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Big deal, but does it add up?

Sun, 27th Feb 2005

IT'S NOT exactly spring, but the sap certainly seems to be rising among chief executive dealmakers. This week's announcement of Novartis's $8 billion acquisition of the German drugs firm Hexal puts the seal on three months of M&A activity that bears comparison with the bull market of the 1990s.

In the US alone, in the three months to the end of January there were 48 deals worth more than $1bn, to a total value of $357bn. A whacking $57bn of that was accounted for by the single takeover of Gillette by Procter & Gamble. Merger activity among smaller US companies and in Europe was bubbling up nicely, too.

By now it's a business truism that, although initially good for ego, megamergers are a rickety vehicle for personal (see the demise of Carly Fiorina at Hewlett-Packard) as well as corporate ambition. Conservatively, two-thirds of deals end up destroying rather than creating value, often wrecking jobs and livelihoods in the process. So is this time likely to be any different?

Although the companies involved will argue strenuously that they are special cases, they probably aren't. We have been here many times before. Rising stock markets bring out takeovers the way spring brings out green shoots, by hotting up the value of acquirers' shares. But while an inflated currency may make deals easier to sign, it does not make them easier to bring to success on the ground.

This is partly a matter of mathematics. Most acquirers have to fork out a premium over the current value to persuade shareholders in the target company to sell. The mark-up - sometimes up to 30 per cent - means that for the deal to break even the acquired company must now do better than what the market had already priced into the shares like the Red Queen in Alice , it must run faster to stand still.

For the deal to hit the money, it must speed up still further - in effect, shift to a new and steeper growth path. The snag is that, in a rising market, expectations, as expressed in price/earnings ratios, may already be challenging. And the benefit of chopping headquarters, headcount or back offices can only be taken once.

So permanently improving the growth rate is a big ask. To take the P&G/Gillette case, Stern Stewart in the US calculated that, although the premium was relatively small, Gillette would still have to increase profits by 12 per cent a year for the next five years for the deal to be rated a winner - three times the historic rate.

The equation becomes more problematic if you look at some of the managerial assumptions underlying the mathematics.

First assumption: melding the businesses is costless. It isn't. Even in the (rare) cases of companies that are well practised at doing takeovers (GE, Cisco, the Hanson of old) there is almost always fallout in the shape of FUD (fear, uncertainty and doubt), culture clash (HP and Compaq) and at least a temporary drop in commitment and energy levels as people take their eye off the ball. Culture may not figure in accountants' merger calculations but, for takeover virgins, the costs of ignoring it are as real as any other, and often higher.

Second assumption: synergies will ride to the rescue. Unfortunately, synergy is the the managerial equivalent of the accountants' goodwill - a last-resort justification for optimism when all the more quantifiable variables have been used up. Like the abominable snowman, synergy is the subject of much excited speculation but rarely seen in captivity. One of the most important reasons why it so regularly fails to materialise is that it's a construct of the proposer - the producer - rather than the customer. And it is the customer who disposes. This means that all too often it is simply a wish, fuelled by unspoken greed rather any probability of consummation.

A service one-stop shop sounds logical to a producer, but that doesn't mean the customer will want to use it. Or take AOL and Time Warner. Five years ago AOL bet $183bn it could find synergies between the distribution and creation of internet content. It, or rather shareholders, lost.

The third assumption is that acquiring company B will somehow make company A more efficient. Unless it is reversing into a much better-run firm or purchasing an unassailable market position, this is another case of wishful thinking. On the contrary, for any less- than-exceptional company, a bid should be considered a warning sign.

How could it be otherwise? However long it tries to put it off by takeovers, reorganisations, write-offs and other one-off improvements, the only lasting test of a company is its performance in improving ability over time to deliver goods or service to customers at a profit. If a company cannot wring exceptional performance from its existing operations, it's unlikely, to say the least, that it will do better with something it knows less well.

The other way round, operational excellence on the part of the acquirer, makes it relatively easy to predict merger success. Having steadily squeezed costs and raised margins in its existing Dutch and UK operating companies, for instance, household goods group Reckitt Benckiser could be confident of doing the same thing with any acquisition.

The Catch-22 is that companies whose strategy is operational excellence rarely do acquisitions. There are exceptions, such as Cisco, but on the whole they don't need to. When Dell went into printers, it used its own superior supply chain and business model to start its own operation from scratch. Or why would Toyota pay a premium to buy someone else's luxury car operation when it knew it could do it better itself?

Takeovers make headlines and give the impression of purposeful activity. But, managerially and mathematically, the odds against them paying off are as high as they ever were.

The Observer, 27 February 2005


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