Wolfgang Fickus says mergers and acquisitions can be a riskier strategy than organic growth but buying at the right time increases the potential for value generation
The global mergers and acquisitions (M&A) market has witnessed a strong upswing over the past seven years.
Can this phenomenon be explained by a greater number of synergies? Or is the M&A market simply pro-cyclical – as low interest rates and high price/earnings (P/E) ratios make deals more attractive in terms of earnings per share (EPS).
Long-term investors would do well to seek high-quality growth companies with dynamic, visible and sustainable earnings growth. Organic growth can be an indication of a lower-risk growth foundation of this earnings development. In contrast, acquisitions tend to be lumpy, less visible and riskier. Even the best due diligence of an acquisition target cannot exclude failures. Corporate cultures can clash. Management can be blinded by the ambition to increase EPS.
What generates value in M&A? Synergies are the source of value creation. A synergy is the value that makes the combination of two businesses greater than the sum of their individual parts.
How is this economic value shared between the stakeholders of the acquirer and the target? The answer starts with the pricing skills of the acquirer and ends with the synergies created from the deal. In absolute terms, the value creation potential for the acquiring firm is the present value of the synergies minus the acquisition premium paid.
What matters most is that the cash generation capacity of the combined entity improves over time. In many cases, there is evidence that these synergies do occur. To put cash generation of M&A into a practical perspective, the impact of M&A on cash flow return on investment (CFROI) needs to be examined.
Not all M&A is equal. Good acquisition timing is one reason why M&A makes sense. Buying when prices are low and nobody has an optimistic assessment about the future reduces the risk of strong acquisition premiums. When acquisition premiums are low the potential for value generation for the acquiring company increases.
The acquisition of quality growth companies does not necessarily correlate to the global M&A market, which is a sign of good acquisition timing. Let us look at some examples.
Tata Motors (Tata) acquired Jaguar Land Rover (JLR) in 2008 when the global M&A market collapsed. The acquisition premium was low as JLR faced multiple challenges such as a US/EU-centric business, a high-cost UK manufacturing hub and a weak Jaguar pipeline. The rationale of the deal was clear: transform an Indian car and truck manufacturer into a globally diversified player, especially in the fast-growing and high-margin premium sport utility vehicle (SUV) passenger car segment.
The timing was countercyclical. During its first 10 months of consolidation (June 2008-March 2009) sales of JLR were down 32% and the company lost £306m. However, Tata continued to invest heavily in new models and restructured production as well as distribution in emerging markets, especially China.
Despite this bumpy start, the strategic vision of Tata’s management proved correct and execution was strong on all fronts: India’s sales share dropped to 14%, from 82% prior to JLR’s acquisition, while Tata gained a solid global footprint. Despite strong investments, the company reduced gearing from 590% in the fiscal year ending in March 2009 to about 40% in the year ending in March 2016 as a result of the strong free-cash-flow generation. Operating margins grew to 9% versus 6% prior to the JLR acquisition and return on equity (ROE) remains at 40%. In addition, JLR unit sales increased by 140% between 2008 and 2015, a compound annual growth rate (CAGR) of 13%.
Another example is Luxottica which, through the acquisitions of eyewear brands Ray-Ban (in 1999) and Oakley (in 2007), as well as retail operations LensCrafters (in 1995) and Sunglass Hut (in 2003), transformed itself from a European frames manufacturer into a vertically integrated owner of global eyewear brands, frame and lens development and retail. Long-term industrial logic made Luxottica’s numerous acquisitions successful over the medium term.
In particular, Ray-Ban offered important contributions to Luxottica’s success. Since its acquisition in 1999 from Bausch & Lomb for just $640m, Ray-Ban grew organically with a CAGR of 10% to €2.4bn sales to 2015. It was a key contributor to Luxottica’s strong growth over this period, which was driven by commercial synergies between its retail operations and eyewear brands.
While CFROI in the range of 10-12% might have been higher without M&A for Luxottica, the company would have been deprived of a long-term source of value generation over the past decade.
In the late 1990s and early 2000s, Royal Ahold was a darling of the stock markets. The company regularly targeted a doubling of sales and profits over five-year time frames in the low-growth food retail market. Such aggressive profit growth targets, however, could only be achieved with the help of M&A.
Ahold’s problems accumulated over the course of an aggressive acquisition spree in the US, the Czech Republic and the Latin American food retail and food service markets. With Ahold’s share price trading in a range of a P/E ratio of 25-35 times in the second half of the 1990s and with ample debt financing possibilities, Ahold raised €10bn in equity and €6.5bn in debt between 1995 and 2001 to finance the acquisitions of much more moderately valued targets. That led to an immediate EPS increase, its stated target.
While EPS grew with a CAGR of 19% between 1995 and 2001, free cash flow was negative in five out of these six years while debt accumulated. Cost synergies and integration benefits were weak as the company took bigger bites to maintain double-digit EPS growth. Management capacity became overstretched as sales nearly quadrupled between 1995 and 2001.
Ironically, the failure of Ahold’s acquisition strategy came to light owing to a large accounting scandal in one of its acquired companies. As a result of this, shares dropped 55% on 24 February 2003, after the company announced that it had overstated its profits by €500m owing to fictitious sales. The scandal highlighted the limitations of a due diligence process.
A well-oiled organic growth model is easier to assess than a lumpy and risky acquisitive growth strategy. In the case of Luxottica, long-term commercial synergies make the company stronger than it would have ever been without the M&A process. In comparison, anti-cyclical acquisition timing was one source of value generation for Tata shareholders.
Likewise, the example of Ahold illustrates that EPS accretion alone may mislead management. Growth benefits from being accompanied by sound free-cash generation. If this is not the case, then investors should begin to worry and, ultimately, flee. If they do not, they do so at their own peril.
Wolfgang Fickus is a member of the investment committee of Comgest