Merger Mania

Mike Kauffelt, CFA, Chief Investment Officer

A quick glance at the business headlines over the past few months highlights a recent flurry of merger announcements and rumors. These mergers include, in no particular order: K-Mart with Sears, Johnson and Johnson with Guidant, Sprint with Nextel, SBC with AT&T and Proctor and Gamble with Gillette, just to name a few. As mergers are announced we usually get questions from our clients about what this means for the stock markets, the companies involved, their competitors and their industries. I’ll address some of these questions in a general sense, based on years of personal observations about mergers, and then I’ll look at two of these mergers with a more detailed review based on their unique issues.

Most mergers are in fact acquisitions; they involve one company completely buying another. One company may purchase another with cash, stock or a combination of the two. Rarely do we hear about the merger of equals, when, in theory, two similar-sized companies exchange stock to form one new company. A typical acquisition goes as follows: the acquiring company (we will call it company A) makes an offer for the target company (company B) that involves a price that is typically above where company B’s stock had been trading in the recent past. If A and B structure the deal primarily in private and announce the merger as a done deal awaiting shareholder approval, that is called a friendly merger. If A cannot purchase B that way, they may resort to a public battle where they entice the shareholders of company B to tender their shares to A at a known price. This war of words is typically fought out in the business media, and if completed is called a hostile takeover.

In either event, a few common things tend to happen. When the takeover is announced, usually the stock of company A declines and the stock of company B increases. B’s stock goes up because its shareholders are normally getting a premium over their current price to surrender their company to A. A’s price goes down because it is expending a lot of cash or stock to purchase and integrate a different business model into its own. Several financial studies have shown that even a year later, company A’s stock is rarely above its pre-merger price. The conclusion: most mergers do not add the expected value and synergy the managers hoped for when they combined their respective businesses.

A textbook example of a merger in which investors may question the synergy, is the announced acquisition of AT&T by SBC. This is a friendly takeover where a large regional telephone company has come full circle and is buying the telecom giant it sprang from many years ago. Over the past decade, AT&T has destroyed shareholder value and has been battered by competition, and is now but a shadow of its once former self. SBC reasons that AT&T’s assets, primarily some corporate customers and the last few remaining long distance customers who never switched service, can be bought at a fair price and easily integrated into their business model. As the deal was announced, AT&T‘s stock went up and SBC’s went down, just as they should. However, this deal will be mired in regulatory detail (it must be approved by the FCC and several state utility boards) before it can be completed and many are suggesting it will be 2006 before the deal is approved and 2007 before it adds any revenue to SBC. The cutthroat nature of the telecom industry suggests many of their competitors will take advantage of these delays to build out their businesses at the expense of SBC and AT&T. SBC stock will probably still be low a year from now and we are questioning our commitment to this holding in many of our managed accounts. One merger that looks like it might work out well for shareholders is Proctor and Gamble’s (PG) purchase of Gillette. Also a friendly merger, these two companies’ stocks behaved in a typical fashion when the merger was announced; Gillette stock went up and PG stock went down. However, the prospect for PG to be higher a year from now looks much brighter. PG bought a strong company that was growing compared to SBC buying a dying AT&T. PG also has a great history of managing consumer products and distributing them throughout the world. The addition of Gillette’s products should give PG additional options to leverage their considerable clout with retailers to garner even more market share from consumers. This is a case of the strongest consumer products company in the world buying another strong competitor and having a chance at realizing the promised synergy of combining two companies and growing even stronger. This industry, although very competitive, is not as regulated as the telecom industry so they can proceed much more quickly to achieve their goals. We expect PG to prosper and we will continue to hold their shares for the foreseeable future.

The quality of any merger is much like the quality of any meal; it depends on the ingredients. If you combine two great companies you have a better chance of getting a great result. If you combine anything less, the odds are stacked against you. Merger mania tends to come in waves based on many of the conditions we have now; lots of companies with strong balance sheets and excess cash who are facing maturing growth and are looking to consolidate into leaner business models. Be leery of all the headlines though; history shows that most mergers make better stories than they do investments. Invest carefully and selectively with any firm that recently merges into another.