The Lofty Price Of Getting Hitched
Has the takeover party gotten out of hand? A lot of people are asking that question after MCI Communications accepted WorldCom's $42 billion merger bid, Starwood Lodging Trust announced a $10 billion deal for ITT, and First Union agreed to buy CoreStates Financial for $17 billion in a matter of weeks.
The numbers are mind-boggling. U.S. merger volume has swelled to some $800 billion so far this year, already well beyond last year's record of $649 billion. And acquirers are paying an average of 28 times earnings, vs. 25 three years ago. "These are prices you would never have dreamed of a year ago," says Robert Willens, tax specialist at Lehman Brothers Inc. "Things are starting to get a little out of control."
The situation doesn't approach the excesses of the late 1980s. Back then, the buyers were hot-shot financiers looking for a quick buck from junk-financed leveraged buyouts and corporate raids.
In the 1990s, by contrast, deals appear to be driven more by solid business logic. The most powerful economic forces of our era--heightened international competition, the rise of fleet-footed entrepreneurs, an explosion of new information technologies, and deregulation--are transforming industries from telecommunications to health care. Consolidation follows as companies seek ways to boost revenue and cut costs.
But price matters. Indeed, several accounting experts, bankers, and analysts are warning that valuations are reaching unjustifiable levels. The signs? Buyers seem excessively optimistic about the costs they can slash out of their newly combined companies. Several high-priced acquisitions are in trouble. More and more deals are funded by sky-high stock. And investors are starting to react badly to news of megamergers. Taken together, these factors suggest that the great merger wave of the 1990s may be cresting. "These things happen at the end of a bull market in takeovers," says Roy C. Smith, professor at New York University and a limited partner at Goldman, Sachs & Co. "People start doing deals that make less sense than the earlier ones."
COMMON THEME. The good news: Since many of the current mergers are stock deals, they can't go as badly awry as the leveraged deals of the 1980s. When companies can't meet interest payments, they can sink into default. When companies pay too much in stock and hoped-for earnings gains don't materialize, their shares get hammered, but they are still afloat, notes Robert H. Lyon, head of Institutional Capital Corp., a Chicago-based money management firm.
Still, there is evidence that stock deals disappoint over time. A study by University of Iowa finance professors Timothy J. Loughran and Anand M. Vijh shows that returns on stock deals over five years are well below the returns on cash acquisitions. One reason: Managers typically only pay with stock they believe is overpriced. "It's funny money," says M. William Benedetto, head of his own investment banking firm. "They're trading one overvalued stock for another."
This is the fifth major cycle of mergers in U.S. history. In the Great Merger Wave of the turn of the century, as much as half of all U.S. manufacturing capacity was on one side or the other of a merger. That was followed by merger waves in the 1920s, 1960s, and 1980s.
A common theme in all these cycles is that the booms sow the seeds of their own destruction, says David J. Ravenscraft, economist at the University of North Carolina at Chapel Hill. Each one, he adds, has been built on a key innovation or idea for coping with dramatic change. A century ago, companies merged to take advantage of the new national markets and build huge mass-production facilities.
But early success breeds excess as optimism soars--and prices follow. Then, when economic conditions change, the combinations falter. Leverage was a genuine innovation in the early 1980s, but deals became based on increasingly optimistic projections of cash flow. Sure enough, what worked at 6 times cash flow was a disaster at 12 times. At the end of the cycle, in 1989, there was no market for $475 million in 15% bonds issued to pay for a buyout of Ohio Mattress Co. Nobody believed its cash flow would cover the interest expense.
Lately, the stock market has been flashing warning signs about deals. On Nov. 18, Total Renal Care Holdings Inc. announced a $1.1 billion stock-swap deal to buy Renal Treatment Centers Inc. Investors pushed down the stocks of both buyer and seller--and they continue to fall.
The high price of bank deals is also raising concern. Consolidation makes sense as deregulation spurs nationwide banking. Still, prices are staggering. Two years ago, banks sold for 2.5 times book value. Now, First Union Corp. is paying 5.4 times book for CoreStates Financial Corp. On Nov. 25, shares of First Chicago NBD Corp. spurted 7% on takeover rumors. Says Richard M. Kovacevich, chief executive officer at Norwest Corp., the Minneapolis bank holding company: "In my opinion, the way deals are being done at the moment, for every 10 deals, seven won't work."
Prices are vertiginous in other industries, too, including telecommunications, health care, and electric utilities. The high prices of radio-station deals prompted P. Gordon Hodge, an analyst at Nationsbank Montgomery Securities, to issue a report called "Radio Ga-Ga," in which he notes that prices are at historic highs of 14 times future earnings--and some deals are going for 20 times earnings. Says Tele-Communications Inc. president Leo J. Hindery, Jr.: "I can't believe the multiples that those deals are getting."
Another barometer of deal mania is how glib chief executives have become about projected savings from mergers. WorldCom Inc., for example, justified a 23% sweetener in its bid for MCI Communications Corp. by suddenly uncovering an additional $5 billion in savings.
Then there's the growing list of deals gone sour. This summer Eli Lilly & Co. wrote down $2.4 billion of the $4.1 billion it paid for drug distributor PCS Health Systems Inc. in 1994. On Nov. 25, PacifiCare Health Systems Inc. said that unexpectedly high costs in a recently acquired Utah managed-care operation would force a fourth-quarter loss. Aetna Life & Casualty Co. has had ongoing problems merging its systems with those of U.S. Healthcare, acquired in 1996, which has resulted in a hit to third-quarter profits of $103 million.
The urge to consolidate still rules. Investment capital remains ample. The cost of equity finance is low. Still, it's beginning to feel like fin de merger cycle.