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They are an effective way to grow quickly, but there are risks to understand
Thursday 12 Nov 2020 Author: Steven Frazer

Companies buying other companies is very common and this is often referred to as pursuing a mergers and acquisitions strategy, or M&A for short. Acquiring businesses can bring numerous benefits for the purchaser, but this strategy is no slam dunk, for where there are opportunities there are also risks to the buyer and to its shareholders.

In simple terms, companies mainly make acquisitions to grow their own business.

An acquisition might open a new geographic market or new industry much more quickly than starting a business unit from scratch, where success cannot be taken for granted. It can also deliver expansion  at a fraction of the cost with lower risk because the target is           already established.

For example, when Vodafone (VOD) bought German firm Mannesmann in 1999 it opened up Continental Europe to the mobile operator, a region where it today makes most of its money.

But companies will also buy another firm for extra products, brands, new technology or expertise, effectively creating a wider market to sell a greater number of products and services. For example, British American Tobacco’s (BATS) purchase of Reynolds added cigarette brands like Camel, Newport and Pall Mall to its own Dunhill, Rothmans and Lucky Strike stable.

Companies might also acquire to defend market share or give themselves a competitive advantage, or simply to cut costs by stripping out duplicated central expenses, like combining manufacturing facilities or streamlining accounting, marketing, sales and human resource functions. These factors are sometimes described as ‘synergies’.

DEAL OF THE CENTURY

Let’s look at what many consider to be among the best corporate buys ever – Google’s 2006 acquisition of YouTube in a $1.65 billion deal, a price deemed ‘crazy’ at the time. Up until that point Google had failed pretty miserably at online video, so rather than commit the time and cost of hundreds of engineers starting over, the company bought YouTube, one of the world’s fastest-growing start-ups whose owners really understood what users wanted out of a video site.

For a business that cares first and foremost about selling online ads against search results, the deal made Google number one in the new online video search market overnight. Whether the deal has proved profitable is hard to say since Google doesn’t strip out YouTube profits, but it certainly gave the stock a massive leg up, hitting a then-record $240 by the end of 2006.

Today the stock trades at $1,762.50 and YouTube revenues have soared and soared, jumping from $8.15 billion in 2017 to $15.15 billion in 2019. In 2020’s three quarters to date YouTube has earned $12.9 billion revenue, and it is the world’s third most visited website behind only Google’s main search site and Facebook.

WHAT COULD GO WRONG?

Beyond the obvious execution mistakes that poor management could make of an acquisition, the main risks are buying for the wrong reasons, complexity and over-paying.

There are numerous occasions when a company boss has pulled the trigger on a large and supposedly ‘transformational’ deal that has more to do with massaging an executive’s ego than creating shareholder value. The early 2000s M&A splurge by former Natwest (NWG) boss Fred Goodwin (known as ‘Fred the Shred’) is one example.

Large acquisitions can also be complicated, and sometimes this is underestimated by a company, dragging senior management away from day-to-day business, which can hurt performance. This was arguably the case with software infrastructure firm Micro Focus (MCRO) when it bought HP Enterprise’s software business for $8.8 billion in 2016, leading to a significant period of what many investors call ‘acquisition indigestion’.

As of November 2020 Micro Focus shares had lost about 90% of their value since 2017, so the lesson to investors is stark.

PAYING THE RIGHT OR WRONG PRICE

As an investor in a company that gets taken over, you’ll likely to think your shares were worth more than you are offered, that’s human nature. But it is really difficult for ordinary investors to decide if a company they own shares in is paying too much for a target. The buying company’s executives will get access to information that you don’t, so trust in management is important. But there are some things to watch out for.

Valuation metrics like price to sales, price to earnings and enterprise value to earnings before interest, tax, depreciation and amortisation, or EV/EBITDA are often provided and can be compared with recent deals in the sector or industry with a Google search.

You should also check that the rationale for the deal sounds sensible. If a company wants to make an acquisition it will want to make it appear very attractive for shareholders, but do its arguments make sense to you? That’s an arbitrary question, but one that could help influence your decision to keep the stock or sell it.

It really helps to get used to reading the official documents that a company issues with acquisitions rather than simply skim-reading the opening few paragraphs. This is particularly important with large acquisitions that often require shareholder approval.

Yes, they can be long-winded and a bit dull, but it’s a good habit to get into. Many financial journalists are taught to skip to the bottom of long announcements where ‘notes’ usually are – any devil in the detail is usually found down there.

Kinsey’s six types of acquisition

1. Improve the target company’s performance

2. Consolidate to remove excess capacity from industry

3. Accelerate market access for the target’s (or buyer’s) products

4. Get skills or technologies faster or at lower cost than they can be built

5. Exploit a business’s industry-specific scalability

6. Pick winners early and help them develop their businesses

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