The Investment Checklist

by Michael Shearn

  Of course, some synergies do materialize. The common element in these is that the customer base is the same, such as when Kraft acquired General Foods. Another example is Pool Corporation (Pool), a distributor of pool supplies. Pool realized that pool contractors were not well served by plumbing or building-products distributors. Pool recognized that customers valued local service and more important, the availability of supplies. Rather than pursuing a strategy of rolling up all firms in the pool-supplies-distribution business, Pool instead focused on strengthening its market position city by city through a combination of focused acquisitions and organic growth. Pool’s success can be attributed to the fact that it focused on building strong market share in each of the local markets where it operated, which gave it pricing power. In 1990, Pool had eight sales centers and by 2010, Pool had grown to 291 sales centers according to its 2010 10-K.

  59. Have past acquisitions been successful?

  Most M&As fail. A few of the reasons are as follows:

  Acquisition candidates are not always available at good prices; as a result, management typically overpays for acquisitions.

  Most businesses that are for sale are not very good, and an acquirer typically ends up buying lots of problems.

  Cultural differences between businesses result in the defection of valuable employees.

  There are seven ways to evaluate whether an acquisition has been successful. The following sections look at these (and other) factors in more detail.

  Do Acquisitions Fit into the Core Competencies of the Business?

  When a business acquires another business, the odds that it will be a successful acquisition improve if it is done within the same industry—such as when Hewlett-Packard (H-P) bought Compaq (both were computer manufacturers) in 2002. After the acquisition was announced, H-P’s management set an objective to realize $2.4 billion in cost reductions in one year after the merger. They exceeded this objective by achieving $3.7 billion in annualized savings within a year of the merger. In contrast, whenever a management team acquires another business outside of its core competencies, it risks becoming distracted as it attempts to understand the acquired business and begins to neglect its core operations. Things such as improving the customer experience in the core business get placed on the back burner and instead, time is spent on integrating the acquisition. Furthermore, if the management team begins to run into problems at the acquired business, it may not have the internal resources to solve them.

  For example, in 1997, John Mackey, the co-founder of Whole Foods Market, acquired a catalog vitamin business, which he thought would fit in with Whole Foods Market. But when the vitamin business encountered problems, Whole Foods Market did not have anyone who knew how to fix those problems. The lesson Mackey learned was that Whole Foods Market’s core competence was in retail sales. The company’s management team did not know what to do or have the people resources to solve problems stemming from catalog sales. In other words, it wasn’t just the type of product that was important to the success of the acquisition; the method of distribution and sales was also critical. Eventually, the vitamin business was liquidated.6

  When you see a business make an acquisition outside of its core business, this may be a signal that the profitability or sales of the original business are declining or maturing. Other times, management egos may be involved. For example, at one time, energy giant Enron controlled large portions of the gas and electricity markets in the United States. Then it began to expand outside of its core business by attempting to corner the market on broadband capacity; Enron even attempted to become the world’s largest water company. Enron lost billions of dollars on these ventures, and the company began to manipulate its accounting numbers to shield these losses, eventually filing for bankruptcy in 2001. Enron may be an extreme cautionary tale of a company acquiring other businesses outside of its core competency, but it’s a great example to keep in mind when you’re considering investing in companies that are starting to do so.

  Does the Management Team Intimately Understand the Business It Is Acquiring?

  Companies that acquire related businesses—or at least businesses that the management team knows how to manage—are more likely to be successful in their M&A strategies and therefore better potential investments. For example, Danaher is a conglomerate that has grown mainly through acquisitions, acquiring up to one business a month throughout its history. The company owns a variety of industrial businesses that make dental-surgery implements, hand tools, testing instruments, and other medical and diagnostic equipment. Over the last 20 years (up to 2010), Danaher’s stock has returned 25 percent annually. Danaher is successful at acquiring businesses because they are able to reduce many potential risks. They do this by becoming intimately familiar with the operations of the businesses they are about to acquire. For example, before Danaher began to acquire medical-technology businesses, its management team studied the industry for about three years, conducting more than 400 customer interviews, as well as numerous interviews with industry experts and competitors.7

  To further reduce risk, Danaher executives tour plants and search for ways to improve the performance of the target company before they acquire that company. They estimate how much they can improve the profit margins of the firm by implementing what they call the “Danaher Business System,” which is a set of management tools used to identify potential efficiencies. This system requires that all employees, from the janitor to the CEO, find ways to improve the way that work is done.8

  In most of its acquisitions, Danaher leaves the existing management in place and provides them with incentives to improve performance in the form of stock and bonuses. As a result of taking its time to understand an industry before making an acquisition and by learning how it can potentially improve a business before acquiring it, Danaher has been successful at acquisitions.

