Gorging on a Diet of Deals
By REED ABELSON
They are serial acquirers -- companies that play Pac-Man by gobbling up other companies, paying for the purchases with high-priced stock. It's a cycle that feeds voraciously on itself: The more a company acquires, the higher the stock price, fueling even more acquisitions.
The buyers include companies like Republic Industries and Nationsbank, Cendant and Worldcom. They promise investors that they will make money by transforming industries, providing tremendous economies of scale and greater efficiencies.
Early in the cycle, it may indeed work out that way. But investors can find it impossible to tell when the game is about to come to a grinding halt -- rudely punishing the acquirer's stock.
Shares in the newly formed Cendant Corp. lost nearly half their value after the company disclosed in April that one of its businesses, the former CUC International, had overstated earnings. Waste Management's troubled accounting and ill-fated diversification attempts eventually crushed its shares and are driving the company into the arms of a rival.
U.S. Office Products' profits have slumped and the company recently ended up spinning off four units composed of some of its purchases.
What all serial acquirers -- the successful and the not-so-successful -- have in common is that their finances can confound even the most sophisticated investors. Buyers of these companies' stocks must decide whether to risk being swept up in the deal-making in the hopes of riding a stock up further.
The sheer complexity of putting together dozens of companies or more -- in each of its most frantic years, Waste Management bought as many as 100 companies -- makes it nearly impossible to see whether the acquiring company's strategy is working.
Adding to the confusion is that many of these companies employ accounting sleight of hand; in perfectly legal maneuvers, they mask the real cost of their acquisitions through write-offs, leaving the buyers looking more profitable than they really are.
In sorting this out, investors get little help from Wall Street analysts, who often play along. After all, corporations can come down hard on naysayers. Thomas K. Brown, until recently a banking analyst for Donaldson, Lufkin & Jenrette, long criticized the acquisition strategy of First Union Corp., which has made more than 70 acquisitions since 1985.
As a result, he said, he was excluded from one-on-one meetings at First Union's headquarters in Charlotte, N.C. (First Union said it had never refused to meet with Brown.)
Another analyst, who asked not to be identified, recalled being threatened with a lawsuit by one serial acquirer after publicly questioning its purchases. Why the heavy-handed treatment? "So much depends on the stock price," he surmised.
Analysts can also be reluctant to look too closely at any one transaction for fear that their company might lose the lucrative investment banking fees on the acquirer's next deal.
A result of this combination of complexity and analysts' see-no-evil, speak-no-evil approach is that the guidepost usually followed by investors -- the analysts' estimated growth rate of earnings -- can vary so wildly for these companies as to be nearly meaningless.
Analysts following Worldcom, for example, peg its annual earnings growth rate at anywhere from 20 percent to more than 50 percent, a range that suggests they are doing little more than guessing.
Enthusiastic analysts are not always wrong, of course, and many investors enjoy long rides up with the stock of acquisition-happy businesses. "Lots of companies have successfully changed the profitability of an industry by acquiring," said John W. Ballen, the chief equity officer for MFS Investment Management in Boston, citing Republic Industries, Computer Associates and Cardinal Health as examples.
But other seasoned investors and analysts are so wary of the serial acquirers that they simply steer clear. "I don't feel comfortable covering a company that makes so many acquisitions," said Stephen Sanborn, the research director for Value Line of New York, which provides stock analysis to individual investors.
Value Line does not cover Starwood Hotels and Resorts, for example, whose buying spree of about 40 businesses in the last three years includes this year's purchase of ITT Corp. for $15 billion.
As a company gets larger, said Robert A. Olstein, a portfolio manager in Purchase, N.Y., "the pressure on keeping that going is growing." Olstein, who has spent decades scrutinizing companies' financial statements, also avoids these stocks. Eventually, he said, the chief executive "reaches too far," making an acquisition that leads the company to stumble.
Sometimes, of course, the game goes on so long that analysts and investors catch on. First Union has been engaged in its feeding frenzy for more than a dozen years, and the drops in its stock price after several of the bank's recent acquisitions indicate that many on Wall Street have grown tired of the game.
But because of the deals' complexities, the so-called experts can be just as ignorant as the average investor about an acquirer's true performance, and the rapid rise in many of these companies' stocks suggests that the game remains as popular as ever.
A close look at three of these companies -- Worldcom, First Union and U.S. Filter -- illustrates the challenges for investors in evaluating a serial acquirer.
Looking at the financial results of a serial acquirer is difficult enough -- the footnotes in its reports are full of references to actual results and pro forma results, depending on how the company is putting together the numbers for different businesses.
But making it even more difficult to decipher performance are accounting techniques that allow companies to erase "good will" -- a measure of how much a company pays over the book value of an acquisition -- and thereby insure that their future earnings do not reflect the hefty price of their purchases.
