By Leslie P. Norton
Investors Beware
It's time to say a few discouraging words about the proposed union of Citicorp and Travelers. Forget for the moment that Citicorp chieftain John Reed and Travelers boss Sandy Weill have proven themselves to be among the most capable managers in Corporate America. The fact is that their planned merger, like most mergers undertaken over the past two decades, has a better than even chance of failing to pay off for shareholders.
To begin with, consider the purchase price. To get control of Citicorp, Travelers will fork over shares valued at something like $72 billion. Based on Citi's earnings of $3.6 billion last year, Travelers would be getting a 5% return on its investment. Even using Citi's expected earnings for this year of $4.28 billion, Travelers' return amounts to only 5.95%.
That's about equal to the return on a 30-year Treasury bond. And let's face it, the risk involved in trying to get a consistent return out of Citicorp over the past few decades has proven far greater than the risk that the U.S. government will fail to meet its bond payments.
It wouldn't be outlandish for Travelers to aim for a 10% annual return on its Citicorp investment, which is about what folks traditionally expect from the stock market. But to achieve that 10% payoff, Citicorp assets would have to earn $7.19 billion, twice what it earned in 1996. And forget about the earnings Citi would need to match last year's 33% return on the S&P 500 index.
However exciting the Travelers-Citicorp union may seem, it's hard to figure out how it will boost profits appreciably. Reed and Weill say their planned corporate marriage is not about cost-cutting. They do hope to increase revenues by cross-selling, which probably means that Citicorp branches will someday try to peddle lots of Travelers insurance policies, not to mention stocks and mutual funds from Travelers' brokerage unit. But do you really think this merger is going to double or triple the profits on Citicorp operations any time soon? The same question could be raised about the proposed BankAmerica-NationsBank deal and the BancOne-First Chicago merger.
One person skeptical about the Travelers-Citicorp marriage is Mark Sirower, a professor at New York University who recently published The Synergy Trap, a book that's highly critical of mergers in general. Of the Citicorp-Travelers plan, he says, "I don't buy the cross-selling and the financial supermarket idea. Sears Roebuck tried it, American Express tried it. We've had a lot of failures where people try to push more product out through a high-cost delivery system. Does the Citi and Travelers deal change any industry structure? Does it limit buyer choices? Supplier choices? Will it make it harder for other people to enter?"
At first glance, the answer to all those questions appears to be no.
A possible explanation for Weill's willingness to pay such a high price for Citicorp may be that he feels Travelers stock is an overinflated currency. If that were the case, the rational move for him would be to spend, spend, spend, as long as his stock continues to fly high. And Weill has done exactly that by acquiring Salomon Brothers last year and Citicorp this year.
No one is suggesting that Travelers shares are as overvalued as those of Cendant, the acquisition machine whose shares fell nearly 50% last week on news of accounting irregularities. But if the history of mergers is any guide, the smart thing for Citicorp shareholders to do may be to sell immediately, or shortly after the Travelers deal is completed.
Sure, investors get all excited about mergers because the share price of an acquired institution surges when a deal is announced, and, in fact, Citicorp's price jumped 37 5/8, to 180 1/2, on news of its betrothal to Travelers. It traded recently near 157. Sometimes the share price of the acquiring company rises too, as was the case with Travelers, climbing from 61 11/16 before the merger announcement to a recent 63 5/16.
That's usually a good sign. Yet studies show that frequently, investor enthusiasm for mergers dissipates. Most of the research indicates that between 60% and 80% of mergers are financial failures. In some studies, failure is defined as underperforming in the stock market, while other studies define it as not delivering promised "synergies" through cost reductions or profit increases.
The consulting firm McKinsey & Co. reviewed 115 acquisitions in the U.K. and the U.S. done in the early 1990s and found that 60% of transactions failed to earn returns greater than the annual cost of the capital required to do the acquisitions. Just 23% of the transactions were rated successful by this measure, and the rest didn't qualify as either successes or failures.
Then there was last summer's study of bank mergers by Keefe Bruyette & Woods. The firm found that of the eight largest bank mergers announced in 1995, six underperformed Keefe's bank-stock index from the day before the mergers were announced to last July 16. Two of the worst laggards were Wells Fargo-First Interstate and Fleet-Shawmut, each of which trailed the index by 40%. The other four losers were CoreStates-Meridian, PNC-Midlantic, Fleet-NatWest USA, and First Union-First Fidelity. The winners were Chase-Chemical and First Chicago-NBD, but even they outperformed the index only modestly.
