Commentary: Worldcom: Paper Tiger?Leah Nathans Spiro
"The simple mathematical fact is that anytime a company with a high multiple buys one with a lower multiple, a kind of magic comes into play. Earnings per share of the new, merged company in the first year of its life come out higher than those of the acquiring company in the previous year, even though neither company does any more business than before. There is an apparent growth in earnings that is entirely an optical illusion."
The Go-Go Years, by John Brooks, 1973
The stock market is in love with WorldCom and its gutsy bid for MCI. By Oct. 3, two days after WorldCom Inc. announced its $30 billion hostile tender for MCI Communications Corp., WorldCom stock had jumped 11%. Never mind that a minnow with $8 billion in revenues is trying to swallow a whale with $28 billion in revenues. Or that the minnow was not paying with cold cash but with levitated stock. The little fish can chase the leviathan because of the gaping disparity between WorldCom's expected price-earnings ratio of 115 and MCI's
p-e of 22, which would automatically increase the combined company's earnings per share. WorldCom plans to issue about $30 billion worth of new stock to buy out MCI shareholders, even though WorldCom's market capitalization is only $33 billion.
What's going on here? In a word, euphoria. Most analysts and investment bankers chose not to see the through-the-looking-glass quality of WorldCom's bid. In their excitement, they are buying into WorldCom Chief Executive Bernard J. Ebbers' story: that WorldCom plus MCI is far more valuable than MCI plus British Telecommunications PLC, which bid $11 billion less than WorldCom. And, implicitly, that the minnow could do a lot better job of managing the whale.
But a few Wall Street veterans have a more downbeat view. They believe the WorldCom deal is a sign that the stock market has gone over the top in its love affair with high-p-e growth stocks. WorldCom's stock has soared because of its fast-growing earnings, which have been
fueled by acquiring companies largely with stock. The euphoria is so complete that "nobody is even thinking about the risk and the downside," says one top investment banker. In his view, the market's "next great train wreck is deals where equity is issued at very high prices and where the management of the new entity can't manage."
The skeptics' advice: Approach the WorldCom deal with caution. If you think WorldCom can keep acquiring companies forever to maintain its fabulous growth rate, think again. History shows that empires built this way eventually slow down, as do their high-flying stocks. If you're an MCI shareholder, think twice before voting in favor of accepting WorldCom paper. "Ultimately, it comes to tears, because companies cannot grow their earnings stream forever through acquisitions. And eventually the core earnings rate shines through," says Gerard L. Smith, managing director at UBS Securities.
The acquisition technique used by WorldCom is not new: finance textbooks call it the "bootstrap" game. "The long-run result will be slower growth and a depressed price-earnings ratio, but in the short run earnings per share can increase dramatically," according to Fundamentals of Corporate Finance, by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus.
Here's how Frank E. Plumley, an analyst with S&P Ratings Services, estimates it could work with WorldCom and MCI (chart). WorldCom, with a p-e of 115, has 1997 earnings of 32 cents per share, which is its second quarter earnings annualized, and 900 million shares. Add WorldCom to MCI, which has a much lower p-e of 22 and earnings of $1.60 per share. Trade in MCI shares for about 900 million in new WorldCom shares, and you have a company with a p-e of 50 and 12 annualized earnings of 70 cents per share.
This gain in per-share earnings would be created not by "capital investment, product improvement, or increased operating efficiency," as Fundamentals says, but by revaluing the earnings of the low p-e acquisition at the higher p-e of the acquirer. "WorldCom's high p-e and MCI's high earnings doubles the pro-forma annual earnings of WorldCom's stock from 32 cents to 70 cents per share," says Plumley.
Investment bankers have seen it all before. In the late 1980s, the funny money du jour was not high-altitude stock but junk bonds and easy bank debt. Eager commercial bankers and junk-bond buyers didn't look too closely at the financial statements. The crest of that binge was Robert Campeau's purchase of Federated Department Stores and the leveraged buyout of R.H. Macy & Co. Both deals went belly-up. "The stock market is showing the same kind of craziness now that the banks and high-yield markets showed in the late 1980s," says the investment banker.
Some skeptics also point to the excesses of the late 1960s, which were even more similar to the late 1990s. Conglomerates such as Gulf & Western were assembled by entrepreneurs buying low-multiple companies with high-multiple stock. By 1969, the market cratered, along with many of the deals.
MERGER COWBOYS. The major difference between the current acquisition binge and earlier eras is that most of today's acquirers, such as banks and telecom companies, are buying entities in similar industries, not creating confusing Sixties-style hodgepodges. These days, the buzzwords are restructuring and consolidation--in other words, cutting costs and improving revenues. But just like the 1960s, stock swaps are all the rage. In the first three quarters of 1997, a stunning 73% of mergers and acquisitions--$424 billion worth of deals--was consummated with more than 50% stock, according to Securities Data Corp. That compares with an average of 40% between 1988 and 1996.
But consider other entrepreneurial cowboys who burst on the scene with great fanfare and built empires with stock-financed acquisitions. H. Wayne Huizenga, the head of Republic Industries Inc., built his empire by buying companies with stock. In recent months, his stock has drifted down as some investors wonder whether his build-up strategy is working. "People used to be happy to take Huizenga's stock," says one takeover adviser. "It's great until it's not."
Two finance professors at the University of Iowa, Timothy J. Loughran and Anand M. Vijh, don't think that such disasters came about by coincidence. They studied 947 companies between 1970 and 1989 and looked at the performance of their stocks five years after the acquisitions. They found that companies that did stock-for-stock deals sank 25%, while companies that used cash appreciated 62%.
What explains such a huge discrepancy? One reason has to do with what academics call "asymmetric information"--the assumption that company officials know more about their company than the market does. "It's a negative signal that WorldCom wants to do the deal in stock," says Iowa's Loughran. "Say the stock is trading at 37. Yet imagine the chief executive knows it is only worth 15. Why not spend their stock?" But if the CEO thought his stock was actually worth 50, "the last thing they would do would be giving away stock to pay for an acquisition. They would pay in cash," says Loughran.
Of course, some stock deals have worked out. And the prevailing view is still that Ebbers will be able to add 1 and 1 and come up with 3.
But MCI shareholders should think twice before voting in favor of accepting the WorldCom deal. It's far from clear that Ebbers and his managers will be able to offset slower growth with real efficiencies and synergies. If Ebbers can't, the market will eventually realize that WorldCom doesn't deserve its vaulted p-e, and its stock will pay the price.
In the short term, though, it will be easy for the stock-for-stock players to ride the acquisition game with the fruits of a euphoric stock market.