Geoff Gannon May 1, 2023

How Acquisitions Add Value – Or Don’t

Someone emailed me this question:

How do you think management should analyze acquisition opportunities? For example, how would you like the management of companies you own to think about them and decide to acquire or not (acquire) a company? Because they could, say, value the companies and determine if they are undervalued or overvalued… also they can make the value of them increase by making changes (e.g., such as Murphy did at Capital Cities by significantly increasing the operational efficiency of acquired companies and Buffett did at See’s by exploiting its untapped pricing power) and so on.

It depends on the company and their approach. The best acquisitions are often horizontal mergers where the company (for example, one rolling up smaller businesses in its same industry) acquires companies that have similar distribution channels, customers, suppliers, etc. and may increase market power this way. There are often cost synergies (especially economies of scales in sharing fixed costs across acquired businesses) in this sort of merger. So, a merger might be done at a high price relative to the acquired company’s previous EBITDA, earnings, etc. but at a reasonable price after these synergies are achieved.

The problem with many mergers (including the above) is that the price paid by the acquiring company is often so high that the benefits of the synergies are really being paid to the selling shareholders from the acquired company rather than being captured by the acquirer. For example, I’ve seen cases where a company pays about 12x EBITDA for a business and probably gets the business at about 5x EBITDA after synergies. The selling shareholders are getting 12x EBITDA. The buyers are – if all goes well – getting something purchased at 5x EBITDA which can work if the company uses debt, cash, or overvalued shares to fund the acquisition. If they use undervalued stock, it doesn’t work well.

It might seem like this “cost of capital” factor couldn’t be a deal killer when you’re getting something for 5 times EBITDA after synergies. Management might think this too. The synergies here are so huge – an EBITDA margin of 10% pre-acquisition is going to become 25% post-acquisition – that the currency used to do the deal can’t possibly matter enough to ruin the deal, right? Actually, it still can. For example, the acquirer I mentioned that has done deals like this has actually traded in the market at 5 times EBITDA itself at times. So, even deals where it feels 80% certain it can immediately take the EBITDA margin of the target from 10% to 25% don’t actually clear the company’s own opportunity cost hurdle. Its own stock without any added synergies is actually cheaper than buying something with boatloads of synergies.

In such cases, the company would be better buying back its own stock at 5 times EBITDA than buying something and doing all the work of integrating it – and taking on the real risk integration won’t work quite as well as hoped – just to get the exact same return a stock buyback would have achieved. So, every factor I’m going to discuss from synergies, to price, to cost of capital (the currency used to do the deal) and so on will matter enough in some situations to ruin a deal that looks good from every other angle.

Often, companies end up issuing stock either to do the acquisition (by paying in shares to the sellers) – or, because they do a lot of acquisitions, they have to regularly raise cash with shares. This doesn’t work well. Either you have to pivot – as Teledyne did – and issue shares when your stock is highly valued and then buy back shares when it is undervalued. Or, you have to create a situation (through your accomplishment, your investor relations, etc.) where you trade at higher multiples of book, sales, EBITDA, etc. than the companies you would be acquiring. Sometimes, this is possible to do for a while. Usually, it is most likely to be a long-term strategy only in cases where you are public and most of the businesses you are acquiring are small, private, and closely held companies in the same industries. Teledyne did this in its early days. Something like Kelly Partners (in Australia) is trying to do this with accounting firms today. It hopes that as a publicly traded company it will be valued more highly per dollar of sales, etc. than the sales it buys from founders who are selling out their small accounting firms. Something like Vertu Motors (VTU – in the U.K.) made acquisitions that were fine in terms of fit, economies of scale, etc. However, this didn’t benefit the stock (cumulatively, it has tended to harm the stock) because the company’s shares were priced below the price-to-book etc. at which the acquisitions were priced. Issuing cheap stock and making expensive acquisitions doesn’t work. It doesn’t matter what the absolute valuation of the acquired businesses are. You could always buy back your own stock, not issue stock, etc. if your stock is cheaper than what you are acquiring.

