Are Mergers Paying Off?
By Jeffrey Marshall
Poor Barbie ended up on the barbeque.
Mattel Inc., the toymaker that is virtually synonymous with the best-selling doll, saw an
opportunity to diversify into non-toy products two years ago. It was riding high with solid
earnings and a strong stock price, and went after the Learning Co., an educational
software firm that it soon acquired for $3.5 billion.
But it was Mattel that learned a hard lesson. The merger was ill-conceived - Mattel didn't
know the software business - and within a matter of months the Learning Co. was put on the
block, selling last year for no cash upfront. Mattel's earnings took a drubbing, with per-share
earnings falling from $1.11 in 1998 to a 29-cent loss in 1999 and a loss of $1.01 last year.
With that, Mattel's stock plummeted as well, falling sharply in 1999-2000 and starting this
year off a full 60 percent from two years earlier. The Learning Co. deal ended up as the last
straw for Mattel's board, which fired beleaguered Mattel chief executive Jill Barad last year.
While few mergers end as badly as this one, to a disconcertingly high degree, U.S.
mergers completed in the past few go-go years have failed to deliver on their promises. By one
common Wall Street watchword, three of four mergers consummated today will fail to meet
expectations. And it's not just the late 1990s that get a weak report card. A prominent airline
analyst recently concluded that of 18 airline mergers completed in the 1980s, only one had
"positive incremental benefits'' - essentially because the acquirer saved millions by firing the
target's entire management team.
Considering all the deals that have been done across industries by sophisticated
companies, why is the record so poor? There is no simple answer, and indeed, there are rafts of
shoals that mergers can founder on: poor pricing, cultural and/or people issues, poor planning,
bad timing, weak integration. Ray Beier, U.S. leader of Structuring Services at
PricewaterhouseCoopers, frames the issue simply: "Was the merger ill-conceived? Or was it
strategically good but poorly executed?"
In either case, instead of new dynamism, many combined companies suffer customer and
executive defections, dissension over strategy and morale woes. So, what often begins in
euphoric public handshakes ends in acrimony. At worst, plaintiffs' lawyers hover like vultures,
then swoop down when the stock tanks and the company's bones are exposed.
Mattel has plenty of company. Among the poorer-performing mergers of recent years were
First Union-CoreStates Financial, AT&T-NCR, Conseco-Green Tree Financial, Aetna-Prudential
Healthcare, and HFS-CUC (which combined to form Cendant). In several cases, chief
executives and their top lieutenants were eventually forced out - albeit with generous severance
packages. A couple of recent deals, Daimler-Chrysler (see "Daimler Hits Some Potholes") and
MCI-WorldCom, have also generated little good news to date.
To be fair, a sizable number of mergers have been successful, giving companies reach
into new markets and more powerful product sets - as well as higher stock prices, probably the
ultimate criterion for public companies. Several huge mergers from last year - Exxon-Mobil,
Pfizer-Warner Lambert and Philip Morris-Kraft - are generally considered good deals, as are
earlier mergers involving Washington Mutual-Great Western and Wells Fargo-Norwest in the
banking world. FleetBoston Financial Group's merger prowess was profiled in the
January/February issue of Financial Executive.
A number of technology-based mergers have also done well, and not just those involving
renowned deal mavens like Cisco Systems. Openwave Systems, the company resulting from
the combination of Software. com and Phone.com, recently reported that it reached profitability
a quarter ahead of its target date, and raised its estimates for the rest of 2001.
Yet, happy stories appear to be the exceptions. Historians looking back at the 1990s will
see an M&A business booming along, fueled by a high-octane mix of soaring profits, an
explosion in technology, inflated corporate egos and a favorable accounting and regulatory
climate. Not surprisingly, the boom was abetted by investment banks eager to reap rich
advisory fees. Until 2000, there had been eight straight record years of M&A activity. That
began to cool, understandably, when many high-flying tech stocks plunged to earth and the
overall economic outlook soured. Weaker stocks, of course, make it harder for companies to
use stock for acquisitions.
Regulators have been watching all of this closely. The Financial Accounting Standards
Board has been engaged in a very public, controversial effort to modify existing merger rules.
