''The deal has potential synergies that make some observers drool.''
-- The Wall Street Journal, commenting on Time Warner's merger with AOL
Synergies, synergies. Everywhere you look these days, companies are paying through the nose for these things ... whatever they are.
Yet ever since Time Warner merged itself with AOL back in 2000, promising to change the new media paradigm (whatever that is), I've wondered about this whole "synergies" business. Time Warner clearly didn't find them at AOL -- and after years of flailing around in search of 'em before it ignominiously dropped the synergy-less AOL right back where it found it.
But what are synergies, exactly? And how do you know when you do have them?
Synergies: Corporate weapons of mass distraction
Practically every company that's ever overpaid to acquire another company declared, at the time the acquisition was announced, that it spied "synergies" of some sort in its new prize.
Salary savings from pink-slipping redundant workers. Operating efficiencies from letting a single set of salesmen sell two portfolios of products. Greater pricing power from decreased competition, as a former bitter rival morphed into a compliant subsidiary.
The supposition of synergies helped explain Delta's purchase of Northwest, Cisco's
But synergies were also cited in the disastrous AOL-TWX marriage, in General Motors' ill-considered purchase of a stake in Fiat, and in Ford's
So how's an investor to know whether an acquiring company will deliver on the promise of those supposed synergies?
The friendly number crunchers at Gridstone Research give us the answer: What it really all comes down to is not "synergies" at all, but execution.
To the guillotine with your synergies!
No, not that kind of execution. I mean competent implementation of the buyout plan and follow-through on cutting costs and improving performance, the basic blocking and tackling of any successful business.
In a recent report, Gridstone reviewed four high-profile tech acquisitions that took place between 2006 and 2008:
-
AMD's
(NYSE: AMD) acquisition of ATI Technologies. - Hewlett-Packard's acquisition of EDS.
- SAP's acquisition of Business Objects.
- And Oracle's
(Nasdaq: ORCL) serial acquisitions of Siebel Systems in 2006, Hyperion in 2007, and BEA Systems in 2008.
Examining profits and revenues at acquirer and acquired before and after acquisition, Gridstone observed a wide range of outcomes -- and often, a wide discrepancy between promise and performance.
The bad
The 2006 buyout of ATI by AMD proved "a disaster on all fronts." Whereas the two companies generated $8.1 billion in fiscal 2006 sales, by the end of fiscal 2009 revenues had plunged to $5.2 billion.
Sure, the Great Recession probably played a part in this decline, but it doesn't explain how an acquisition that was "expected to strengthen AMD's presence in the GPU market" instead resulted in ATI-AMD "losing market share in both the CPU (to Intel
The good
On the other hand, "companies like Oracle and HP have a strong management which makes sure that such acquisitions produce the desired results despite the massive challenges that a dramatic downward swing in business fortunes can bring."
Gridstone even wonders aloud why, if the recession was to blame for AMD's troubles, it didn't hurt Hewlett-Packard nearly so badly. After all, the companies operate in the same industry.
HP's revenues did in fact decline post-acquisition-of-EDS, but only by 5%, and according to Gridstone, "it could have been much worse." Instead, the acquisition of EDS shored up HP's depleted revenue streams. And by cutting costs at his new prize, CEO Mark Hurd delivered on HP's promise to find "synergies" and raise profit margins.
Result: Even in the middle of the Great Recession, and even after absorbing a previously less-profitable business, HP held its profit margins steady in 2009.
Best of all was the result at Oracle. Oracle purchased a string of businesses with profit margins weaker than its own, and yet managed to double both revenues and operating profits between 2005 and 2009, infecting each of its new businesses with the parent company's penchant for profits.
And now, the Foolish lesson
In other words, the critical question is not whether a company acquires another, but whether you can trust it to do so effectively. How, though, do you go about gauging whether a company will succeed?
By examining past performance.
This goes against conventional wisdom, I know. It contradicts the practice of valuing companies on their forward earnings estimates and violates a central tenet of every prospectus disclaimer you've ever read, warning that "past performance is no guarantee of future success."
But at Motley Fool Stock Advisor, we're convinced that management matters -- and that the best way to predict whether a company will deliver promised "synergies" is to examine whether it has executed in the past -- whether in making profitable acquisitions, or in the simple workaday task of earning its profits organically.
That focus on management has enabled us to crush the market's returns for the better part of a decade. It's why we're convinced that companies like Berkshire Hathaway -- and the others who populate our portfolio -- will continue to trounce the market for years to come. If you'd like to see which managements we like best of all, click here for a free, 30-day trial. There's no obligation to subscribe.
Fool contributor Rich Smith does not own shares of any company named above. Berkshire Hathaway and Intel are Motley Fool Inside Value recommendations. Berkshire Hathaway, Ford Motor, and NVIDIA are Motley Fool Stock Advisor selections. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended a buy calls position on Intel. The Fool owns shares of Oracle and of Berkshire Hathaway. The Motley Fool's disclosure policy is the gift that keeps on giving.