For Worldcom Inc., the strategy of gobbling up other telecommunications players, mostly through stock-based purchases, has been a raging success to date.
"They actually understand their business and make moves that are strategically intelligent," said Michael J. Mahoney, who owns the stock as the manager of the AIM Global Telecommunications fund. Shares of Worldcom, which is based in Jackson, Miss., have gained an average of around 50 percent annually over the last three years.
The overwhelming majority of analysts who follow Worldcom continue to urge investors to buy the stock, despite the drastic changes ahead as the company swells more than four times its current size with its pending $37 billion acquisition of the MCI Communications Corp. (The final purchase price depends on a number of factors, including the price of Worldcom's stock.)
The analysts' logic goes something like this:
Worldcom is expected to earn $1.95 a share in 1999. With an estimated long-term growth rate around 30 percent a year, the stock can command a price-to-earnings multiple of 25 to 30, roughly in line with its growth rate. Presto: The stock is worth $48.75 to $58.50, making it a buy at its current price of $50.1875.
In that equation, however, the key number is the growth rate. On its own, MCI has been a much slower grower than Worldcom, says Anthony F. Ferrugia, an analyst at A.G. Edwards and one of the rare members of his profession not pushing the stock.
And Worldcom is paying a huge premium for MCI. So while there may be substantial savings when the two companies combine, it is not at all clear to him how fast the combined company can grow.
"When I look at all those numbers, I don't have a crystal ball," Ferrugia said.
Mahoney acknowledges that achieving the projection of 30 percent-plus growth "takes everything working."
It also takes a little accounting magic. Over the last two years, Worldcom has managed to bolster its future earnings by a little more than $2.5 billion by making a like amount of good will vanish through write-offs, which are usually discounted by investors as one-time anomalies.
The technique used by Worldcom is becoming increasing popular, particularly when, because they have been buying back stock or for other reasons, companies cannot treat an acquisition as a pooling of interests, in which no good will is created.
Instead, the buyer contends that some part of the price of a purchase is acquired research, which must be written off immediately under current accounting rules.
That, effectively, increases future earnings by reducing the amount of good will amortized each year, a figure that is subtracted from earnings on a company's income statement. For acquirers, the attraction of this technique is that management gets to determine how much good will it can write off: it is the buyer that assigns a value to the acquired research, although managements bring in appraisers to help.
"It is a very, very subjective estimate," said Baruch Lev, a professor at New York University's Stern School of Business who has recently completed a study of the technique.
What concerns Lev is the possibility that investors are failing to discount such companies' future higher earnings. "Some of this growth in earnings and high return on equity will turn out to be bogus," he predicted.
Look at what would happen to Worldcom's earnings-per-share numbers if the company had not taken those write-offs in the last two years. If it had amortized the good will over 20 years -- Worldcom's practice varies from 10 years to 40 years -- it would have eliminated roughly $125 million a year in goodwill expenses, or around 12 cents a share.
If estimated 1999 earnings were, therefore, $1.83 a share, the stock, at a multiple of 25 to 30, would today be worth $45.75 to $54.90. And that would make it less of a buy.
Investors should be prepared to see the same technique used when Worldcom completes its merger with MCI, which is expected to result in about $25 billion in good will, the premium it is paying for MCI. Worldcom may write off some of that sum as acquired research -- about $3 billion, according to the company.
"It could very well be a higher number," added Gary Brandt, Worldcom's vice president for investor relations.
Brandt argues that Worldcom is already being penalized by its accounting for earlier purchases, from which the amortization of good will wipes out about 50 cents of earnings per share a year, he said. The company, he added, relies on independent appraisals to determine how much it can write off for research and stays well within accepted accounting practice.
Kevin M. Moore, an analyst with BT Alex. Brown, dismisses the significance of Worldcom's accounting treatment. "The creation of good will is an accounting charge and does not change its cash flow," Moore said, adding that the latter is the most important measure in determining what a company is worth.
And he is not concerned about how Bernard J. Ebbers, Worldcom's chief executive, arrives at his results. "As long as they do $2, however they do it is fine with me," he said.
Lev counters that analysts rely heavily on earnings in valuing companies, so how they come up with those numbers is important.
"Accounting is accountability," he said, adding that managers have little incentive to pay less for an acquisition if they do not have to account for its full price.
Serial acquirers are so difficult to analyze because of the guesswork in determining even the most basic information about a company. How fast would it grow if it had made no acquisitions? How fast are its new businesses growing?
Few companies have been shopping as busily as U.S. Filter Corp., which has completed more than 150 acquisitions since 1991 -- roughly 60 in the last year alone -- to become the nation's largest provider of water-treatment systems.
