On Thursday, November 17, 2016, shareholders of Tesla Motors and SolarCity Corp. approved by a big margin Tesla’s $2.1 billion all-stock offer to acquire SolarCity and create one company under Elon Musk. Tesla’s stock reacted positively to the good news: share price rose 2.7%. Evidently, everybody was happy with the merger, despite the media skepticism. But not for long: on the very next day, November 18, Tesla’s share price declined almost 2%, and continued to drop the following Monday. Buyers’ remorse? I am not surprised.
The evidence on mergers’ success isn’t encouraging. Already 40 years ago, in one of my first research projects, I have documented on a large sample that companies which acquire businesses perform, post-acquisition, worse than similar companies (same industry, size, etc.) that didn’t engage in M&A. This dismal record didn’t improve over the years: In 2012, Professors Melmendier, Moretti, and Peters (“Winning by Losing”) performed a smart empirical study. They examined all contested acquisitions (with at least two potential acquierers) between 1985 and 2009, and compared the post-acquisition 3-year stock performance of the winners (those who ended up buying the target) with losers. The results will astound you: Whereas during the 20 months before the merger announcement the share performance (stock returns) of winners and losers were closely aligned, on average, during the three years following the merger, winners underperformed losers by a whopping 50%. Truly—winning by losing. Other studies on all M&As, not just contested ones, reached similar conclusions.
Various reasons for the frequent failure of M&As: (1) In contested (more than one bidder) acquisitions, the target price is bid up, and the winner often pays an inflated price relative to fundamentals. Consequently, subsequent merger benefits fail to justify the initial investment, and stock performance suffers. (2) Many acquisitions are performed by companies in dire straits, mostly reaching the end of the “growth dream.” Maturity sets in (think Cisco) and sales and earnings stall. Acquisitions are aimed at rejuvenating growth, but they often fail to do so because of strategic misfit and overpayment. (3) Managers often underestimate the high cost and serious difficulties of merging organizations with different traditions, cultures, and clashing personalities. (4) Mangers sometime acquire businesses just for empire building and compensation enhancement (executive pay is a function of firm size, among other things).
Most M&A failures are of the conglomerate type, where acquirer and target operate in different lines of businesses, like Tesla and SolarCity. The stated justifications for such acquisitions are: (1) Risk reduction—operating in different sectors provides an “insurance” when one sector slows down. (2) There will be significant synergies—cost savings—in combining the two companies. Both arguments are weak. The risk reduction via a conglomerate M&A can easily and at lower cost be achieved by investors owning stock of the two companies. As for the synergies, they are obviously difficult to come by when the two merger partners operate in different industries (different business models, assets, technologies).
Occasionally, mergers are a great success, like Google’s acquisition of YouTube in 2006. More often they are resounding failures, like the almost 50 acquisitions made by Yahoo! during 2013-2015 and still failing to rejuvenate Yahoo!’s growth. Or, the colossal collapse of HP’s $10 billion acquisition of Autonomy in 2011 (HP soon wrote-down $8.8 billion of this acquisition).
The lessons to investors: Be very wary of corporate acquisitions. Don’t be swayed by managers’ “sweet talk.” They always justify the acquisition in glowing terms: great synergies, unusual market penetration opportunity, excellent strategic fit. Often they also provide exaggerated expected EPS gains from acquisition. Be particularly skeptical of conglomerate (unrelated) acquisitions. Also, be wary of acquisitions made by companies with slowing-down operations. Such acquisitions are often desperate attempts to regain growth, resulting in strategic misfits and are highly overpaid. Look dispassionately for a clear strategic justification for the merger, like a pharma company acquiring a biotech outfit to increase dominance in a certain therapeutic area, or airlines merging to expand landing reach. And, importantly, consider the acquisition premium: price paid per share relative to the target’s share price before the first acquisition announcement. Typical acquisition premia in recent years were in the 30-35% range. Substantially higher premia strongly suggest overpayment and subsequent disappointment.
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