In banking, insurance, etc. there have been cases where companies were serial acquirers who got great compound results for their stocks. Usually, these companies maintained consistently higher valuations in terms of price-to-book than what they were acquiring. This is a very effective playbook for as long as you can keep doing it.

The best serial acquirers usually have higher priced stocks (or are public and buying private companies) versus what they acquire and then they implement expense reductions and other financial process improvements at the firms they buy. For example, both Teledyne and Kelly Partners improved cash flow relative to reported earnings, etc. as part of their strategy. They always had more of a focus on cash generation than the sellers had when they owned the business.

With Capital Cities, you also had better management. The company was decentralized. And it often replaced management of what it acquired with younger managers paid more heavily in stock and with incentives tied to successful operation of the business. The company tried to improve both revenue and income. But, it especially had a focus on the idea you could control your own costs better than you could control your own revenue (Cap Cities depended almost entirely on advertising revenue). Managers were required to move all around the country on no notice and take jobs (move their families etc.) many times in their careers. They were also required to move from one kind of business to another they were unfamiliar with. In this way, the best managers were constantly being moved to where they could do the most good. They stayed with the company because they were highly incentivized via stock and because they were given nearly complete autonomy. At other companies, they’d make less money if they were successful (though more if they were unsuccessful). And they’d have much less power to actually get things done without permission to do so being granted by others. So, they had more freedom of action and more outsized rewards when successful. This meant Cap Cities could retain and relocate extremely high performing managers better than owners of other media properties. At other companies, it was not nearly as common to move people from property to property and especially from one type of business to another. Managers didn’t normally move from running a radio station to running a TV network affiliate on the other side of the country to producing a network TV show to running a TV network, etc. the way they did at Cap Cities.

Berkshire basically only buys companies that already have managers with a successful track record who are willing to stay with the business. In areas where this hasn’t been true, Berkshire has had much more trouble. So, Berkshire’s playbook really couldn’t include buying either less well run businesses and improving them or buying less well managed businesses and dropping in better managers. They had to rely only on situations where the business and the manager were already performing well and the manager was willing to stay on pretty much indefinitely. This limits the kind of things they can buy and raises the kind of prices they have to pay.

There’s no simple answer to what acquisitions work. Horizontal mergers are easy to do repeatedly. And improving management is – in some industries – a very good way to improve results. A lot of cost synergies combined with new management and improved processes for operational (usually expense) improvements and cash flow focus seems to be the best recipe for repeated acquisitions working out. This requires having an idea of what you do when you take over a company and taking action quickly to do it. It also requires a lot of managers, usually highly incentivized, who are willing to take new jobs in new places and learn new things. A lot of companies are very, very limited in the pool of managers they have who can do this. And most companies are not set up to provide a lot of autonomy and a lot of big upside payoffs for managers of individual businesses. Most companies have more people at headquarters, pay them more, etc. To be a good serial acquirer, a lot of the decision-making and a lot of the compensation has to be pushed down to the smallest unit analyzable as a “profit center”.

The other issue is the company’s own cost of capital and what it has to pay for what it acquires. It’s better to pay less for what you buy. And it’s better to have a lower cost of capital for funding acquisitions. The price is usually lowest for distressed, unwanted, and private (especially very small) businesses. So, you are going to get the best prices when buying smaller units being discarded by bigger companies, by buying units in no-growth and secularly unattractive industries, etc. It’s very hard to get good prices on any business with a publicly traded “comp” that has a high multiple. So, you get good prices when industries are out of favor, financial conditions (at least for that industry / company / etc.) are really tight, and when bigger companies are restructuring. Basically, what early leveraged buyout targets were is what makes a good acquisition. Spin-offs have replaced some of what was once sold in an LBO, a management led buyout, etc. However, many companies try to sell companies to 100% buyers before they consider doing a spin-off. So, sometimes – but not always – a spin-off may be an even less popular business than what buyers of entire businesses are willing to take off a bigger company’s hands.

