How Gillette Wowed Wall Street

It structured the Duracell buy to juice up earnings immediately

Two thumbs up? Try four, or even six. Such was the overwhelmingly positive reaction to news that Gillette Co. would pay $7.1 billion in stock to buy battery maker Duracell International Inc. In the two days after the deal was announced on Sept. 12, Duracell's stock shot up 27%, while Gillette's rose 8%. Together, the two added a remarkable $4.1 billion in market capitalization--an unusually large gain relative to the deal's size, says Steven N. Kaplan, a University of Chicago professor of finance. "The market," adds Kaplan, "says this is a huge home run."

Why such rave reviews? For starters, the deal seems a logical fit, combining two companies with premier consumer brands and stellar track records. Duracell is the top player in a global battery market expanding at double-digit rates. But it's lagging outside the U.S. and Europe, and Gillette's international marketing prowess could quickly add muscle. Even rivals are impressed. "What would have taken Duracell years to achieve on its own, Gillette has the ability to do almost overnight," says David A. Jones, CEO of Rayovac Corp., the No.3 U.S. battery maker.

But that only partly explains the market's enthusiasm. Gillette executives also did a masterful job of selling the deal to the Street. Indeed, they've laid the groundwork for years, having racked up 24 straight quarters of double-digit earnings growth with nary a missed target. That gave Gillette credibility when time came to unveil a deal that might normally have gotten a more skeptical look. Most analysts, for example, take it on faith that Gillette will be able to reverse a slowdown in Duracell's growth that began late last year.

What's more, Gillette executives deliberately structured the deal to cater to Wall Street's simplistic emphasis on reported earnings per share. They chose an accounting treatment that would appeal to the Street--even though it may cost shareholders more money.

For a taste of how the Wall Street game is successfully played, just look at trading in Gillette stock the day the Duracell deal was announced. After the news leaked early that morning, the stock swooned, a predictable reaction when a company pays a 25% to 30% premium for a large acquisition. Also, investors often assume that companies using stock in an acquisition are announcing that their stock is overvalued: Otherwise, why not pay cash?

But Gillette CEO Alfred M. Zeien quickly put on his salesman's garb. In a conference call with analysts, Zeien virtually promised that Duracell would accelerate Gillette's robust growth rate. The clincher came when he emphasized that the deal would immediately boost earnings per share. "That was all I needed to hear," says one analyst. Within moments, Gillette stock jumped $3 a share, to $67. Zeien was so focused on the market's reaction that he interrupted the conference to ask an aide how the stock was doing. He, and everyone on the call, heard it was up.

Making sure that the Duracell deal would immediately add to reported earnings was one of Zeien's key goals. But to do that, he had to ensure the deal was structured as a stock swap. If Gillette had paid cash for Duracell, which has a low book value but a high market value, the larger company would have absorbed at least $125 million in annual charges for goodwill and depreciation. To analysts focusing on the bottom line, that would have been a downer, and could have depressed Gillette's share price. A stock swap, by contrast, allows Gillette to employ a "pooling" accounting calculation, which merges the two companies' balance sheets and eliminates such pesky problems as extra goodwill.

Accounting experts say there is no economic difference between the two methods. "The market should be sophisticated enough to see through the accounting treatment," says William H. Coyle, a professor of accounting at Babson College. "But it often doesn't. So you have the accounting driving the behavior, which is not the way it should be." So important was the accounting strategy that one Gillette adviser says the company would have walked away had Duracell insisted on a cash deal.

PENALIZED. For Gillette shareholders, there are two downsides to a stock deal. First, it may already have cost them money. An all-cash deal at $58.50 per Duracell share (the price when the deal was announced) would have cost Gillette about $7.1 billion. But because Gillette's stock soared on the news, Duracell shareholders may get several hundred million dollars more. Another problem: The rules on pooling restrict Gillette's ability to buy back shares for two years, to the dismay of some institutional shareholders who see such buybacks as a way to soak up excess cash and boost the stock price. Gillette already has cut short a modest share buyback program.

Zeien admits that "a cash transaction might be the best thing to do for an individual who wants to hold the stock for five or 10 years," but says shorter-term holders would have been penalized by Wall Street's focus on earnings per share. "Anybody you ask will tell you that the stock price will go down" if a company takes on a huge slug of goodwill in an acquisition. Zeien also hints that the company might resume its share buyback program after the waiting period.

Gillette can hardly be blamed for playing Wall Street's game, and playing it well. After all, that's the currency by which companies are measured, and managers compensated. And to be sure, the enthusiasm for this deal among investors is genuine. Most observers believe Duracell will thrive under Gillette's vaunted management. But investors probably could have figured that out whatever accounting was used.

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