Given the high prices being paid in recent acquisitions, it seems CEOs aren't thinking about what these deals mean for shareholders. That's the contention of Chicago merger consultant John Lafferty. "You rarely see any discussion about the commitment of capital and what the returns on that capital are," he says. "Return on investment is the ultimate standard management is held to. There are always alternate uses for a company's capital, such as buying in its own shares or raising the dividend." In fact, Citicorp's buyback program isn't expected to continue after the merger with Travelers.
As illustrated by Sandy Weill's involvement in the Citicorp deal, even some of the best merger men in the business seem willing to accept fairly puny returns these days, perhaps because they have no choice if they want to make acquisitions in today's sky-high stock market. Another name that comes to mind in this regard is Ed Crutchfield, the guy who has made his Charlotte, North Carolina-based First Union into the nation's sixth-largest bank, largely thanks to his ability to arrange and execute mergers. Despite all Crutchfield's acquisition prowess, by just about anyone's lights, his purchase of Philadelphia-based CoreStates last year looks risky. First of all, the $16 billion pricetag is more than five times CoreStates' book value. How on earth is Crutchfield going to earn an acceptable return on this deal?
Given CoreStates' earnings of $813 million last year, the return on First Union's $16 billion outlay amounts to 5.3% -- about the same as a certificate of deposit. True, First Union has talked about wringing out $250 million in annual cost savings, and, if in place last year, that would have brought the annual take to $1.1 billion and increased the return -- to 6.8%. But to get a 10% return, Crutchfield will have to more than double what CoreStates' operation earns. That's not easy in a slow-growth economy or in a mature industry like banking.
A look at some other big mergers raises similar questions. WorldCom, for example, plans to pay about $35.3 billion in stock for MCI, based on its recent stock price. That's almost three times the value of WorldCom's own common equity. The combined organization is expected to post losses, and WorldCom hasn't announced any plans for cost savings. Lafferty sees MCI earning $740 million this year, suggesting a 2.1% return on WorldCom's acquisition price. To earn 10%, MCI's earnings would need to rise fivefold, to $3.5 billion.
"For this deal to be even minimally acceptable, you have to get earnings on the MCI assets up by over $2 billion," Lafferty says.
Among other recent shockers is Household International, whose plans to gobble up Beneficial Corp. were overshadowed by the announcement of the Travelers-Citi merger the previous day. Household is buying Beneficial for roughly $7.7 billion in a stock deal. Beneficial earned about $254 million last year, which indicates that before cost savings, Household is getting a 3.3% return on its investment. For the current year, Beneficial's earnings are expected to rise to $300 million, making for a 3.9% return. Beneficial's chairman has said he can cut annual costs by $450 million through the merger, for a total of $750 million, or a 9.77% return. That's great -- if he can deliver. And even then, 9.77% is a lot less than what the S&P 500 has been posting lately.
Wall Streeters, of course, are quick to dispute the contention that most mergers don't pay off. Lehman Brothers strategist Jeffrey Applegate recently wrote that he expects merger activity to add to corporate profits across the U.S. Smart strategic mergers, Applegate reasons, should expand a company's market and let it shed redundant operations. Also, he points out that fragmented industries are likely to continue consolidating, potentially increasing profit margins at electric utilities, regional banks, energy exploration outfits and computer-services firms.
Corporate chieftains, too, argue vehemently in favor of mergers. Leo Hindery, chief executive of the cable giant TeleCommunications Inc., has done about 150 transactions in his lifetime, including about 45 since he came to TCI in February 1997. Hindery chafes at hearing statistics that suggest well over half of all mergers are financial flops. "I believe more than half are successes!" he exclaims. "Look at General Electric, which has done thousands of transactions. I can recall just two failures in their history, and one is Kidder Peabody. I know more about deals than anybody alive, and I believe most are successes."
Others bristle, too, including Ed Crutchfield of First Union. "The endgame will be a handful of huge financial-services companies," says Crutchfield, who has overseen some 80 acquisitions over the past 13 years. He believes that some company officials could probably execute mergers more deftly; in too many cases, for example, he thinks employees are kept in the dark for too long after a merger is announced. But like Hindery, he believes the academics' numbers are lying. "It's nonsense to say a merger doesn't add value. If you look at acquirers over one to two years, it may not look like a good deal. Your survey period has to be longer."
