It’s MADness! (Mergers, Acquisitions, And Divestitures)
Approximately half of all mergers & acquisitions eventually fail. There seems to be little benefit to long-term investors from M&A. If a stock is truly undervalued, it is worth owning. How do companies create value for shareholders? In the long run, nothing matters more than earnings and earnings growth. The more a company earns, the higher the stock price should go. That might seem obvious, but it might also surprise you if you have been listening to what CEOs say. For example, Hewlett-Packard (NYSE: HPQ ) announced a few months ago that it was planning to split itself into two companies. In July, CEO Meg Whitman said, “Today, I’m more convinced than ever that this separation will create two compelling companies well positioned to win in the marketplace and to drive value for our stockholders.” In other words, the CEO argued that the sum of the parts is greater than the whole. If Whitman believes that earnings drive value, then she must also believe that the combined earnings of the two separate companies will be greater than if they remain together as one. Sounds logical. But on Tuesday, Walgreens Boot Alliance (NASDAQ: WBA ) announced plans to acquire Rite Aid (NYSE: RAD ). Rite Aid CEO John Standley said, “Joining together with Walgreens Boots Alliance will enhance our ability to meet the health and wellness needs of Rite Aid’s customers while also delivering significant value to our shareholders.” In other words, Standley believes that the whole is greater than the sum of the parts. If he believes that earnings matter, then he must be arguing that the combined entity will create more earnings and more value than if they remain separate. Can both Whitman and Standley be right? When two companies merge, they often argue that the merger will create “synergies.” In other words, they might be able to reduce total costs by getting rid of duplicate functions. (For example, you don’t need two CEOs.) The merger might increase market share and, therefore, create more pricing power. There may also be some tax advantages or perhaps a greater degree of diversification. If the benefits of the merger outweigh the transaction costs, then shareholders should come out ahead. If that’s the case, then why are there divestitures? Companies often argue that a divestiture (in the form of a spin-off, carve-out, etc.) will create value by allowing distinct business segments to separate into new companies in order to focus more intently on their separate businesses. They may claim that the market does not understand or appreciate the value of the combined businesses, and that a divestiture will “unlock” value for shareholders. So, if you believe all this, it must follow that separating a large company into two creates more value. Two companies merging into one creates more value. One company buying another creates more value. And a company splitting off a small part of itself creates more value. Well, do you believe it? There are lots of examples of mergers that have succeeded; yet, there are also plenty of examples of mergers that have failed. One of the best-known failures is Hewlett-Packard’s own acquisition of Compaq. It’s still haunting former CEO Carly Fiorina on the presidential campaign trail. When it comes to mergers, acquisitions, and divestitures, here’s what we know for sure. When Company A announces plans to buy Company B, it typically pays a premium. In order to convince the target company’s shareholders to approve the deal, it has to offer to pay more than the market price. So, Company B’s shareholders often see a quick and significant increase in the value of their shares. What happens to the shares of Company A, however, is less consistent. Sometimes they rise a little when the deal is announced. Sometimes they fall. Over the long run, how the shares perform depends on a number of factors, including whether the merger was really a case of exploiting potential synergies, or a desperate bid to grow the top line without regard to profits. As far as divestitures go, we know that they often follow mergers & acquisitions. In fact, academic studies show that 35-50% (or more) of acquisitions are later divested by the acquiring firm. In other words, it appears that approximately half of mergers & acquisitions eventually fail. They may create a lot of value in the short term for shareholders who want to sell, but there seems to be little benefit to long-term investors. Over the years, I have recommended the stocks of many companies that acquired other businesses, were acquired themselves, or that engaged in some sort of divestiture. When that happens, there is often a quick increase in value. I’m happy to take the gains. However, my recommendations are never based solely on the hope that these kinds of transactions will occur. In my view, if a stock is truly undervalued, it is worth owning. It may take a while before the true value is appreciated by the rest of the market, but that’s something I’m willing to wait for.