There is a logic to the strategy of the company, which is based in Palm Desert, Calif. "You have an industry that's just ripe for consolidation," said Patrick S. Adams, a portfolio manager for Berger Associates in Denver who owns the stock.
But keeping track of all of U.S. Filter's activities is nearly impossible. Its frenetically acquired operations range from waste-water treatment plants to the sale of bottled water. And the sheer number of purchases means that most investors do not know how quickly certain businesses are growing and how profitable they are.
"How many people have done real in-depth models for every division they've acquired?" asked one portfolio manager, who has owned the stock but asked not to be identified. "Probably no one."
The real mystery may be the company's internal growth rate, which is the measure of how quickly U.S. Filter is increasing its business without the benefit of all of its acquisitions. Like a lot of companies, U.S. Filter will tell curious analysts what that rate is -- somewhere in the vicinity of 10 percent -- but the figure never appears in the financial statements available to the average investor.
"It is an estimate, yes," said Tim L. Traff, a co-founder of the company and its executive vice president for development.
And while U.S. Filter has been quick to supply anecdotal evidence of how its purchases have fared, a more systematic appraisal is essentially impossible, because the company does not provide detailed information about every purchase, said Rod Lache, an analyst at Deutsche Bank Securities.
Lache, who nevertheless recommends the stock, concedes that the anecdotes "are not helpful in modeling" the company's future performance.
In fact, figuring out how U.S. Filter's purchases have fared proved so challenging that the Securities and Exchange Commission asked the company earlier this year to improve the disclosure in the company's public financial statements.
The SEC declined to comment, and the company said its discussions with the commission were routine.
"We give out as much information as we humanly can on a daily basis," Traff said.
Like Worldcom, U.S. Filter seems to be a master of accounting wizardry, which contributes to the difficultly in estimating future earnings growth.
According to the Center for Financial Research and Analysis, a group in Rockville, Md., that studies corporate accounting for professional investors, U.S. Filter took several charges in its December quarter that could help inflate future earnings.
The company's acquisition last month of Culligan Water Technologies for $1.5 billion in stock complicates matters further because Culligan itself made more than 35 acquisitions in its most recent fiscal year and took several charges.
U.S. Filter defends its accounting as appropriate and has promised to take away at least some of the mystery. Starting with its quarterly results due out in August, the company said, it plans to disclose more information about its individual divisions, like their revenues and operating margins.
"It's the first time we'll be able to dissect the company and judge the progress of the company," said Lache, who, with the information that is available, has projected an earnings growth rate of 25 percent or more for U.S. Filter.
Eventually, analysts and investors can judge the results of a serial acquirer's strategy. If they grow skeptical -- even sending the stock down on news of another purchase -- a company may send its Pac-Man strategy packing. First Union seems to be taking that step.
In the whirl of acquisitions among banks, First Union has been among the busiest, growing from a single-state bank with about $7 billion in assets in 1984 to a 12-state banking giant with $220 billion in assets.
But some analysts and investors have grown sharply critical of the bank's strategy and say its acquisitions have diluted its earnings. The market's judgment is that First Union has overpaid for its purchases, using stock with a relatively low price-to-earnings multiple to pay for companies with higher P/E ratios.
"Guess what -- that causes dilution," said Brown, the early critic of First Union. He is now working for Tiger Management, a money manager in New York.
The company's stock has certainly suffered. Over the last five years, First Union has returned 184 percent, compared with a 304 percent gain in the Standard & Poor's large-bank index. On the day last November when First Union announced it would buy Corestates Financial in a $17.1 billion deal, First Union's stock lost more than $2 a share -- roughly a 4 percent drop.
Regardless of the bank's efforts to show that its acquisitions make sense, "the market is saying that these deals do not have as much economic value," said David Ellison, a portfolio manager for the brokerage firm Friedman, Billings, Ramsey.
First Union has apparently heard Wall Street's complaints, although the bank declined to comment on its strategy. Edward E. Crutchfield, its acquisitive chairman, is now telling analysts and investors that the bank will not pursue deals in which it must pay a premium, like its acquisition of Corestates, but instead will look for a partner with which to achieve a "merger of equals."
Ellison, for one, is not so easily convinced. He said First Union's management, having watched the bank's stock suffer, would try to increase the P/E ratio. Cynics might argue that executives are trying to get "the currency up so they can do a deal," he said.
In general, it pays to be skeptical of any company whose fast growth is largely a result of a frenetic buying spree. The company will almost surely stumble, said Ballen of MFS, who is a big shareholder in one recent sufferer, Cendant. "It's going to happen," he said. "I'm sure that it's happened to every company that makes acquisitions."
And that is why investors who are interested in reducing their risks might want to consider sitting out this particular game.
Sunday, July 5, 1998
Copyright 1998 The New York Times |