  Cisco follows a similar strategy by routinely developing products in-house before acquiring another company. Cisco attempts to answer the question of whether it is cheaper to develop a product itself or if it is better to acquire another business. This way, the company develops the advantage of understanding how a product works and an in-depth understanding of whether it can compete with the products of a potential acquisition candidate.9

  Does the Business Retain Its Customers After an Acquisition?

  One of the best ways to assess whether an acquisition is successful is to monitor the retention rate of customers after an acquisition. If a business is able to retain the majority of customers three years after an acquisition, then this is a positive indicator that it is making good acquisitions.

  Some industries simply have better customer retention regardless of ownership change. Medical-disposal businesses, for example have high customer-retention rates. Stericycle, a medical-disposal company, successfully retains its customers after buying another company. Contrast this to an advertising agency where, on average, customer contracts come up for renewal every two years and there is high customer turnover. If an advertising agency acquires another agency, take into consideration that customers may not renew their contracts with the acquired agency. This increases the likelihood that the acquisition may fail as the earnings of the acquired agency decrease, due to customer defections.

  Does the Business Retain Its Employees After an Acquisition?

  Acquisitions often destroy a company culture. When a business acquires another business, it typically tries to standardize the acquired business, which can damage the entrepreneurial spirit of the acquired business, making it less valuable. For example, when Lehman Brothers bought money-management firm Neuberger Berman, it stifled the culture, and many of the talented asset managers left the business to start their own firms. The departure of many of these asset managers contributed to value destruction at Lehman.

  Attempt to understand the attitude that management has toward the employees of the acquired business. For example, Whole Foods Market always respects the people who work for the companies it acq
uires. In fact, Whole Foods Market often promotes some of the employees from the acquired business to create a climate of trust. There is not an attitude of arrogance on the part of the acquirer, which often causes the most talented employees of an acquired firm to leave.

  Cisco learned the importance of retaining talented employees after acquiring StrataCom. After the acquisition, Cisco tried to speed up sales and ended up losing not just sales but 30 percent of the employees as well. Since its first acquisition in 1993, Cisco has acquired almost 150 companies and has developed a set of principles and practices that make the acquisitions successful: Buy small, buy early in the product’s life cycle, and most important, put the people you’re acquiring above everything else. Since 2002, more than 90 percent of the employees acquired by Cisco have stayed with the company.

  When Cisco buys a business today, it largely leaves the practices of the acquired businesses in place in order to retain employees. To transfer its values to the acquired business, it uses a mentoring system, in which Cisco managers support managers at the newly acquired company.10 Early on, Cisco communicates openly with the employees of the acquired firm and gives them essential information about its plans for the business. This gives employees ownership in the process rather than creating uncertainty and a lot of updated resumes as employees look for other jobs. Ned Hooper, vice president of business development at Cisco says they structure the acquisition to retain people through this adjustment period. After that, they can look at Cisco differently. “For us, the people are the strategic asset. . . . We need the expertise.”11

  In 1999 when Cisco acquired Cerent Corporation (a maker of optical networking gear), Cisco made sure its employees were ready to contribute from day one. Employees arriving at work on the morning that Cisco took over the company found new business cards and bonus plans waiting for them. They also found their new health plan information and ready access to Cisco’s computer system. In the first six months, Cisco lost only 4 of 400 Cerent employees.12 Look for acquirers who communicate with employees early so they are not worrying about their jobs and can instead focus on sales and customer satisfaction.

  Cisco’s Linksys acquisition illustrates why it’s important to retain talent for the long-term. When Cisco bought the home and small-business router company in 2003 for $550 million, it wanted to keep the same people who had created the Linksys router. Cisco thought that the market had billion-dollar potential, but that potential existed in marketing future versions of the router that only its creators had envisioned. The product’s future was in the employees’ heads, so to speak. Watch for those businesses that retain employees after an acquisition as this is often a good sign that the management team is making a good acquisition.13

  Does Management Have Discipline or Is there a Risk That They Will Overpay?

  Management teams, even good ones, usually overpay for acquisitions. This represents a huge source of risk for you as an investor. For example, in October of 2007, online auction house eBay admitted it overpaid when it acquired the Internet phone services company Skype Technologies for $2.6 billion in 2005, and took a $1.4 billion write-down. This write-down represented 53 percent of the total EBITDA generated by eBay in 2007.

  Companies overpay because quite simply, they don’t know the real value of the target company. They often think they do, which adds to their problem. The seller, of course, is more likely to know the true value and is unlikely to strike a deal on less-than-favorable terms. Here’s one more reason that valuation is difficult—excitement. Acquisitions are very exciting and often cause managers to lose objectivity.

