M&A Is Back -- But This Time, It's DifferentPublished: November 24, 2009 in Knowledge@Wharton
If the past month is any indicator, acquisitions are not only thawing but heating up. In October, Comcast made a bid to merge its operations with NBC Universal to create a cable programming giant. In early November, Kraft Foods announced a $16.5 billion bid for U.K.-based chocolate maker Cadbury -- also being sought by confectionery companies Hershey and Ferrero. The activity spans several sectors, including technology, with Hewlett Packard's agreement to purchase 3Com for $2.7 billion, and Google's $750 million acquisition of mobile advertising startup AdMob. What's behind this shopping spree, and is the trend likely to continue? Knowledge@Wharton spoke with Wharton management professor Larry Hrebiniak and finance professor Pavel Savor about M&A strategy in a post-recession environment.
An edited transcript of the conversation follows.
Knowledge@Wharton: The M&A market seems to be heating up. Does this surprise either of you or does it make sense in terms of where the economy is?
Larry Hrebiniak: I am not surprised. You could see it heating up. We have had a terrible recession and during that recession, what happened? Companies hunkered down. They saved money. They cut costs. They laid off people. They didn't have many opportunities to spend, and they just tried to pull back. The recession created a kind of forced savings. A lot of big companies generated cash and held on to it. Now that things seem to be perking up, it is like, "Let's make a move -- quickly. Let's start using that cash. We need growth. Organic growth is going to be too slow. We are under pressure to grow."
And what's the fastest way to grow? Mergers and acquisitions. Take that cash you have built up. Banks are beginning to lend money. The credit markets are perking up a little bit for companies with solvent balance sheets.... We can expect activity to continue.
Pavel Savor: I agree with Larry. Companies have been hunkering down. They saw in the last quarter of 2008 what the world would look like without access to financial markets and it scared them greatly. They avoided anything risky. It could have been psychological as well. We were all scared -- the CEOs as well. There might have been pent-up demand among some acquirers, which is being met now that the financial markets have opened a little bit.... Companies are saying, "Maybe we will not be cut off for the next five years." They feel emboldened to do some deals. [But the deals] are different than what we saw during the few years before the economic crisis.
That fear will stay. Companies will not do anything that will hurt their credit ratings or that will add a lot of risk in terms of integration. They are still thinking valuations are low so they are reluctant to use equity. All that will stay at least for a few years.
Hrebiniak: If I could hitchhike on one point you mentioned: the psychological side. It seems that people were reluctant to do things. It was almost, "Who is going to go first?" Now there is a fear factor as people begin to acquire. I have called this, jokingly, a rush to imitate. Some data I saw ... showed that in a three-month or four-month period, there was a 600% to 700% increase in mergers and acquisitions. It's as if, once it starts, you can't be left behind.
Savor: From zero it grows.
Hrebiniak: Everyone is doing it.... [And picking up] on your psychological point, it is going to feed companies that want to do things now.
Knowledge@Wharton: Would you say overall, though, that the deals now are different from the deals before the crisis? Are companies more strategic? Or is this just jumping on the growth bandwagon?
Hrebiniak: They are jumping on the bandwagon, but I also think it is more strategic. One thing I should have mentioned before: Given the troubles over the past year or so, the amount of private equity has gone down. When the bubble existed, private equity money was chasing acquisitions and making companies react quickly because they were under pressure to close deals before private equity came in and did an LBO. Now with the decline in private equity funding, companies can look more strategically and say, "I'm not under as much pressure, and given the better climate, I can be more strategic."
One other thing I will mention regarding strategy: [Deals] will be more strategic, but I predict that you will see a lot more horizontal expansion, or related diversifications, as companies try to build on their strengths. Banks are lending but I'm not sure if they are going to start funding unrelated diversifications -- or what they see as more risky diversifications going into different markets. The recession is creating a strategic thrust for [acquiring] businesses that are consistent with core capabilities. Look at Kraft and Cadbury, Stanley and Black & Decker, and Disney and Marvel, [which is a deal that] is building a super-hero capability. You have [a capability] already. You build more. We are going to see a lot more related diversifications and fewer unrelated diversifications, LBOs and risky ventures, at least for a while.
