Why takeovers don't work for investors

by the Investment Team, Hyperion Asset Management

Involvement in major merger deals equates to major investment withdrawals for Hyperion.

Takeovers, mergers and acquisitions... at Hyperion we don’t like owning companies that are involved in “major” deals of this nature, either as the target or as the acquirer.

 

Our rigorous investment criteria are designed to maximise the likelihood of creating portfolios that will produce above benchmark returns over rolling five year periods.  Our view is that major merger transactions require substantial capital investment from businesses and make it difficult to predict their future growth rates.  As such, these companies represent too much of a risk to warrant inclusion in our investment portfolio.

 

Defining a major acquisition

Hyperion has an equation that it has developed to determine whether a transaction represents a “major” deal and calculates the impact it will have on the business it owns.  It measures the size of the acquisition versus the enterprise value of the company and if that figure is greater than 35 per cent of the company’s enterprise value, then Hyperion would sell its holding immediately.

 

If the result is greater than 10 per cent but less than 35 per cent, Hyperion would downweight the company in its portfolio.  For example, Hyperion held ownership in AMP when it announced plans to merge with AXA.  When Hyperion applied its equation to the merger, it fell into the 10-35 per cent category and, as a result, Hyperion reduced its holding in AMP.

 

As the target

Takeovers are good for shareholders of the target company if they have a short-term investment horizon (i.e. in it for a trade), or if the company is approaching maturity and doesn’t have many long-term growth options ahead. 

 

But at Hyperion, our portfolio consists mostly of companies with strong, long-term organic growth options.  We don’t want our companies to be purchased and as a result, our shares to be compulsorily acquired.

 

Although investors would receive a short-term boost to returns via a takeover premium, it generally would not compensate them for potential earnings growth and therefore, the share price increase that they miss out on in the future.

 

As the acquirer

Takeovers can be good for the acquiring company, but history has demonstrated that this is more the exception than the rule.  Some industries, such as banking, gaming and laboratories, which are dominated by fixed-cost businesses, are more conducive to mergers or acquisitions and have a greater chance of success.  The Westpac and St George merger is as an example of a successful outcome.

 

But for companies in other industries, most of the issues arise in the integration phase when the acquiring company tends to lose focus on the core business while attempting to merge the two organisations.  Some of the main integration issues that the acquiring company can encounter include:

 

• Cultural clashes – it’s easier for a company to recruit people with certain values than to convert them to its ways, particularly if they are acquiring a competitor.  The cultural clash can impact turnover and productivity levels, resulting in decreased revenue and increased costs.
• Difficulties in integrating the systems of two companies – the reluctance of employees to learn or adapt to new systems can result in higher costs than expected.
• Supplier concentration issues for the customer that result in revenue loss.
• Information disadvantage – the target company is always going to know more than the acquiring company about its own business, so revenue and cost synergies may not be as great as forecast.

A major reason why Hyperion doesn’t like its companies making major acquisitions is that we place strong emphasis on a business’s track record of achieving above-average levels of profitability. 

 

When a company makes a large acquisition, the track record of management becomes largely irrelevant as it has become a different business.  How different depends on the type of acquisition, but for companies that stray from their core competency, the outcomes are particularly uncertain and they become an even greater investment risk.

 

A good example of this was Primary Healthcare’s 2008 acquisition of Symbion Pharmacy Services.  Prior to the acquisition, Primary Healthcare was predominantly a company that owned and operated medical centres.  Post-acquisition, it is as much a pathology company as it is a medical centre company.  In Hyperion’s view, they have strayed too far outside their circle of competence.

 

Fosters believed they could leverage their distribution capability by slotting in a portfolio of wine brands and eliminating a sales force in its acquisition of Southcorp in 2005.  What they didn’t consider was the different sales skills needed to sell wine as opposed to beer.  Fosters have since unwound that strategy and are in the process of demerging their wine business.

 

Another factor to consider is that companies that make large acquisitions often use debt to help fund the purchase and gear up their balance sheets.  Hyperion has a strict 4x interest cover requirement that is often breached when companies go on the acquisition trail.

 

Summary

Hyperion makes it its business to buy companies with high return on capital and with strong organic growth options.  This means that the companies we own generally do not need to merge or make acquisitions in order to fulfil their potential.  But when a company we own does announce such a move, our investment team rigorously examines the deal and more often than not decides that it is not in our investors’ interests to retain the stock.

 

While there may be a short-term bounce in the stock price, history has shown that the longer-term outlook for a merged entity is not positive.

 

Next time a company you hold is the target or the acquirer in a M&A situation, why not ask your fund manager for their thoughts on the long-term outlook for your investment.

The information in this document was prepared by Hyperion Asset Management, ABN 80 080 135 897 AFSL 238 380, for wholesale investors. The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This document does not take account of any person’s objectives, financial situation or needs and before acting, an investor should consider the appropriateness of the investment having regard to their objectives, financial situation and needs. This document is provided to the recipient only and must not be copied or passed on to any other person without the consent of Hyperion Asset Management. Past performance is not an indicator or guarantee of future performance. Investment performance is presented gross of investment management fees and other expenses, including custody. Hyperion Asset Management believes the information contained in this communication is reliable, however, no warranty is given as to its accuracy and persons relying on this information do so at their own risk. Figures provided as at 31 March 2011.