It is the eternal corporate dilemma: Buy, build or hand the money over to shareholders?
As the U.S. economy slowly revives, companies that hoarded cash during the financial crisis have increasingly deployed that excess capital toward acquisitions. Cash-rich companies can sit on dry powder for only so long before they begin to feel pressure from shareholders to do something productive with it, and acquiring assets when prices are low is always a temptation. Some companies may buy back shares or pay shareholders a dividend. Most, however, have opted to diversify and expand via acquisitions.
And so we now enter a part of the M&A cycle when companies swing from passively defensive to active acquirers. When that occurs, a second question arises: Do any of these deals really add much, or are they simply boondoggles to drive CEO pay or convince shareholders that management has a pulse? The reality of all this is that every M&A situation is different. And some of the best deals occur in a period immediately following a downturn, when assets are relatively cheap and companies are being careful with how they spend their cash.
According to data from Capital IQ, as of March 31, 376 strategics on the S&P 500 had about $1 trillion in cash on hand, compared with $893 billion in cash from 2010's first quarter. The information technology, healthcare and industrial sectors accounted for 67% of that sum. About 16,000 global strategic deals have been announced so far this year, representing $1.1 trillion in transaction volume, according to Dealogic. For 2010 more than 37,000 global strategic deals were announced, with close to $2.3 trillion in volume, an increase from the nearly 34,000 global strategic deals announced in 2009, with about $2 trillion in transaction volume.
Despite the critics, industry observers generally believe that spending cash on acquisitions rather than buying back shares or paying a dividend can be an effective way for corporates to quickly gain scale. "I think it is a general desire for growth," says Ropes & Gray LLP partner Chris Comeau. "It is an easier way to grow rapidly."
Not that the strategy doesn't pose risks. When companies chase rapid growth, they often experience only a temporary boost in margins. Worse yet, some of these deals will fall apart. M&A is not for the faint-hearted. "In a lot of industries, it's hard to grow organically," Comeau admits.
M&A nearly always involves a gamble of some kind. Take Microsoft Corp.'s $8.5 billion cash acquisition of Internet phone company Skype Technologies SA, announced on May 10. The deal, engineered by CEO Steve Ballmer, is an attempt by Microsoft to boost its position in Web communications, where it lags behind rivals such as Google Inc. It represents a pretty big bet. Analysts estimate that the Redmond, Wash.-based software giant paid some 30 times Ebitda for Skype. Concerned that Microsoft overpaid, investors hammered the shares down almost 8% after the deal was announced. Last year, Skype posted a $7 million loss on $860 million in revenue.
The deal is Microsoft's most expensive ever, surpassing its $6 billion acquisition of online advertising company aQuantive Inc. in 2007. That's a worrisome comparison. Microsoft never realized significant value from aQuantive. Its profit margin for 2007's third quarter, when it completed the aQuantive acquisition, hovered around 31%, then fell to 29% the following quarter and to 27% in 2008's second quarter.
Was that all aQuantive's fault? Hardly. Microsoft is a big company, and margins are shaped by any number of factors. But some analysts do blame internal politics at Microsoft for the fact that aQuantive played less of a role in Microsoft earnings than the price would suggest. Last year $1.9 billion of Microsoft's $62.48 billion in revenue came from online revenue.
Microsoft had a similar situation when it acquired a cellphone manufacturer called Danger Inc. for $500 million in 2008. Microsoft dominated personal-computing software so completely for so long that it rarely felt the need to use its cash hoard to buy anything. But as competition mounted, Microsoft looked to diversify and ran into the same trouble with Danger as it had with aQuantive. In the third quarter of 2008, after the announcement of the Danger deal, Microsoft's profit margin stood at around 29%, only to fall to 25% in the fourth quarter and to 22% in 2009's first quarter.
To be sure, Danger was not a major acquisition and the decline in profit margins was mostly attributable to the recession. But it's hard to see the Danger deal as much more than a waste of time and money. Danger was set to manufacture a new cellphone after the Microsoft acquisition. However, the company canceled the project in favor of a competitive handset that would become Windows Phone 7. The majority of Danger's staff, including co-founder Andy Rubin, had left the company by the end of 2009.
The fact is, there are many ways to go wrong in M&A: Technologies and strategies can shift, cultural problems can arise, overpaying can make success difficult, the economy can crater. Industry watchers insist, however, that success depends most heavily on how well buyers perform post-merger integration. Microsoft must justify the price by efficiently integrating Skype's communications offerings across its products, including its Office suite, Xbox entertainment consoles, mobile phone software and enterprise communications tools. It wouldn't hurt to hold onto Skype's best talent.
