If you mix raisins with turds, they’re still turds.

Charlie Munger

This is part three in a series on capital allocation (Part 1, Part 2) and, honestly, I’m not sure how many more parts there might be because I could probably write thousands of words about the topic and thousands more about the nuances therein. Anyway, this post will focus on the various types of mergers and acquisitions (M&A) that companies will typically engage in along with a discussion of their motivations, financial and otherwise.

Before we get into the various types of mergers and reasons for doing them, let’s start with the simple fact that the vast majority of mergers destroy value. Numerous studies have examined the failure rates of mergers and the results are, um, not good. An oft-cited KPMG paper found that 83% of mergers did not add value. Some reasons for failure include: paying too high a price, over-estimating the amount of synergies, not accounting for dis-synergies, and cultural conflict. Even worse, some managements do deals for ego (gotta be the biggest!) or personal gain (bigger company, bigger paycheck). Of course, despite evidence to the contrary, human nature makes managers believe that they have the magic touch so they keep trying. Just like we are all above average drivers.

So, let’s make a list of the kinds of merger companies normally do:

  1. Acquisition of unrelated business
  2. Horizontal acquisition
  3. Vertical acquisition
  4. Defensive acquisition

The Acquisition of An Unrelated Business
The most famous acquirer of unrelated businesses is Berkshire Hathaway. Buffett and Munger acquire whole businesses to operate under the Berkshire umbrella. It is important to note that the price they pay is fair on a standalone basis i.e. they don’t pay up for synergies or reduced cost of capital etc. They don’t try to make their businesses work together or report to head office; they leave them alone. As Buffett has said many times, “we delegate almost to the point of abdication.” Conglomerates and holding companies are in the business of making acquisitions that may have no overlap at all.

So, that’s one end of the spectrum where investors get involved because of management’s capital allocation skills. On the other end is an operating company that surprises its investors with the Gotcha! acquisition. For instance, earlier this year the Intercontinental Exchange confirmed that it had approached Ebay for a takeover. I don’t know about you but if I owned a financial exchange and they wanted to go out and buy a consumer marketplace, I’d be a little miffed. Often, the companies in question will have very elaborate presentations to show the value of the combination and potential synergies to convince investors to go along with it. LabCorp, a medical diagnostics company, purchased Covance, a contract research organization, and after the initial upset from investors, the deal seems to be working out as the CEO had hoped. Then there’s Tesla and its acquisition of Solar City; I mean, talk about screwing over your shareholders for personal gain.

You’re really relying on management’s financial acumen when they acquire an entirely new business. They need to pay a fair price and need to be realistic about the benefits the deal will provide, if any.

A serious problem occurs when the management of a great company gets side-tracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette). Loss of focus is what worries Charlie and me when we contemplate investing in businesses that in general look outstanding.

Warren Buffett

The Easy Ones
Now, a horizontal merger is different; these are mergers between companies in the same industry. Here, besides a fair price, the manager’s operating acumen is what really matters. We can split the reasons for horizontal mergers into two categories: 1. adjacent markets and 2. adjacent products.

With adjacent markets, a company is basically expanding its sales footprint in some way. That may be geographically (Charter acquiring Time Warner Cable) or it could be something like a new distribution channel (QVC acquiring HSN). The important thing is that if it’s done right, synergies can be achieved through headcount, advertising, PP&E, procurement, distribution, R&D, capital spend etc. However, companies have to be careful to not acquire when the synergies are illusory. Currently, JustEat, a European food delivery operator, is in the process of buying GrubHub for $7.3 billion for the privilege of entering the U.S. market. It’s unclear that there’s any real industrial logic to the deal. Are there any synergies at all? Time will tell. Another issue that can occur involves culture and, for lack of a better word, half-assed integrations. For example, over the years, Expedia has acquired numerous other online travel agencies (OTAs) – including Orbitz, Travelocity, Wotif – but never really integrated them instead choosing to let them operate as separate fiefdoms. This has led to a bloated cost structure. Contrast that experience with Charter doing the hard work and spending three years integrating the decentralized systems and billing platforms from TWC and Brighthouse down to one.

Barry Diller lamenting Expedia’s unwieldiness on the Q4 2019 conference call
Tom Rutledge insisted on Charter doing clean-up before trying to focus on growth, Q3 2018

The other type of horizontal deal – acquisitions of adjacent products can be a little riskier but have huge payoffs if done well. The two main reasons I see for these deals are: 1. the new product makes the company’s core product stickier with their consumer i.e. an add-on and 2. the new product can be distributed to a wider audience through the company’s existing sales channels. Salesforce started as a CRM product but has made numerous large acquisitions to become more useful to their customers and have upsell opportunities (Heroku, ExactTarget, MuleSoft, Tableau). Meanwhile, AB Inbev most recently acquired Craft Brew Alliance and can now pump their Kona brand through their global distribution system thereby extracting far more value from the business than CBA ever would be able to.