After many months of deliberations and redeliberations, the FASB is preparing to issue a final
rule that would disallow the pooling-of-interests treatment for mergers, which could slow down
the merger machine noticeably - but perhaps not as much as some might think (see "FASB
Readies Grave for Pooling," page 31). Figures show that only 9 percent of U.S. deals used
pooling in 2000, down sharply from 53 percent in 1998 - no doubt a reflection of many tech
companies struggling mightily last year and sitting out the deal dance.
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Behind all the merger mania are not just corporate egos but companies' desires to slake
analysts' thirst for growth. To paraphrase Wall Street's Gordon Gekko's take on greed, growth is
good - and projections of high growth rates are rewarded with high multiples. "Investors don't
want just growth, they want speed, too," says Idalene Kesner, a professor of strategic
management at Indiana University's Kelley School of Business. "The opposite of slow, organic
growth is acquisitive growth." As a result, many mergers are fundamentally about acquiring
more customers to sell to. Indeed, in mature industries, it's almost a situation of buy or die,
since acquirers live to see another day and perpetuate their name; acquirees disappear.
Often, the bar is set too high. "In lots of deals, you had to hit a home run every week - a
double didn't get you there," says Van Conway, a principal with M&A and financial management
consultants Conway MacKenzie & Dunleavy in Birmingham, Mich. "There were massive
projections and multiples. If you were projecting 30 percent growth and you had 10 percent, you
were in trouble."
Some mergers, understandably, fall victim to outside events and changed business
environments. WorldCom, the surviving entity from the 1998 merger of MCI and WorldCom, saw
its stock fall by about two-thirds in the 18 months that ended in January. A major factor was the
blistering consumer long-distance rate war unleashed by AT&T, itself struggling badly to find its
footing in the cutthroat telecom marketplace.
Financial columnist Christopher Byron writes that the rate war has brought WorldCom's
consumer long-distance business "to a screeching halt, and is now expected to cause the
company's consumer long-distance revenues to decline by perhaps as much as 2 percent in the
year ahead. As a result, in 2001 the company's MCI-based business is not expected to
generate cash income of more than about $115 million, which wouldn't even begin to cover the
goodwill cost of the acquisition itself." A recently announced "corporate realignment," writes
Byron, "amounts to an admission by WorldCom that its 1998 acquisition of MCI was an
enormous and costly blunder."
What's striking about many of today's poorly performing mergers is that they are frequently
combinations of scale in similar businesses - and not riffs on the discredited "conglomerate"
model pursued by W.R. Grace, ITT and others in the 1960s and '70s. Conglomerates did
mergers in the name of diversification, believing that good performance in one area would
overcome a slump in another. But many of the pieces didn't fit together, and headquarters
managers frequently didn't understand them; as stepchildren, often without size or focus, the
subsidiaries under-performed competitors and gradually sapped the conglomerate parent.
Scale mergers in vertical markets were supposed to work far better. Many depended,
however, on accounting with the pooling approach, in which the companies' balance sheets
were pooled in a common set of books. Many market-watchers argue that pooling has
precipitated a host of uneconomic mergers, when companies pumped up with high stock
multiples waded into deals, often precipitating bidding wars in which the true economics of the
acquisitions weren't readily apparent.
Some observers are practically apoplectic on the subject. Bill Parish, a former analyst and
CFO who has become a kind of accounting/reporting gadfly, has lit into Citigroup over its
pooling practices. "My strong opinion is that Citigroup has become a 'watered stock' due to the
excessive use of the pooling loophole for mergers," Parish says. "In effect, [it has] almost no
real capital if related goodwill paid were recognized."
Parish points to the fact that "there are simply a lot more shares outstanding as a result of
pooling-based mergers. Citigroup has more than five billion shares outstanding, and with a
market cap of $250 billion, a 4 percent dividend would cost them $10 billion. That is tough
math." He adds: "Of course, investors generally buy banking and utility stocks for a good
dividend. Citigroup now pays only 1.1 percent."
Experts say that pricing is a critical component of a good merger. "Is the pricing right?"
asks Conway. "Lots of deals have been done where the acquirers paid too much. If you
overpay, you may not be able to dig yourself out later. Reasonableness is a key component."