Knowledge@Wharton: Pavel, do you see any differences?
Savor: We are going to see much fewer transformative deals than we have in the past. Firms are still too scared to do them and banks may not fund them even if they tried. The financing is also a lot different, which is now a big consideration. Even firms with a lot of unused debt capacity that could borrow from banks are being very careful how they do this.
Comcast is the definition of a cash cow, in my mind -- at least going by my cable bill. As it now bids for NBC, it is being very careful. It is contributing assets [and using] only some cash. And that's only for half the purchase price. The rest is going to be paid over time, based on performance and mostly coming from NBC.
But [doing such a deal] limits the universe of firms you can go after. Public for public is still going to be quite hard because you have to offer some type of relatively fixed consideration -- that is, giving shareholders stock, cash or some combination thereof. The more contingent payments are harder to pull off, but that is exactly what firms would like to do while there is still a lot of uncertainty about what is going to happen. Comcast paying GE based on NBC's performance is great. They can do a deal they could not do otherwise if they disagreed about what is going to happen with the economy. You can't do that with a million shareholders. Those deals may still be harder to pull off.
Hrebiniak: I agree about Comcast. My bill suggests that it is making a lot of money. I spent some time with Comcast at the end of September.... It is optimistic about [the deal] and something interesting came up in looking at not only the buyer side, but also the seller side. GE, which had been a diversified company, got hit very hard during the recession. It has to pull back. It is willing, and other companies like GE perhaps are willing, to get rid of non-performing assets. The buyer has money and is looking for [acquisitions]. But GE is saying, "There are certain businesses we should get rid of," like its security business and NBC -- properties that caused them problems during the recession. Indirectly, the sellers are fueling M&A by being much more prone to looking at selling assets.
Knowledge@Wharton: Do you agree that these are bargains and, if so, how long will the bargains last if everyone starts jumping into the fray?
Savor: That is a harder question. The future is always hard to predict. I wouldn't say they are bargains. They seem moderately priced. If you have a vigorous recovery in the general economy, it is going to be a bargain. But do these bids look very cheap by some valuation ratios? No. They actually look reasonably expensive. When things were really cheap in March, everyone was too paralyzed to do anything. Now, valuations are much higher. The stock market went up by 60%.... In my mind, those don't look like bargains. But that is a question related more to the general view of the economy than the M&A market in particular. If you are going to participate in M&A at a certain time, you just have to accept that current stock market valuations are at least fair. If you think targets are overvalued, you cannot do deals even though economically they look good. The price you would have to pay would not justify those.
Hrebiniak: The question of bargain is an ex post issue.
Savor: Yes, we will answer [your question] in two years.
Hrebiniak: If an acquirer buys the company, integrates it well and does all the right things to it, we will be able to judge if it is a bargain.
Knowledge@Wharton: Will this uptick in activity have a residual effect on the recovery in general? How will an increase in M&A activity affect Wall Street, if nothing else?
Hrebiniak: [Wall Street] will get more fees. There is more confidence. There is more activity. People like to see activity. They like to see especially large firms getting involved here. It shows confidence. That might carry over. We see the market going up.
We have other issues, of course. We have currency issues -- the value of the dollar and [the value of commodities]. There are a lot of other things besides M&A that are going to affect optimism. It is kind of wait-and-see. But generally, it will affect the market to some degree.
Savor: The market likes to see big deals. Firms have proprietary information -- typically, they have customer order flow [and other] on-the-ground knowledge. If they become optimistic, there is hardly a better signal than their being willing to put money on the line to buy something and take on the risk. Of course, investors are going to be more optimistic as well. It is purely rational. If you say, "Warren Buffet knows what is happening. He is in touch with a lot of businesses and he thinks it is a good time to buy a railroad," that is telling you something about what one informed investor thinks is going on. That might make you more likely to buy stocks. Now, whether this is some kind of feedback loop -- the stock market goes up; the CEOs are optimistic; they buy; the market becomes more optimistic -- that is more speculative.