"One reason you would buy a company is synergies," says Jones Day partner Marilyn Sonnie. "The actual integration of the merger is getting rid of overlap. Some [companies] are better at it than others." But that process of extracting synergies can get messy politically. Microsoft's Lync technology, which provides video, instant messaging, voice and desktop sharing, resembles some of Skype's offerings. Some argue that Skype can leverage Lync, but others fear that the two products will clash just like other deals Microsoft has struck.
For all those difficulties of M&A, few companies have an R&D product pipeline robust enough to sit on their cash without at least considering acquisitions. Even Cupertino, Calif.-based Apple Inc., which had $16 billion in cash as of March 26, has begun to feel pressure to put that cash to use, despite the tremendous revenue generated by its iPhone and iPad products. "They either have to invent something or buy something," says James Rybakoff, CEO of New York-based middle-market investment bank Akin Bay Co. LLC.
Apple has rarely used acquisitions to gain scale. However, CEO Steve Jobs has indicated that the company will become more acquisitive as its cash reserves grow, leading to speculation of potential targets including Netflix Inc., Facebook Inc., Sony Corp. and Adobe Systems Inc. Realistically, however, few companies share Apple's enviable position of strength. Indeed, the dominant positions held by companies such as Apple and Google may force the hand of competitors to try to catch up through M&A. Of course, as Microsoft has discovered, no dominance lasts forever.
"You have companies that can't increase their margins or grow their business the way you want them to," Rybakoff notes. And so they must act, even if acting involves wasting some money.
Of course, tech companies are not alone in M&A swings and misses. New York pharmaceutical giant Pfizer Inc. had $1.7 billion in cash on hand as of Dec. 31, but has stopped making acquisitions. The company has a history of building its pipeline through M&A.
However, with the patent on Pfizer's cholesterol-lowering blockbuster, Lipitor, expiring in November, Pfizer has few major drugs in its pipeline, despite spending billions of dollars on both R&D and M&A. In fact, a series of huge acquisitions have made its position more problematic, since generating growth from such a behemoth is increasingly difficult.
In an effort to focus on its core businesses, Pfizer has begun selling assets to raise cash. In April, the company unloaded its capsule-making business to private equity firm Kohlberg Kravis Roberts & Co. LP for $2.38 billion. Industry analysts argue that Pfizer should focus on additional asset sales, possibly of its animal health or nutrition units, or just splitting up altogether.
Rupert Murdoch's News Corp. made a failed deal of its own when it acquired Myspace.com owner Intermix Media Inc. in 2005 for $580 million. News Corp.'s entrance into the social media universe was ill timed. Though investors are currently falling over themselves to buy shares of social media companies -- via initial public offerings as well as the secondary market -- News Corp.'s deal for Intermix amounted to a bet on the wrong horse at the wrong time.
News Corp. wanted to expand its digital media business. At the time, Intermix was attracting about 27 million users to its websites, notably Myspace.com, which was then the fifth-ranked site in terms of page views, according to industry tracker comScore Networks Inc. Today, however, Myspace.com has been shredded by social media rivals led by Facebook and is mostly known as a showcase for musical artists.
News Corp. put Myspace.com on the auction block in January after it posted a $156 million loss for the quarter ended September 2010. News Corp. is hoping to find a buyer by the end of June.
Rob Enderle, a tech analyst for Enderle Group in San Jose, Calif., does not believe News Corp. ever understood social media. "It was a bad marriage between two entities too far apart, where the parent lacked the necessary skills to either create a service or understand their mistake [in timing]," he says.
According to consulting firm Booz & Co., up to 40% of acquisitions by strategics attempting to diversify are more likely to fail than succeed, depending on the sector. This isn't stellar, though there's always intense debate about those numbers. Booz partner Gerald Adolph believes the risks of making a mistake can be reduced by executing better due diligence. But Adolph says corporates will continue to pursue deals because acquisitions are an important tool for growth.
Paul Schneir, the head of KeyBanc Capital Markets Inc.'s M&A and private capital groups, points to aerospace and defense technology maker Transdigm Group Inc. and General Electric Co. as corporates that have rarely misstepped when they have pursued acquisitions. "GE is a well-tuned acquisition machine," he says.
Corporates seem certain to continue to look to M&A for growth in new areas, especially in distressed assets. In May, one famously opportunistic buyer, Liberty Media Corp., made a $1 billion bid for book retailer Barnes & Noble Inc. Liberty Media has a history of investing in media assets including Starz, Sirius XM Radio Inc. and HSN Inc. B&N has resisted, but John Malone's Englewood, Colo.-based vehicle apparently sees a significant investment opportunity in the book retailer.
The fact is, strategics with cash will always seek acquisitions because they represent an easier and quicker way to grow. Are they always right or necessarily smart? No, but the alternative is, in the long run, just as risky: to depend on lagging internal growth while the rest of the world seems to be out on a shopping spree.