Says Indiana University's Kesner: "You need to know what you're willing to pay, or you may end
up paying off debt at uneconomic terms. Companies with huge debt loads start behind the eight
Richard Schrader, executive vice president and CFO of Parsons Brinckerhoff Inc. in New
York, a privately held engineering and construction firm that has done a series of smaller
acquisitions, says that in situations where there were other bidders, "We put in a price that was
subject to review. You're committing something in advance of any [complete] information you
have. The trick is to get enough information to get an evaluation you're comfortable with, but
make it subject to due diligence."
"How you structure a transaction in terms of leverage - debt or equity - can impact its
success," Conway says. "Larger middle-market transactions are often done through debt, but if
you have a bump in interest rates and get a decline in the industry, you can really throw the deal
into a dive. If you have more equity on the front end, you're better able to weather any storm. If
it's all leverage, there's less margin for error."
Inadequate due diligence - failing to adequately assess the target company, warts and all -
has been the downfall of countless mergers. Too often, Conway says, the due diligence suffers
be-cause "people want to marry the deal. You need to understand what you are buying and how
the fit is from a financing, cultural and operational standpoint." Much ad-mired merger players
like Cisco and General Electric Co. often have carefully formulated merger teams and templates
to draw on every time they do a deal.
Parsons Brinckerhoff's Schrader says his company has developed a standard approach to
due diligence. "We normally assemble an in-house team, typically with HR, finance and IT. It's
usually led by someone with some degree of independence from the champion of the project,
so we don't get biased results.
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"We try to set a timeline," he adds. "If there are issues that come up early, we flag those,
and we may have to deal with them then and there. With a lot of the deals we've done, involving
small ownership groups and privately held companies, we can deal with those issues
immediately." He adds: "You want to flush out any deal-breakers, in addition to being sure
you're buying what you think you're buying." As a result of the company's experiences, he says,
"We've beefed up our due diligence and integration efforts."
Internal audit is another resource that should be called on during due diligence, argues
Barbara Davidson, president of the Investment Training and Consulting Institute. Auditing can
help verify company histories, customer orientation and concerns - and perhaps more
importantly, check for "undervalued/overvalued and unrecorded assets" such as software,
marketable securities, intangibles and inventories.
A dispute over inventory, in fact, was in early February clouding the merger between
Tyson Foods and meat-packing firm IBP. Tyson executives were complaining about inventory
costs in IBP's hors d'oeuvres business. Moreover, Tyson said it hadn't learned of an SEC
investigation of an IBP pooling merger done in 2000 until after the Tyson-IBP deal was finalized.
When corporate cultures differ, mergers really get tricky. A number of financial services
deals faltered in the clash of cultures between commercial and in-vestment banking. Banks had
the capital to do the deals, but their conservative, hierarchical approach and relatively rigid
compensation practices threatened to stifle investment bank deal-makers. When Bank of
America bought Montgomery Securities a few years ago, for in-stance, Montgom-ery's then-
chairman, Thomas Weisel, soon bolted to start his own firm - and took many former colleagues
with him. While BofA executives defended the deal, it's abundantly clear that Thomas Weisel
Partners has snatched a lot of business that would have gone to BofA if the defections hadn't
occurred. Weisel says it did work on $105 billion in transactions last year.
A similar set of troubles came in the money management business, where banks found
themselves paying high prices for money management firms - then had to pay up lavishly to
keep the key players, often through retention bonuses that weren't always properly factored into
the deal pricing. Here, too, there were instances where top managers walked away to start their
own firms, frequently taking with them the firm's biggest clients and the top-performing
What are the hallmarks of a successful deal? It's widely agreed that long-term stock
appreciation is one. "In strategic mergers, this happens," says Conway. "Short-term
appreciation may not be a sign." In his view, a lot of gain is by subtraction. "Walking away can
be the best strategy. We're involved in a lot of deals where we don't think the price makes
sense." Shareholders may end up a lot happier, he believes, if weak deals don't get done.
An enhanced reputation is another good sign. Says Parsons Brinckerhoff's Schrader: "As
an engineering and construction firm, we're acquiring people and reputation assets, not plants
and fixed assets. We're looking closely at the people and the depth of management team."