Knowledge@Wharton: Returning to strategy, let's look at one case: Cadbury, which is very much in the news lately. What would a company like Kraft be hoping to gain by acquiring Cadbury with its $16.5 billion bid?
Hrebiniak: Number one, quick growth ... [and] an increase in international expansion. It would be getting into international markets that it doesn't have right now and, in fact, that would be a big plus for it.
It is an acquisition, but it is almost a kind of organic growth, building on what it does well. It is a pretty good move, especially given the international expansion they anticipate.
Knowledge@Wharton: And Cadbury is big in India and Latin America, correct?
Hrebiniak: Yes, and Kraft isn't. A lot of its traditional business -- such as the grocery business -- has been slowing down. It is a different world out there. It has to do it.
Knowledge@Wharton: Now Hershey and Ferrero are putting together their own counterbid. Would they be looking to gain the same things?
Hrebiniak: They are trying to get the same gains because people think Cadbury is an interesting target. We go back to the imitation idea: You have a major competitor making a move and you think, "If they get Cadbury, then Hershey, Mars, Nestle and the others worldwide might be hit a bit by a larger organization that is willing to move." Part of [the counter-bidding] might be to slow things down, limit a competitor's options and make it a little more difficult for Kraft to do the deal. Plus, they got signals from Cadbury that it didn't like the hostile takeover. It could very well be that they are saying, "Hey, let's throw our hat in the ring and see what happens because we might benefit. Kraft has done some due diligence [that says] Cadbury is okay. Let's build on it. Let's assume it is right and take a look at the same deal."
Savor: It is clearly a strategic response if two of your major competitors are planning to merge and you think it will have a negative effect on your operations. You respond almost because your hand is [forced]. There is an optimistic interpretation, which is, "Others are doing deals, so let's jump in." It could just be avoiding future problems: "We would rather see Cadbury remain independent, but now we know it is not happening. So let's move."
You see this a lot historically in industries dominated by a few big competitors. The companies left behind really worry about becoming too small to compete and becoming targets themselves, so they engage in bidding wars. Once someone makes a bid for you -- like in the case of Cadbury -- you are on the market. Everyone knows it and perhaps is jumping in, especially if the initial [bid] was not met with friendliness. You know you have some advantage over [the initial bidders].
As Larry said, Cadbury is not happy with Kraft right now. That may make it easier for other bidders, not purely in terms of price ... but in terms of a lot of other stuff -- information it would offer prospective buyers, how friendly the board is going to be, a lot of things you negotiate in mergers like warranties and other terms. So, especially if you think a target that is on the market is looking for a white knight, this may be a great move.
Knowledge@Wharton: In general, is an acquisition a good way to enter new markets globally?
Hrebiniak: It is the fastest way. If you were to look at direct foreign investment as a strategy, it is much slower and harder to do [and there are] obstacles to overcome. If you can acquire a good property quickly and pay a reasonable price for it, it is the fastest way to enter foreign markets.
Savor: I second that. You cannot grow more quickly typically than by doing M&A. A big acquisition could double the size of your company. Organic growth can almost never do that.
Knowledge@Wharton: What do these companies have to keep their eyes on in terms of post-merger integration? Will there be hurdles that wouldn't be there ordinarily because of the fragile economy?
Hrebiniak: Many hurdles exist regardless of the fragile economy. If one is acquiring a firm, one has to look at its integration. One has to look at the things that are done to implement the strategy to make it work. Some questions are going to pop up. Before, I said that we might see a lot more horizontal diversifications. If that is true, it might raise some interesting issues. If I buy companies that are like me and I'm building on my capabilities, it is a horizontal diversification. That means what I'm looking for may be synergies, cost reductions, or a combination of product line and structural change, because we look alike and we are in some of the same markets. By doing what we think is safer, I might face additional implementation issues [in terms of] how to meld two structures or how to pull things together when, for example, no one wants more layoffs. But if I am trying to reduce costs and a reduction in manpower is on my list, I have to tread very carefully because we just came through a recession where we had layoffs and unemployment is high. I might not get synergies and cost reductions right away.
