Returns from the Merger Boom

Before we began the acquisition returns study, we were intrigued by a comment made by Carly Fiorina, CEO of Hewlett-Packard Co. Referring to the near 20% drop in the price of H-P’s shares on the day of announcement of its acquisition of Compaq Computer Corp. in September 2001, she claimed in a BusinessWeek interview, “You don’t make this kind of move, and judge its success, by the short-term stock price.” That certainly is a testable proposition. We examined more than 1,000 deals valued at $500 million or more announced between July 1, 1995, and August 31, 2001. We first excluded those deals in which the acquirer’s share price could not be tracked on a major U.S. stock exchange. Then, using the rationale that a deal had to be of material relative size, we excluded those deals in which the value of the seller was less than 15% that of the acquirer. Finally, we culled those deals in which the acquirer subsequently announced another significant acquisition within a year. That left a sample of 302 deals, for which the average acquirer market capitalization was $14.2 billion and the average seller market capitalization (five days before announcement) was $5.5 billion. The average market capitalization of sellers relative to their acquirer was nearly 50% – so these were very significant deals. To measure performance, we calculated total shareholder return (stock price appreciation plus dividends) to the acquirer at the announcement of the deal (one week before to one week after) and one year later. While one year may seem a short period in which to judge success or failure, the first year is critical to deliver performance promises because it signals the credibility of those promises. Moreover, there is a growing body of research that shows that initial market reactions are very good predictors of the acquirer’s operating performance over subsequent years. We examined not only absolute return but also a relative total shareholder return (RTSR) relative to both the broader market (S&P 500) and the acquirer’s industry peers within the S&P 500. The key results for our sample of 302 deals using RTSR to industry peers (very similar to the S&P 500 benchmark results) are as follows: Acquirers, on average, underperform industry peers Average returns to acquirers around deal announcement are minus 4.1%, with 64% of deals viewed poorly and 36% viewed positively by the market – a familiar result. One year later average returns are still minus 4.3%, and 61% of acquirers lag their industry peers. Initial reactions are persistent and indicative of future returns One year later, the portfolio of deals that begin poorly (minus 9.2%) maintained almost the same negative return (minus 9%). The portfolio of deals that began positively (5.7%) maintained a strong positive return (4.9%). A closer look shows that 67% of the initially negative deals were still negative and 50% of the initially positive deals were still positive a year after announcement. So while a positive start is no guarantee of future success, if companies do not subsequently deliver on promises, a negative start is very tough to reverse – and even tougher for negative deals using stock as currency. Three out of four stock deals that are initially negative are still negative a year later. Delivering results after a good start pays off big Deals that begin in the right direction – and deliver – dramatically outperform deals that begin poorly and stay that way. In the year following announcement, acquirers whose deals were met initially with a negative investor reaction, and continued to be perceived negatively, posted an average return of minus 24.9%, whereas acquirers whose deals initially received, and continued to receive a favorable response, returned an average of 33.1% – a difference of 58 percentage points! Price matters The average premium paid for targets across the entire sample was nearly 36%, with an average premium of 38.4% paid by the initially negative group and 30.7% by the positive group. One year later, virtually the same finding is intact. Those buyers that are ahead of their peers one year after announcement (regardless of the initial reaction) paid on average 31% premiums; those buyers behind their peers paid 39% premiums. Most striking, the average premium paid by the persistent negative performers was 40.5%, whereas the persistent positive performers paid an average premium of only 25.8%. Cash deals outperform stock deals Cash deals, while less common (12% of all deals in the megadeal-dominated sample), markedly outperform stock swaps. At announcement, the returns relative to peers of cash deals beat all-stock deals by 4% (minus 1.0% versus minus 5%). One year later, the gap widened to 8.3%: Cash deals beat their peers by 0.3% while stock deals lag their peers by minus 8.0%. This finding reaffirms the widely reported result on the underperformance of stock deals. Further, poorly received stock deals are the most persistent performers, with 73% of them still negative a year later (having a minus 26.8% return). Sellers benefit most from deals While buyers lose on average, shareholders of selling companies earned an average 20% return from the week before the deals were announced through the week after. Deals create value at the macroeconomic level Mergers create value for the economy. While buyers’ shareholders most often lose value, sellers’ shareholders most often gain value. In the aggregate, there is net value creation of 1% at announcement, based on combined market capitalization changes of both the buyer and seller. In our sample, stock deals had negative combined value creation of minus 0.5% while cash deals yielded a positive return of nearly 7%. Figure 2 illustrates the general pattern of returns to acquirers during the recent merger boom. These important findings are not accidental. Investor reactions are powerful forecasts based on previous expectations and the new information given by the company about the economic wisdom of the transaction. Acquirers that truly deliver or show evidence of their ability to honor their promises do extremely well over time; acquirers that deliver on the negative expectations do extremely poorly over time. It is interesting to note that the initial market reactions of both the persistent positive and persistent negative portfolios (5.6% and minus 10.3%, respectively) were later discovered to have been nearly the same as the overall initial positive and negative portfolios. The subsequent performance of the persistent performers is largely a function of acquirers confirming – through rapid delivery or non-delivery of results, or convincing signals to either effect – the initial perceptions of investors. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com