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March 1, 2005

When Everything Comes Together

Three experts discuss the classic consolidation cycle and why some deals work and some don't.

Worldwide merger and acquisition activity rose to more than $1.9 trillion in 2004, the highest it has been since 2000, when global volume stood at $3.4 trillion.

As long as a number of variables hold true—lots of cash, good earnings, access to financing, healthy profit growth—consolidation activity should remain strong, says Richard Peterson, chief market strategist for Thomson Financial.

“It seems like a domino effect,” Peterson says. “Corporations have large piles of cash right now. Corporate earnings are good. This past quarter [Q4 2004], 58% to 59% of S&P companies outpaced their consensus earnings estimate. Financing is available. The high yield markets raised $140 billion in junk bonds, which sometimes fuels LBOs. It's the reverse of a perfect storm, it's a perfect calm.”

The classic consolidation cycle begins with strong growth in the gross domestic product. M&A activity tends to parallel GDP; that has been true the last 25 years. But every cycle looks different—the hostile takeovers of the 1980s or the huge high tech deals of the 1990s—but in all cases, “after a boom or a bust, variables impact deal making from a macro standpoint,” Peterson says. “In the mid-to late-1990s, when the high-tech deals didn't work out or collapsed, that coincided with a collapse in the NASDAQ. It had been trading above 5,000 in March, but now it's trading at less than 2,100.”

Deals ebb and flow, Peterson says. “Deals beget more deals. And the size of them—P&G and Gillette, for instance—accounts for some of the attention. On a monthly basis, August of last year was very strong. But September and October, during the election season, slowed and it was only once the election was resolved that it picked back up.”

Consolidation also has a downstream effect, Peterson says. “Big telecom deals may lead to similar activity among telecom suppliers,” just as metals production consolidation has led to service center consolidation.

SHAREHOLDER VALUE AND DUMB SIZING

In general, if done correctly, consolidation is a “good thing,” Peterson says, “if it increases margins and shareholder value.” Reducing structural costs, entering new markets, adding to lines of business, acquiring new core skills or building customer service are all examples.

As companies merge, expand and become tougher competitors, the also-rans start looking for ways to stay in the running, says Glenn MacDonald, John M. Olin Distinguished Professor of Economics and Strategy at the Olin School of Business, Washington University in St Louis. “The smart way to do that would be to innovate and become more effective. But the easy way to do it is to buy something. Those mergers that are solely driven to get bigger for size sake alone go under. The ones that improve value or are successful deals are those that tend to occur in areas where you're going to do a huge amount of R&D, streamline, improve processes and the bottom line. If you're just trying to get big, what usually results is huge volume and tiny margins.”

There is also a psychological aspect to consolidation cycles, and it's that side of things that often gets companies into M&A trouble, says Dr. Mark L. Feldman, a mergers and acquisitions consultant and former global practice leader for PriceWaterhouseCoopers.

“It is relatively easy to determine that a deal can be done, but the question that usually isn't asked is, ‘Should it be done?'” says Feldman, founder and managing partner of his own consulting company, Five Frogs Group. “There's a lot of time and money invested in deals that probably shouldn't have been done.”

Typically, there are three stages to consolidation. In the first stage, consolidators acquire competitors and bulk up, building economies of scale. Next, they focus on strategic or operational areas that need improvement and add muscle to the acquired and combined businesses. Finally, they seek out and establish partnerships with other companies that complement their own business models to offer a broader range of products or services to their customers.

All of those steps are beneficial, but Feldman notes nine areas where mergers can be problematic.

  1. Cash must be diverted to service acquisition debt.
  2. Employees can easily waste an hour a day or more thinking about the personal consequences
    of the merger.
  3. Acquirers very often buy weaker competitors, with all the market and personnel hurdles
    that involves.
  4. “Every company makes the same terrible mistake,” says Feldman of the move he calls “dumbsizing,” or reducing the workforce by cutting, among others, employees who possess critically important institutional memory.
  5. The “Goldilocks Factor,” or the effort to make decisions so that “everything is just right” among the merging organizations. If everything is just right, compromises have been made, including compromises in areas where firm decisions are more appropriate.
  6. Because of the lost work time, lost personnel, and related issues, margins decline.
  7. Defectors from the staff include the best employees because they have the greatest
    professional mobility.
  8. Although some companies say they will adopt the best practices of both sides of a merged organization, what usually occurs is wasteful internal competition. “Studies of best practices show that other people's best practices work best in other people's companies,” Feldman says.
  9. The “Law of Misconception” takes root. “There is no such thing as a merger of equals,” he says.

Transitions following a merger must be accomplished quickly. “Companies that move quickly do better than those that move slowly,” Feldman says.

“Everyone thinks they can be one of the big survivors,” MacDonald says. “But there can only be so many survivors.”

Source: Dr. Mark Feldman
Source: Dr. Mark Feldman