Benjamin Graham wrote in Security Analysis that “Wall Street becomes easily enthusiastic over mergers and just ebullient over segregations, which are the exact opposite. Putting two and two together frequently produces five in the stock market; and this five may later be split up into three and three. Such inductive studies as have been made of the results following mergers seem to cast considerable doubt upon the efficacy of consolidation as an aid to earning power. There is reason to believe that the personal element in corporate management often stands in the way of really advantageous consolidations, and that those which are consummated are due sometimes to knowledge by those in control of unfavorable conditions ahead.”
Times have changed little from the 30’s. Mergers and acquisitions with illusory benefits still plague the stock market today. In “Billion Dollar Lessons” Paul Carroll elaborates on some of the failed combinations of firms. He writes that these paper synergies are conveyed in studies which show that 70% of anticipated revenue from synergies never materializes.
One of the pitfalls in synergies is the illusion of seamlessly merging upstream and downstream operations. Union Pacific purchased Overnite Transportation Company in 1986 on the notion that Union Pacific could service its customers “end-to-end.” Carroll noted that the trucking business proved to be entirely different than rail with much more complex logistics and truck drivers with an independent mindset. Union Pacific was unable to mend these differences and would later spin off Overnite in 2003 for a price that was a third of what they had paid in 1986.
A more glaring incident of proposed synergies is an exaggeration of profits. In the case of the leveraged buyout of Revco drug stores, the banks who sought to profit from the deal in Solomon and Wells Fargo had assumed a profit margin that was double Revco’s average margin for the prior 2 years. It was also 35% higher than the industry average for the preceding 12 years. Needless to say the company filed for bankruptcy 3 years later as the higher margins never came to fruition making elevated interest payments impossible to meet.
Unfortunately Wall Street does not make money when deals aren’t happening. Bankers will naturally be inclined to produce a laundry list of synergies, but less available is the list of the destruction to value that a merger or acquisition could do.
Sometimes outright fraud can have a hand in acquisitions. One of the most prolific acquirers of recent times was that of Tyco. In the 9 years to 2001 the company purchased over 1,000 companies and spent over $60 billion. One of the components of synergies is elimination of costs through reduction of workers. The company certainly eliminated jobs which in some cases were up to 18% of the workforce of the targets.
However, the company was actively misrepresenting their accounting of acquisitions and this became evident in their purchase of CIT. CIT, the now well known bankrupt commercial lender, was initially purchased by Tyco in 2001. But because of CIT’s dependency on public debt markets the earnings of CIT could not be consolidated with Tyco’s. After the acquisition it then became clear that Tyco was depressing earnings prior to acquisitions and making the acquisition look spectacular afterwards when earnings pop back up. CIT recorded a $221.6 million write off to earnings prior to being acquired. Consequently it showed earnings of $252 million in the 4 months after the acquisition vs. $81 million in the 5 months prior. When investors became aware of Tyco’s shenanigans the stock promptly took a hit and Tyco was forced to divest CIT through an IPO expensing some $6 billion.
The management guru Peter Drucker was quoted as saying “dealmaking is romantic (and) sexy. That’s why you have deals that make no sense.”