Other positive signs include growing customer rolls, rising customer satisfaction and employee
retention. And, of course, better earnings, though merger charges frequently depress earnings
in the short term. At bottom, the markets want a merger to make money, for the company and
It's widely held that putting two ailing giants together with the belief that bigness is a path
to salvation is entirely wrongheaded, even if the deal is touted as a "merger of equals." Few of
the resulting companies have really thrived. One big problem with so-called MOEs is that they
are often that in name only, despite protestations from the two companies' managements. With
large corporations, especially, it takes virtually Solomonic wisdom to create a structure that
gives both parties equal say in how the combined entity is run. Many MOEs are perceived, in
fact, as defensive mergers accentuating size rather than skill, and quite a few CEOs and CFOs
have refused to do them.
"Honestly, it makes more sense going in [acknowledging] that someone is going to take
over. Recognizing that saves a lot of anguish," says Indiana University's Kesner. "But it's
becoming harder and harder to create success because now we have bigger entities, with more
history and bigger cultural issues. Often, the post-merger process is what spells disaster."
Indeed, many mega-mergers suffer from sagging employee morale as workers fret about
job cuts and business realignments. At upper management levels, especially, things get very
dicey - how many companies need two CFOs? When big deals are announced, a lot of worry
translates into less work getting done, poorer customer service and a stock that drops, even if
analysts and regulators bless the deal, which they often do. (For more analysis on why many
integrations fail, and how to do them right, see "Making Mergers Work," page 34.)
Mega-combinations always raise questions about whether the combined entity can live up
to sometimes-exalted expectations. That's certainly true of the new AOL Time Warner, which
was officially born in January after a year of regulatory scrutiny. CFO Michael Kelly, who had
been CFO at AOL, has said the company is standing by its targets of 12 to 15 percent revenue
growth and 30 percent growth in earnings before interest, depreciation, taxes and amortization
(EBIDTA). Still, AOL TW announced in January that it would be laying off at least 2,400
employees, a clear signal that it thinks expense cuts are needed to meet its targets.
PricewaterhouseCoopers' Beier doesn't see merger activity drying up, even in the current
economic slowdown. "Fundamentals still drive activity, and companies still want to do
transactions. Very large deals will still happen," he says. "There may be more smaller
transactions, because big mergers will result in more pieces being spun off."
There's an element of chance in every merger, but "predicting too rosy a future" has
become a common problem, with companies taking advantage of "very loose debt and capital
markets," says consultant Conway. "Everybody's been doing deals in the past five or six years,
and often justifying a purchase price on the availability of debt - what the bank will give you.
There are a lot of deals that never should have been done, but things have really tightened
substantially in the past few months. I think people will really kick the tires this year."
Daimler Hits Some Potholes
Deals between major foreign corporations - a product of globalization forces that
accelerated in the 1990s - may be particularly tough to execute because cross-border
differences in style and methodology can be daunting. The merger between Daimler AG and
Chrysler is a shining example. To many in the auto industry, the 2000 deal looked hugely
promising, a model of two major international automakers combining to create a global
colossus. One year later, however, red ink is flowing and another kind of ink - bad press - has
humbled the resulting company, DaimlerChrysler AG.
The company has taken on a distinctly German cast, with American executives getting the
ax and Germans brought in to replace them. Late last year, DaimlerChrysler CEO Juergen
Schrempp acknowledged in an ill-advised interview that the "merger of equals" idea was
essentially a ploy for Daimler to capture Chrysler, and that he had always viewed the deal as a
takeover. Criticism of the merger erupted like a lava, and amid what is a relatively bleak outlook
for the big automakers, DaimlerChrysler keeps revising estimates downward.
The company announced in January that it expected a fourth-quarter 2000 loss of $1.2
billion for the Chrysler operations, and further losses in first-quarter 2001. Then it announced a
massive layoff plan affecting 26,000 jobs - 20 percent of the Chrysler workforce - over the next
three years, with three-quarters of the cuts coming this year.
