholders in the form of higher dividends or stock repurchases. While this might be the “right thing” to do, it appears that many companies are now looking at M&A as a more attractive outlet for this cash. Examples of such deals are Intel’s $7.7 billion deal to buy McAfee which was Intel’s second within one week as it had announced just days before that it had agreed to buy Texas Instruments’ cable modem product line for an undisclosed amount. These announcements came to the market on the heels of a number of other bids including the $39 billion offer by BHP Billiton for Canadian firm Potash Corp.
Management at bidding companies can make a very credible argument that today’s weak equity values present attractive buying opportunities for bargain hunting acquirers. They can also try to assert that with the consumer on the sidelines during this anemic recovery, growth opportunities are few and far between, thus making M&A the most viable means of achieving growth.
In order to decide if this is a good idea or not it helps to consider the track record of corporate M&A. When we do so we discover that it is spotty at best. Research has shown that the returns to shareholders of acquiring companies who make cash offers are on average zero or negative. And, in markets like this one, sellers may be reluctant to sell when the values of their companies are so low and they may be more inclined to resist bargain hunting bidders. Takeover resistance tends to cause bidders to raise offer prices which benefits target shareholders but comes at the expense of acquiring shareholder’s returns. If targets are able to facilitate an auction for the company, it is more likely that bidders may overpay and be stuck with what is called the “winners curse.”
Another cause for concern is the underlying motives of acquiring managers and CEOs in particular. The intentions of acquisitive CEOs are too often highly questionable. Research shows that CEOs tend to be rewarded in the form of increased compensation by their boards for completing deals. In addition, CEOs of larger enterprises tend to be paid more, thus providing another financial incentive for CEOs to empire build and acquire companies for acquisition’s sake.
The Intel acquisitions are interesting as they mark an expansion of a very successful chip maker into other fields. Research also shows that CEOs of diversified companies earn 13% more than their undiversified counterparts even though the stock value of diversified companies reflects what is known as a “diversification discount.” In contrast, when companies become more focused and sell off units, such as prior diversifications, share values tend to rise. CEOs, however, may be reluctant to do this as these smaller, more focused businesses may provide lower compensation.
Far too often deals are motivated by hubris instead of sound strategic planning. This problem is reflected in a whole host of modern M&A mega-failures such as Daimler’s acquisition of Chrysler and Citigroup’s serial acquisitions that eventually resulted in an unmanageable financial conglomerate. Jean Meissner’s highly acquisitive and dangerously debt laden Vivendi reflects a similar abandonment of strategic planning in favor of sheer size. There are also many examples of questionable strategic planning that can be pointed to such as the second largest deal of all time and the biggest flop – AOL-Time Warner.
At times like this, with so much of shareholders’ money trapped in corporate entities, boards need to be extra vigilant to make sure that it is allocated to its most productive use. Too often boards are beholden to CEOs and fail to exercise sufficient oversight, allowing the CEOs they are charged with supervising to engage in unprofitable empire building. With companies filled with readily available cash, directors need to ensure that there is a very convincing reason why this cash should not be turned over to shareholders in light of the losses so many have incurred in their shrunken portfolios and downsized 401Ks.
Author: Patrick A. Gaughan, Ph.D.
Dr. Gaughan is president of Economatrix Research Associates, Inc. He is also a full professor at the College of Business at Fairleigh Dickinson University where he teaches mergers and acquisitions. He is the author of the award winning graduate textbook Mergers Acquisitions and Corporate Restructurings. The fifth edition of this book will be released by John Wiley & Sons this October.