m and a lessons

Firms can grow in two ways: By reinvesting their earnings back into the business. By using their excess cash or issuing stock to acquire other firms. Both represent reinvestment without which there is no growth.

Usually, firms start with organic growth. It is only when growth in their core business dries up, they look for other ways to grow. There is nothing wrong with the strategy, except that very few firms are good at identifying right targets at right prices. 

When managers stop getting projects that earn excess returns, it is wise is to accept the reality that the firm has matured and behave like one. Here, cash flows are more predictable, debt is more affordable, and dividends and stock buybacks are more value accruing for owners. Investing, financing and dividend decisions are less complicated. For a good business, continuing as a going concern, albeit at lower growth, works best. For a bad business, well, slow decline or liquidation is the preferred route.

There is a problem, though. It is not common for managers to exhibit common sense. As if to prove that common sense is so uncommon, they refuse to accept the reality. This leads them to do one of the two things.

They continue to believe that their business is always capable of earning returns that are acceptable. Attributing below par earnings to a temporary setback, they continue to pour cash into the business. Nothing is worse than dissipating cash, which rightfully belongs to the owners. This will only lead to the eventual value destruction of the business and consequently, poor returns for the stockholders.

If they realize that pouring cash back into the business is not a wise idea, they continue to believe that there are other ways to grow. They trust their hubris more than their capital allocation skills. The result is acquisitions. Most of the mergers and acquisitions around the world start with this framework. Firms need to grow; the bigger they grow, the faster they grow, the higher they are valued. It really doesn't matter whether just physical growth is good enough for the business and its owners. 

The rationale is the standard M & A lingo: Control and Synergy. Firms can be run better and the combined firm is always more valuable than sum total of the individual firms. In addition, operating, financial and tax synergies are quantified. Lo and behold, the firm with no growth becomes bigger and superior. There is more fun when stocks are issued instead of cash. Magically, growth is created without even using cash. 

What is lost somewhere is the fact that all growth does not add up. They are not created equal. There is a cost to the capital used. Again, it goes down to the basics. A business that lacks durable economic advantages is not worth buying, except as a bargain. A business that is unrelated to the core business of the acquirer is difficult to operate since there is lack of experience. In all acquisitions, the key question to ask is whether value of the business is far more than the price paid. Unfortunately, many acquisitions fail in all three counts: an unrelated business that is lacking durable excess returns acquired at an exorbitant price. Often, managers do not hesitate to use high leverage in buyouts. Even corporate cultures hinder otherwise workable mergers.

One justification offered in buying an unrelated business is diversification. A better idea is to let investors use their own cash in dealing with that issue. Owners give cash to the managers to invest in core business. Managers should rather stick to that instruction.

In fact, acquiring a business is no different from investing in stocks. All that matters is a good business bought at a reasonable price. 

What managers learn from history is that they don't learn from history. There is always more action in a vibrant market. While there are many acquisitions that have made sense, many more have not. Cisco did phenomenally well by inorganic growth in the past. HP did not.

The latest one playing the game is Anheuser-Busch InBev and SAB Miller. When price is at a 50% premium to the market value, and when we aren't even sure whether market value is lower than its intrinsic value, we realize the blame is on some one.

It is not that acquisitions are bad, it is only when asking price is way higher than the present value of cash flows that is available in return.

When price is high, no action should be the action. Like someone rightly said, all trouble starts when people are unable to sit quietly at a place.