Daimler also revealed in January that its net cash position for its manufacturing operations
was effectively zero, down from $5.6 billion at the end of the third quarter - though a good deal
of that cash had gone for acquisitions. And CFO Manfred Gentz conceded that there could be
"a further drain" on that cash position in coming months as the auto industry wrestles with
Criticism has been harshest from the American side. Longtime auto writer Jerry Flint,
writing in Forbes, recently argued that many of Chrysler's best products "were created by
managers who either were pushed out or fired by Juergen Schrempp…. Schrempp wiped out
the best auto leadership in the world."
Others are more forgiving. Daimler "is committed to a turnaround, but yes, there is pain
and suffering," says Van Conway, a merger consultant in Michigan. "They're doing the things
they should be doing. The first thing is to reduce costs. They also need to address their
penetration in the marketplace, but in the short run, they have to cut."
Indiana University business professor Idalene Kesner sees a continuing influx of European
buyers exploiting an advantage in the cost of capital when they do deals in the U.S. "But the
cultural differences are pretty substantial. It behooves European companies and Asian
companies to understand that you have clear cultural disparities - and you need to be allowing
foreign subsidiaries a fair degree to autonomy." That means "you need to shift your timeline. It
takes a fair degree of patience."
That's going to be a quality that more and more managers will need, given the influx of big
European buyers, especially in businesses like food, where Unilever is buying Bestfoods and
Nestle recently agreed to acquire Ralston Purina. A little patience now may prevent a lot of
indigestion down the road.
FASB Readies Grave For Pooling
It looks like the only thing that could save pooling right now is divine intervention.
Advocates of the much-beleaguered accounting treatment have argued strenuously that pooling
of interests should remain an option for mergers, but the Financial Accounting Standards Board
appears to have closed the door. It voted unanimously in January to eliminate pooling when the
final statement on business combinations is released, likely in late June.
Critics of pooling, including many accountants, have argued that it hides the true cost of
combinations and has fomented a host of economically unwise mergers by firms who used
then-buoyant stock prices to outbid others. In its January announcement, the FASB said it
"concluded that the transparency of the reporting for business combinations would be greatly
improved if all business combinations were accounted for under the purchase method."
Added FASB Chairman Edmund L. Jenkins: "The purchase method, as modified by the
Board during redeliberations, reflects the underlying economics of business combinations by
requiring that the current values of the assets and liabilities exchanged be reported to investors.
Without the information that the purchase method provides, investors are left in the dark as to
the real cost of one company buying another and, as a result, are unable to track future returns
on the investment."
In an interview, Jenkins was asked if the decision to kill pooling was akin to the popular
analogy of the Federal Reserve Board taking away the punch bowl just as the party is getting
going. "To continue with that analogy, some might say we're not taking the punch bowl away,
but spicing it up," he replied. "I'm hearing now that a combination of potential decisions to
eliminate the amortization of goodwill, together with eliminating pooling and the onerous
[qualifications] to achieve pooling status, may give a [result] that is encouraging to business
combinations. It might also result in acquisitions that are more fairly priced."
In the absence of pooling, the FASB is laying the groundwork for an impairment test of
goodwill that could be implemented "when an event or series of events occur indicating that
goodwill of a reporting unit might be impaired." An exposure draft on that subject was to be
circulated in February.
Jenkins is convinced that an impairment test would improve balance sheet transparency.
"What we've learned from our re-deliberations is that analysts and other investors do not use
the amortization charge in their analyses," but "both analysts and preparers do hold responsible
companies accountable for the amount invested in goodwill - that amount showing on the
balance sheet," he said in the interview. "It seems to us that a combination of showing
investment in goodwill on the balance sheet, and not showing amortization, and having a high
level of information on write-offs, does provide much better transparency."
Other accounting professionals also like the idea. "If I don't do an impairment test, I'm not
comfortable, because I don't know if that goodwill is declining in value," says Ray Beier, U.S.
leader of Structuring Services for PricewaterhouseCoopers. "I like the fact that it has to be
tested. Is that expensive? Yes, but it's good for investors. It makes a tremendous amount of
sense." Concerns have been raised about scores of companies with mountains of goodwill,
booked in mergers done when their multiples were high, that now find this goodwill may even
exceed their net worth. An impairment test would almost certainly drive some toward insolvency,
but Jenkins sounds unmoved. "One has to question whether such companies took an adequate
look at whether that goodwill was impaired," he says. "I think our proposal would clearly require
that an impairment test at least be made."