But some of the surveys cover more than a decade, and even Crutchfield concedes that a few of his own deals have been stinkers. In his haste to buy a Georgia bank after interstate banking first began in 1985, for example, he bought without fully inspecting the organization, and "cost ourselves a lot of money," he admits.
A lot of mergers go awry because the acquirer either pays too much in the first place or doesn't adequately mesh its operations with those of the acquired company. Either way, such deals often end in a corporate divorce. In one study done in 1992, at least 44% of the companies that were acquired were later sold off -- often at a loss. The authors of that study, Steven Kaplan at the University of Chicago and Michael Weisbach at the University of Arizona, found that in nearly half of those cases, the divestitures were decidedly unhappy events.
NYU's Sirower says mergers frequently founder because companies are unable to make changes that produce genuine gains in advantage against other firms. In some instances, a merger may make even rivals keener to compete. One recent example of an unsuccessful combination is Quaker Oats' ill-conceived purchase of Snapple for $1.7 billion in 1994. Quaker shares fell 10% after the deal, and then things got worse. Soon afterward, PepsiCo and Coca-Cola said they would introduce products to compete with Snapple's noncarbonated drinks. Quaker wrote down $1.4 billion of its investment.
It's worse yet when the company pays a premium for its target. "You've got to pay back that premium before you really start to generate value as a result of the acquisition," observes Martin Sikora, editor of Mergers & Acquisitions.
And just about everybody makes mistakes. We can't very well write this story without mentioning the $1.6 billion purchase of Telerate by Dow Jones & Co., which publishes Barron's. Late last year Dow Jones took a charge of $900 million to write down the value of Telerate, and recently the company agreed to sell the unit for $510 million to Bridge Information Systems.
Writedowns are not uncommon in the world of mergers -- far from it. Take Sony's 1989 purchase of Columbia Pictures, which proved to be a big headache, complete with an exodus of senior managers and spiraling production costs. In 1994, Sony wrote off $2.7 billion of its investment. The same year, Eli Lilly bought PCS Health Systems for $4.1 billion. Last year, Lilly wrote down the value of PCS by $2.4 billion.
In late 1995, Sweden's Pharmacia purchased Upjohn, with both firms expecting to benefit from combining their drug research operations. But a series of missteps ensued. Executives couldn't agree on much of anything, so the company ended up with "corporate centers" in Stockholm, Kalamazoo, Michigan, Milan and London. Top managers left. The much touted powerhouse in research and development failed to mesh. There followed an earnings collapse and a new chief executive.
In the technology sector, there are lots of examples of merger miscues, including AT&T's 1991 purchase of NCR, and Silicon Graphics' acquisition of Cray Research. Among the banking industry's most visible flops has been Wells Fargo's 1996 purchased of First Interstate. Wells paid a 26% premium for First Interstate, only to see deposits slip away and to fall short of earnings expectations last year. Now Wells itself has become one of the most talked about takeover targets in the banking industry. Eventually, the costs will be wrung out of Wells, whether by its current management or by an acquirer like U.S. Bancorp.
Some mergers fail because they are put together by financial experts, not by the operations folks who actually have to execute the merger plan. Says Hindery of TCI: "I've never tolerated a circumstance where the deal people felt removed from the operating people, because that's a recipe for disaster."
Perhaps that is one reason for the debacle that has emerged at Union Pacific, the new poster child for merger problems. In late 1996, Union Pacific completed its purchase of Southern Pacific, for $3.9 billion, creating the nation's largest railroad company. But since then, freight shipments have been snarled, making for the biggest shipping logjam in history. In February, Union Pacific said it would slash its dividend and raise $1 billion to improve its system in Texas and the Gulf Coast. But those solutions are still to come. Last month, Dow Chemical filed suit against Union Pacific for breach of contract, claiming that chronic disruptions in rail service have cost Dow $25 million in lost revenue and extra shipping charges. Shareholders have filed suit against the company's officers. Since the merger, Union Pacific stock has fallen 32% to a recent 55.
The troubles at Union Pacific caused Mike Dugan, an analyst at Delaware Management Co., to advise his company's portfolio managers to sell Union Pacific stock, which they had owned for more than five years. "As late as October, when things were falling apart, they promised everything would be back in order come Thanksgiving and January," Dugan recalls. "They continued to deny there were problems, so the Street was caught off guard."
