FOOL ON THE HILL
Be Wary of Acquisitions

Major strategic acquisitions generate a lot of press and publicity -- not to mention huge fees for investment bankers -- but usually destroy value for stockholders. More managers should take a hint from Warren Buffett, Whitney Tilson says, and cease such behavior.

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By Whitney Tilson
November 6, 2001

I recently started reading The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers, a new book by Robert Miles. I haven't finished it, but chapter two alone is worth the purchase price. In it, Miles quotes the Berkshire Hathaway (NYSE: BRK.A) chairman discussing the types of companies and CEOs he looks for when considering investments, why such parties should sell to Berkshire, and how he will manage them once they are part of his company. 

I found an excerpt from Buffett's 1981 letter to Berkshire stockholders on why corporations are so acquisitive -- despite overwhelming evidence that this is folly -- to be particularly entertaining and insightful. In it, Buffett notes:

We would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share.  Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior.

However, we suspect three motivations -- usually unspoken -- to be, singly or in combination, the important ones in most high-premium takeovers:

1) Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and challenge. At Berkshire, the corporate pulse never beats faster than when an acquisition is in prospect.

2) Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list and, invariably, the number responded will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfully compiles ranking the same 500 corporations by profitability.)

3) Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad's body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget).

Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?

In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We've observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses -- even after their corporate backyards are knee-deep in unresponsive toads.

The more things change, the more things stay the same
Given that 20 years have passed since Buffett wrote these sage words, one would think corporate managers might have learned something, and scaled back value-destroying behavior. Nope. We are now drowning in unresponsive toads! By any measure, corporations have become even more acquisitive, yet the results continue to be dismal. 

According to Mark Sirower in The Synergy Trap, some 65% of major strategic acquisitions between 1979 and 1990 were failures. A major study by McKinsey & Co., meanwhile, also suggests that well over half of all major strategic acquisitions have been failures. It's not surprising, therefore, that one study covering 1993-95 revealed that on average the shareholders of acquiring firms lose an average of 10% on their investment on the announcement of an acquisition.

One doesn't need to do more than open a newspaper to find abundant anecdotal evidence supporting the conclusions of these studies, such as Daimler Benz's acquisition of Chrysler, forming DaimlerChrysler (NYSE: DCX), or AT&T's (NYSE: T) disastrous foray into cable. Even worse for shareholders are the all-too-common situations in which the acquirer discovers fraud, as was the case when McKesson (NYSE: MCK) bought HBOC, or when Cendant (NYSE: CD) acquired CUC

I've been burned myself on a few occasions, such as when Symantec (Nasdaq: SYMC) acquired (and vastly overpaid for) Axent in July 2000, triggering a 21% decline in the stock the next day (and a 57% decline over the next five months).

What to watch for
While most acquisitions are failures, some succeed, so savvy investors must evaluate each one on its own merits.  According to Sirower's study, there are three critical warning flags for acquisitions that are likely to fail:

  • The acquirer pays a large premium to the current stock price;
  • It is a large acquisition, relative to the size of the acquirer; and
  • The acquirer pays with stock, not cash.

As case studies, let's look at two recent acquisitions: Symantec's acquisition of Axent and Berkshire Hathaway's acquisition of XTRA. The former failed all three tests: Symantec offered a 67% premium, paid in stock, and, while Symantec was a much larger company, it offered 24% of its outstanding shares, so there's no question that it was a major acquisition. In contrast, Buffett offered a mere 5% premium to acquire XTRA, paid in cash, and the deal was tiny relative to Berkshire's size. Guess which company made the wiser acquisition?

For all the reasons noted above, as a general rule I suggest avoiding companies that are serial acquirers and/or have recently initiated a major acquisition or merger. Things might work out okay, but so many things can go wrong that it's not worth the risk. That is why I shared concerns about General Electric (NYSE: GE) when it was planning to acquire Honeywell (NYSE: HON) in January. Today I have similar concerns about AOL Time Warner (NYSE: AOL) and Tyco (NYSE: TYC.)  

And failed acquisitions aren't necessary bad news -- if you buy after all the bad news is out and the stock is really, really cheap. I loaded up on Berkshire Hathaway early last year, for example, after the stock was beaten down in part due to poor results from the recently acquired General Re. Similarly, Symantec and McKesson have done exceptionally well since the lows reached in the aftermath of their acquisitions. 

Conclusion
I'll let Buffett have the last word on this topic, in which he describes his own acquisition efforts with his usual humility: "We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes -- but they were princes when purchased. At least our kisses didn't turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices."

Purchasing fractional interests in easily identifiable princes at toad-like prices: That attitude, folks, is invaluable to successful investing.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/