  It is often difficult to discern whether a business has paid a reasonable price. Also adding to the problem of evaluating the price paid is the fact that it can take at least three to five years to determine if an acquisition has been successful. Johnson & Johnson’s management often did post-mortem analyses of its M&As after three years. Former CEO Ralph Larsen said in his 2000 annual report that they also made it a point to weed out acquired companies:

  While the Company actively seeks business-building M&As of companies and product lines, we also have in place a process to continually evaluate those businesses that are under-performing, or which no longer meet our growth objectives and would be better off in someone else’s hands. Over the past 10 years, for example, we have divested 21 businesses or product lines.

  There are certain situations where an acquirer is more likely to overpay for an acquisition:

  If there are a lot of competitors bidding, in an auction-type situation, with investment bank pitch books, then the price will likely be high. On the other hand, if the seller cares about who it sells to, then this is a good sign because price becomes a secondary consideration. For example, Berkshire Hathaway has been able to purchase many businesses at good prices because the sellers want to sell to Berkshire Hathaway CEO Warren Buffett. Bill Child, founder of furniture retailer R.C. Willey, sold his business to Berkshire Hathaway on May 29, 1995, for $175 million in stock. Child said, “When I have spoken to students and business people, I have told them that if they ever have a chance to associate with or be a partner with Warren Buffett, to do it and do it fast. It will be the best decision of your life.”14

  The management team of a business may fear that a competitor is making new inroads into its core business or creating a new market for its customers. For example, because toy manufacturer Mattel feared that the software and games made by the Learning Company threatened its business, it acquired the company—and almost went bankrupt as a result of this acquisition. When Mattel acquired the Learning Company (May 1999) it was suffering from a decline in its core business even though the toy industry was growing in the low single digits. Mattel was not keeping pace. Mattel acquired the Learning Company to transform the business into something beyond a toy company and to spur growth. Management at the time publicly stated that they wanted to grow Mattel’s revenue by 10 percent a year. Mattel ended up selling the Learning Company for $27 million at the end of 2000, even though it paid $3.6 billion to acquire it a year and a half earlier. By that time Mattel had replaced the CEO who bought the Learning Company. The new CEO, when asked why they’d sold for so little said, “Because that was the best offer at the time and it was losing about $1 million a day in cash. We needed to stop the bleeding.”15

  The larger and the more ambitious the deal, the greater the risk that management will overpay. You can recognize these deals when management uses the words “transformational” or “game changing” to describe the merger or acquisition. Steve Case, founder and former chief executive officer and chairman of America Online (AOL), stated, “Now that the AOL Time Warner merger has closed, we have a new company for a new world—one poised to spark a transformation of the media and communications landscape—connecting, informing, and entertaining people in innovative ways that will enrich their lives.”16 Case further explained, “These unmatched assets position AOL Time Warner to speed the development of the interactive medium and capitalize on such transformational opportunities as digital music, interactive television and broadband Internet services.”17 Shortly after the merger, the share price of AOL Time Warner dropped 90 percent from its peak value.18

  If the business is healthy, it will usually be able to attract higher offers. On the other hand, if the business is a damaged property, it typically sells for a lower price. The sale price of the Learning Company illustrates as much. Its sales had continued to fall throughout the time it was held by Mattel.

  Acquisitions made when markets are down tend to be at lower prices than those made when markets are up. In 2009, after the United States entered a recession, hotel properties were sold at low prices. According to Lodging Econometrics, the Portsmouth, New Hampshire, hotel-research firm, the average selling price for a hotel room was $58,190 in 2009, which increased 86 percent to $107,988 one year later. Those businesses that bought hotel properties in 2009 paid a lower price than those who acquired hotel companies in 2010.19

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p; Successful acquirers have a disciplined acquisition strategy. For example, here are just a few successful acquirers: Brookfield Asset Management; Penn National Gaming; Cisco; Danaher; and Berkshire Hathaway. The CEOs of these businesses are willing to walk away from a deal if they believe they are about to pay too much.

  For example, at Penn National Gaming, CEO Peter Carlino did not get into a bidding war with investor Carl Icahn to buy the unfinished Fountainbleau Resort in Las Vegas because he felt he would be paying too much if he offered a higher price. As Carlino said (during a quarterly conference call), “We hit our limit of where we wanted to go and then walked away. Buying properties at full price at high multiples is like treading water. Why use the firepower of our balance sheet on opportunities that will not really increase shareholder value?”

  Similarly, Bruce Flatt at Brookfield Asset Management often walks away from deals, even after investing significant amounts of time in them. When a group led by investment bank Morgan Stanley bid $3 billion to buy the famous London-based office development firm Canary Wharf, Flatt offered a rival bid. As the bidding continued, Flatt walked away from the deal when shareholders demanded an estimated $20 million more in cash (a relatively small amount compared to the deal size).20