That may have been because Union Pacific originally was viewed as a class act with a good track record, having swiftly absorbed Chicago & Northwestern rail system in 1995.
Dugan asked the right question on behalf of at least one major mutual fund he advises, the $1.1 billion Delaware Decatur fund, which has a very strict dividend policy on the stocks it holds. If there's any suggestion at all that the dividend will be cut, Dugan and analysts working for the fund recommend the managers sell. At a meeting with Union Pacific officials, Dugan asked whether the dividend was safe. "I thought it was a ridiculous question," he recalls. "I didn't think it would be a problem. I expected them to say the dividend was sacrosanct. But the answer I got suggested the dividend was open to consideration. You know, the way we think about dividends around here, it should take a corporate Act of Congress to cut it. And I thought, 'Oh, my God. There is no percentage hanging on here.' "
Besides worrying about operational problems, investors in merged companies may soon have to keep a wary eye on Washington regulators. For the most part, government intervention to block mergers hasn't been much of a concern since the early days of the Reagan Administration. But that seems to be changing fast. Regulators undid the proposed merger of the office supply chains Staples and OfficeDepot, and now the union between defense giants Lockheed and Northrop may be similarly stymied.
Bill Baer, director of the Federal Trade Commission's bureau of competition, says that right now 85% of the merger filings with his agency don't require special scrutiny. But that percentage is sure to shrink as merger deals grow ever larger and various industries become more concentrated. You can be sure that antitrust cops will be a lot more active from here on in.
Although it's not easy to tell which mergers will pique the interest of Washington's antitrust regulators, academics say there are clues to which ones will benefit shareholders most. NYU's Sirower has documented that the shares of acquiring companies whose prices fall immediately after a merger announcement usually continue to deteriorate, especially if the acquirers don't meet their timetable for delivering projected cost savings and other supposed synergies.
Jerrold Senser, a money manager at Institutional Capital in Chicago, puts a lot of emphasis on executives in the merged company measuring up to prearranged performance goals. "I try to set up specific benchmarks or targets for management, and if they don't stick to it, I leave the situation... . Many mergers do fail, that's the reality. But in some cases, they can work really well."
Sometimes, good old common sense does the trick. Says Rick Lawson, a top-performing portfolio manager of Weitz Hickory, an Omaha-based mutual fund, "I always look to see a couple of things. Can I see sense in the deal itself? Does it seem synergistic? Sometimes, so many variables are going on I can't see everything that's happening."
Predictably, a fixit industry has sprung up around the issue of busted mergers. The publishing industry has pushed out at least two new books this year, including Joining Forces, by Mitchell Marks and Philip Mirvis, which addresses the psychological aspects of making mergers work, and Winning at Mergers and Acquisitions, by Mark Clemente and David Greenspan, which focuses on improving revenue growth to make mergers pay off. The American Management Association has cooked up several week-long merger workshops, including one on how to avoid wishful thinking and achieve true synergy in mergers and acquisitions. Some consulting firms also offer computer programs to help mergers succeed.
One old hand at this industry is Alfred Rappaport, a former Northwestern University business professor who with Carl Noble, another Northwestern professor, founded Alcar, a Skokie, Illinois, consulting firm. The outfit sells software to help companies model the financial impact of corporate events like mergers. It's now run by Noble's son. A separate consulting company of the same name, based in San Diego, still advises companies directly on how to make mergers succeed, and this firm employs Rappaport, who is now a professor emeritus at Northwestern.
The disasters at Sony, Union Pacific and Upjohn make it clear that buying a company is one of the most dangerous things a chief executive can do. But the reality is that Sirower, Lafferty and various academics probably overstate the failure rate of mergers somewhat. Like most transactions on Wall Street, mergers offer high reward along with high risk. A study by McKinsey & Co., for instance, found companies that do succeed at mergers beat the stock market by 50%.
And now, at last, some of the risk in mergers may be shifting to those investment bankers who arrange corporate marriages and rake in huge fees -- whether the marriages work out or not. Last week, a Federal court in Oakland, California, began hearing arguments in the case of Daisy Systems, now defunct, against Bear Stearns. At issue is whether investment bankers have a fiduciary duty to the clients they advise. Before long, when a merger fails, fast-talking investment bankers who oversell deals or mislead buyers might feel the pain right along with shareholders. That should make tomorrow's merger disasters a little bit easier to bear.