Are merger & acquisitions good or bad?
Does it serve the interests of minority shareholders or not?
Do we get all excited by the “new growth stories” and buy them up even at high valuations or do we treat companies that do M&As as another “Enron” and avoid them like a plague – guilty unless proven otherwise?
Over the previous class, our students learnt a critical skill which enabled them to foresee the explosions of fellow Enrons years before they exploded and brought immense harm to investors, both institutional and retail ones. Yes, professional fund managers do fall prey to such obvious schemes, too.
In its hay days, Enron was a 100 billion revenue company which was 4 times the revenue size of Microsoft at that point. It hired 29,000 humans – surely the government will bail them out?! No matter. The company value fell by 99.71% into an abyss. Interestingly, it was named “America’s Most Innovative Company” for 6 straight years by a famed media publisher just before they exploded.
Maybe they were too innovative – too out-scheming, that is.
Consider these two following cases:
1) 2012, company STHI (very interesting anagram) reported an almost 100% increase in their revenue, growing to USD5.3billion from USD2.9billion the year before, and a 48 percent rise in profit as well, the results of a recent mega acquisition where the deal amounted to about 75% of the total company value. Any investor looking at these figures will surely be captivated by their new sexy growth story, not to mention the company’s longstanding reputation built with the founder’s bare hands.
And many were, investors bought in to the management’s vision of becoming world number one in their field, and the management did not disappoint.
Encouraged by the global influx of easing money, the company continued their buying spree which had been going on since at least 1998 anyways. STHI (i might actually mistype the anagram) went on to buy businesses from all over the world, making the growth story a global one now.
They made at least one huge acquisition per year, growing their revenue by at least 30% each year. At the half year point in 2017, their revenue had grown 510% from 2011. The media wrote highly enamouring articles about their unique strategy, they became the market darling. Investors rejoice and jump in joy, celebrating the immense success that the highly charismatic CEO has achieved, for their wealth had grown with the jump in share price too. (Does this actually sound like a certain president of a country?)
And then the bubble burst.
Some of the partners whose businesses were acquired began to cry foul, dissociating themselves from the management, and relationships ran amok. The auditor that STHI engaged refused to sign off their financial statements, even though they cleared the same books for prior years. Authorities stormed their office to collect critical documents. The CEO stepped down with immediate effect and an investigation started.
Swiftly, STHI’s share price crashed by 98%. Shareholders flocked to sell off their shares after the truth became news, but it was too late. More than 12 months on, STHI is still battling legal lawsuits from their (corner)stone investors who cry foul, seeking to claw back their investments from the CEO and Chairman.
Looking back, it was as though the management intended to be world number one business acquirer or the world champion out-schemer.
If we paid just 3% attention instead of blindly chasing dividend yields, we could actually see that the damage was already done at least 5 years before and might choose to avoid it at all cost.
After all, who wants to buy SHIT?
2) Compare that to Company Bloom, which has also been acquiring businesses throughout the past decade amidst global inflow of easing money, so they seemingly used the same acquiring strategy amidst the exact economic conditions.
However, Bloom only acquired peers within their industry which have fallen sideways due to the government’s disciplined pressure to bring costs down on a national level, and they have repeated these until they are now the number two business in the industry (number one if we consider their core reach). Each year, the CEO would share about how difficult business conditions have been, and that they foresee continued pressure to survive.
They paced out the buying of peer companies at least 3 years apart, and each acquired peer amounted about 1% to well within 10% of their revenue stream, such that coupled with their highly disciplined costs, their operations grew revenue by 2-5% a year for the past decade. In a similar period since 2012, Bloom’s core earnings per share grew by 180%. With an obvious scale advantage, Bloom was able to quickly “digest” and improve business aspects of these parallel companies, which adds further to their scale.
And with their even highly disciplined financial choices, their balance sheet is so strong that they can now buy out their next biggest peer with cold hard cash tomorrow if they want to. Bloom never had to use debt to buy these companies, putting them at a vantage point when discussing buyout valuations, hence they never had to account for huge goodwill – This problem simply does not exist.
Meanwhile, investors continue to price them at low valuations. Some friends asked us “why are their valuations seemingly persistently low?”, to which I thought “you mean you want to buy them after their valuations become high?”
Do not let the no-trade situation and the media distract you from the fact that such high-quality businesses still exist with low valuations.