If I buy an unrelated company and I leave it as a separate entity, there is very little integration needed. Culture almost doesn't come into play. But if I have a company that is like me, I have to worry about cultural considerations -- melding two companies, keeping both sides happy and [deciding] who is going to run the show. A lot of things are going to come up. Most of these are typical execution or implementation issues, but a few might be related to the type of horizontal diversification we are seeing [as a result of] this recession.
Knowledge@Wharton: Pavel, do you foresee any landmines?
Savor: I'm an economist. We assume integration just happens.... But Larry is very right. When you do a deal, you bear a lot of risks. Are you overpaying? Is the target overvalued? Are the synergies that you expect to harvest really there? But you also bear the small idiosyncratic risk, which is integration risk.
People in finance have a lot of work showing that horizontal deals -- deals between related firms -- tend to do best. Perhaps that's because synergies are really there.... Larry described it all. I'm buying a completely unrelated business in China. What do I do? I install some controls and maybe send over a new CEO. That's it. If I buy a company that does exactly the same thing that I do in a different market, we cut costs, which means firing people now.... There may be a lot of turnover among senior management as well. All that complicates things.... But if you don't integrate, why do a deal in the first place?
Knowledge@Wharton: Is there a typical timeline for when firms have a good sense of whether these are valuable deals? You mentioned it would take about two years before you would even know if it was a bargain.
Savor: ....To the extent that we are changing something within the target firm or our own firm, we have to move quickly because a deal creates a sense of urgency. Everyone is involved. If we wait to do the painful things, we will never do them. But when do you say this was a success or this was a failure? That takes a long time. It is a long-term investment. You buy and see whether synergies were really there. You see what competitors [are doing] over that time. Maybe I bought at a good time or at a bad time. It takes awhile [for the value of a deal to] reveal itself. The finance people don't even evaluate deals until three or five years have passed.
Hrebiniak: I would agree with that. The only thing I might add is that we have shareholders and others who are looking for quicker responses. What companies will try to do ... is look at a certain shorter-term matrix -- what might be called low-hanging fruit, things that they can do quickly and say, "This is successful." That's to keep shareholders and others [from] saying, "Yeah, it might have been a good deal." I agree that in fact most of the evaluation has to occur after a few years when [the two parties] have had a chance to work together and we take a look at competitive conditions. Are they gaining market share? Are they profitable? It takes a little while. But companies always try to give you some quick feedback [to reinforce the idea that,] "Wow, this was a great deal."
Knowledge@Wharton: Do you foresee 2010 being a very active deal year?
Savor: We will see. That is hard to predict. It will depend largely on what the economy ends up doing and what the capital markets do. If the recovery continues, if unemployment at least stops [rising], the economy restarts its growth and we see no more shocks in the capital markets, it could be a very active year.... For now, this has been a capital markets-led recovery, the same way that it was capital markets-led on the downside. Capital markets have really come a long way since March.... If they maintain that progress and the economy picks up, we could see a lot of deals. But unless the economy catches up with the capital markets, I don't think it will be an overly active year.
Hrebiniak: It is hard to predict given what we see now. We seem to be seeing optimism creeping in and that people want to make deals. If you just look at that, you can extrapolate and say, "Maybe it will continue." But I agree fully that it depends on what happens to the capital markets -- whether we get any shocks. And what will happen to the dollar? There are other things that probably will enter [into the picture]. But my gut feeling is if things continue as they are, we will see a decent year.
Savor: The capital markets are still reasonably shallow. We see banks lending a little bit more. We see bond issuance. But apart from financial firms -- with the government implicitly standing behind them -- we haven't seen huge debt offerings or bank loans being taken out. Whether that is even possible, we don't know at this point. If someone went to their banks and said, "We are doing this deal where we are doubling in size. Can you finance us?" -- the answer may well be, "No. We are just not willing to take on that much risk."