[02/27/19] When Will They Learn? Big Mergers Often Fail

On Friday, February 22, 2019, shares of food giant Kraft Heinz (KH) dropped 27%, amounting to a $14 billion shareholder loss. The main reason for the price calamity: a $15.4 billion write-down of Kraft’s major brands, like Oscar Mayer, Velveeta Cheese, Planters Nuts, and Maxwell House Coffee. An asset write-down means that due to operating setbacks and competitive pressures, the present value of the expected cash flows from these brands is now lower than their balance sheet value. In other words, the value of the brands dropped precipitously. Goodwill from the acquisition of Kraft by Heinz in March 2015 was written-down by $7.1 billion. For non-accountants: goodwill, the difference between the price paid for a business acquisition and the fair (current) value of the acquired net assets, generally reflects the expected value of synergies and other benefits from the acquisition. Slashing down goodwill reflects management admission that those synergies, justifying the high price paid for Kraft ($54 billion) didn’t and will not materialize. So goes the dream of creating a giant food company owning multiple, well known brands. A sad story for shareholders.

I was not surprised by the colossal failure of the Kraft acquisition. Having studied the merger phenomenon for over 40 years, I know that most large acquisitions disappoint. From the spectacular failure of Time Warner’s acquisition by AOL in 2000, to recent debacles, like Teva’s―the world’s largest generic drug manufacturer―acquisition of Allergen Generics for $40.5 billion in 2016, or General Electric’s problematic acquisition of Alstom in 2015 for $9.5 billion. Large acquisitions by large companies often fail.

In these, and other large acquisitions, acquiring managers always gushed with optimism, extolling the huge synergies from the merger (“stronger together”), the market power to be gained, and the “particular fit” of the merger partners, only to disclose to shareholder 2-3 years later that “Unfortunately we wasted a lot of your money.” Sorry! We were “overly optimistic on delivering savings that did not materialize.” said Kraft Heinz’s CEO on the write-downs.

So, I was not surprised by the Kraft failure. What did surprise me, was that after this debacle, the Wall Street Journal (February 22, 2019) reported: “The company [Kraft Heinz] said the write-down―along with other new strategies [I wasn’t aware that a write-down is a strategy] like selling off low-margin brands and cutting its dividend―will help position it to do a major acquisition.” (emphasis mine). Consider: Kraft Heinz management just admitted the loss of billions of dollars of shareholders’ money from a large acquisition made a few years ago, and they are now promising a new one. When will they learn? And how long will shareholders acquiesce to be taken for a ride by managers?

What surprised me even more is that the Sage of Omaha, Warren Buffett, who, by the way, shares responsibility for the Kraft Heinz write-downs (Buffett’s Berkshire Hathaway is a major owner of Kraft Heinz), said in his recent, 2018 letter to shareholders: “We continue, nevertheless, to hope for an elephant-size acquisition. Even at our ages of 88 and 95―I’m the young one―the prospect is what causes my heart and Charlie’s to beat faster [I hope not too fast]. (Just writing about the possibility of a huge purchase has caused my pulse rate to soar.)” And that as Buffett admitted in a CNBC interview on Monday that Heinz overpaid for the Kraft acquisition.

So, Mr. Buffett and other executives yearning to make large acquisition, often prodded by investment bankers standing to gain handsomely from such acquisitions―here is the evidence. I am currently conducting what is likely to be the most comprehensive research on corporate acquisitions. I am using a sample of over 40,000 corporate acquisitions made during the past 25 years, to establish which acquisitions, and under what circumstances, succeed. I define acquisition success when the acquiring firm, post acquisition, demonstrates: (1) 3-5 years of sales growth (relative to peers), or cost of sales decline, (2) positive share returns, and (3) no goodwill write-offs (like those of Kraft Heinz). A multi-dimensional measure of acquisition success. This research generates lots of important findings, but the one directly related to Kraft Heinz is:

The likelihood of acquisition success by a large company is very small.

 

For my entire sample, the likelihood of acquisition success by my measure is 45.8%, slightly less than 1-in-2. This success likelihood decreases significantly for large acquirers. Classified into deciles, for the 9th size decile (80-90% largest companies), the acquisition success likelihood is 36%, and for the 10th decile (10% largest companies) the success likelihood drops to 24.6%. Less than 1-in-4 acquisitions succeed. Would you bet on such odds? Perhaps, if you are not betting your own money.

Why are large companies such poor acquirers? Several reasons come to mind. Large companies are often overly bureaucratic with a set culture, complicating the integration of the acquired targets. Furthermore, large companies are often mature, desperately trying to reignite growth. A large acquisition seems the natural solution, but in their zeal to acquire, these companies often overpay for the target. There are probably additional explanations, but the fact is: the likelihood of acquisition success by large companies is rather small. Moreover, studies have shown that internal growth, by R&D, brand enhancement, etc., takes longer, but is more likely to succeed than growth by acquisition.

The lesson to investors: When you are asked to approve an acquisition by a large company, examine carefully the deal and its circumstances before you vote. Take managers’ rosy predictions of synergies, strategic fit, or an unusual bargain, with a healthy grain of salt.

 

This post first appeared on SeekingAlpha on Feb 27, 2019, here.

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