Cost of capital can be low for some insurance companies, banks, etc. It depends on a lot of issues. But, sometimes it’s possible for a company in a strong financial position in these industries to take on a company in distress financially if the combination of the two companies would be adequately capitalized. Like a large underleveraged bank / insurance company can basically absorb a small / overleveraged bank or insurance company at a really good price for the equity it is buying only because the combined result is going to be financially strong enough and yet the acquired business was too weak financially if left on its own.

Other than in finance (and to some extent utilities, railroads, etc.) the cost of capital issue is simpler. It’s whether you use stock, earn outs, options, etc. Or whether you use debt. Or whether you use cash you already have on hand. For an already successful company with good things ahead for it if left on its own – stock is usually way too costly to make for a good acquisition. Berkshire has rarely gotten more for its money in cases where it paid a lot of the price in shares. Sometimes, Berkshire was willing to do this when its stock was pretty pricey and when it thought it was buying something cheap. But, except for cases where Berkshire was able to like re-allocate away from overvalued stocks it owned which were then overvalued in Berkshire’s own share price – this didn’t work too well. The Gen Re and the Burlington Northern acquisitions did re-arrange Berkshire in a big way. Some other partial or whole stock deals weren’t so good. But, sellers in a strong position may insist on stock. For example, Disney wanted to buy Cap Cities for 100% cash. But, Cap Cities was not going to sell to Disney for cash. A lot of CEOs / owners who have compounded well at their company, understand capital allocation, etc. would be really, really hesitant to do a deal which results in just a one-time cash payment. It’s hard for that kind of deal to work out as well in the long-run as something that defers taxes, keeps investors in a good industry long-term via equity in the acquiring company, etc. So, cash deals aren’t always possible.

Debt is usually the cheapest form of capital for a publicly traded company to use. Maybe in a bubble, stock could be a better form of currency. But, usually it’s debt. So, it is usually in an acquirer’s best interest to figure out how much debt the company can reasonably carry and then to continually leverage the business up to that level when doing acquisitions. If a company decides 3x Debt/EBITDA is the right level, for example – it would then need to regularly do acquisitions (or buybacks or special dividends or something) to maintain such a high level of debt. Otherwise, it would quickly pay down the debt and end up with like an average level – weighted for time – of like 1 or 1.5 times Debt/EBITDA even though it always tried to lever up to 3x when doing a deal. This is because deals are infrequent and debt declines over time relative to EBITDA (which is always growing). Berkshire has very rarely used debt. But, it has used its strong balance sheet in a way where float can be like debt for it. It does use debt in special situations today (like in regulated industries that always include long-term bonds on company balance sheets) and in places like Japan where there is a positive spread of dividend yields that are way, way higher than bond yields. Berkshire issues Yen denominated debt and then buys Japanese stocks that have higher yields than the bonds do. This is similar to what insurers, banks, etc. do all the time with their float. So, it’s just a financial engineering (instead of natural business model liability) way of doing much the same thing Berkshire has always done.

Even so-so acquisitions can add value if they tick off most of the boxes I mentioned. So, if you are getting an “unpopular” business type price, it’s a horizontal merger with cost synergies, you have a playbook (and maybe a new manager) to improve expense controls and cash conversion, and you are maxing out the amount of debt its reasonable for you to carry to do the deal. Even if the business you were buying in this scenario was really pretty mediocre – you’d be adding value for your shareholders, because the end product of the favorable factors mentioned above would be wealth creating for your shareholders.

Again, though, this isn’t really different from the early days of private equity doing LBOs. Those work. And they work because of the above factors. You use debt, you focus on cash conversion, you cut expenses, and you buy something at a time when other people don’t want to bid for it – so, you get a good price.

The difference is companies are usually going to stick permanently with their acquisitions – whereas, private equity is probably going to try to do all its improvements and financial engineering tweaks and so on in like 3-7 years and then flip the business and then find another thing to do. Obviously, if done right, that will lead to much higher annualized returns than simply buying and holding an acquisition the way publicly traded companies like to do