Overall, the scale benefits to horizontal transactions are real. Some of the best investment opportunities have come about when skilled operators see a highly fragmented industry and decide to consolidate it or roll it up. I had started a running list in a thread on Twitter that you should check out at your leisure but one of the best examples that comes to mind is the rollup of the cable industry by TCI. The synergies from each acquisition in that case were relatively easy to calculate and achieve. (You could fire almost everybody if you bought the cable franchise from the town next door.) From 18,000 subscribers in 1972, they reached 13 million subscribers in 1998 before selling out to AT&T (the worst large cap capital allocators of all time?). For a few years along the way, TCI was averaging an acquisition a week!

horizontal and vertical mergers
Diagram courtesy of my wife. No, she’s not a graphic designer. 😂

Going Up and Down the Value Chain
Next, we come to vertical mergers. In these, a company acquires a company that is part of its supply chain with the hope of extracting synergies by removing a middleman. So, moving upstream, a company may acquire one of its suppliers in order to have more control over production and also reduce costs. Last year, Allison Transmission spent $103 million to acquire Walker Die Casting, an important supplier of critical components in their transmissions. Another, much quirkier example is Costco vertically integrating its rotisserie chicken business. On the surface, these deals make sense but they aren’t as easy as the horizontal ones. Like, you can’t just immediately fire the old employees and put in your own because the jobs they are doing are totally different and require specialized knowledge. I’d like to see a Costco cashier become a chick sexer.

On the flip side, going downstream – closer to the customer – can be a telltale sign of trouble especially if you see a company start to acquire its distributors. There are lots of accounting games to play. Garmin, the GPS maker, did this in 2008 as competition with Magellan and TomTom became more fierce and the iPhone with Google Maps was introduced.

Can’t Afford Not To Buy It!
Lastly, we have the acquisitions that managements don’t want to do – the defensive ones. Usually, a company is backed into a corner by a competing technology or product or, in some weird cases, legal troubles and they are forced to acquire to maintain their competitive advantage. Mark Zuckerberg famously saw that Instagram was taking attention away from his Facebook ecosystem and decided to pay what outsiders thought was an absurd $1 billion price (a few weeks before the Facebook IPO no less!) The rest, as they say, is history. Instagram’s user base has grown and it is now considered one of the best acquisitions of all time. Zuck also attempted to buy Snapchat in a defensive maneuver on a few occasions and was rebuffed by CEO Evan Spiegel.

An example of a defensive acquisition to deal with legal troubles is Google’s 2011 acquisition of Motorola Mobility for $12.5 billion. They acquired Motorola’s patent portfolio to head off patent trolls and other deep-pocketed tech companies taking advantage of them. They ultimately sold the Motorola business for $2.9 billion but the deal was a “success.”

And finally, if you’re into conspiracy theories, Verizon’s acquisition of Straight Path for $1.6 billion will make you scratch your head. The rumor is that Verizon basically paid a bunch of money just to try and screw AT&T over and diminish their ability to quickly and efficiently build out a 5G network. At any rate, I wish I was a holder of Straight Path stock – markets get crazy sometimes.

Straight Path from $20 to $240

Don’t Overpay
Well, those are the four kinds of acquisitions I think about. Ultimately, a successful acquisition program means extracting the synergies for yourself and not giving them up in the form of premium to the target. Also, dis-synergies are very real and often unaccounted for because the forecasts only paint a rosy picture.

Overly optimistic assumptions lead to the graveyard of corporate acquisitions.

Sam Zell

Please share your thoughts if you think I’ve got something wrong or you have interesting anecdotes about mergers that worked or didn’t work. Oh and definitely check out my list of rollups – good and bad.

I’m going to leave you with the video below. It’s an interview with John Malone from a strategic finance class and it was posted by The Cable Center in 2012 . The video is 1 hour and 40 minutes long. But, if you’re really into investing, it’s better than any movie you’ll ever see. Get your popcorn. It’s worth multiple viewings. It is an absolute master class on capital allocation. The Doctor covers the philosophy of mergers, financing, leverage, taxes, and management and includes a whole bunch of great examples from his career. As of now, it has ~48,000 views which is really just more evidence that markets aren’t efficient.

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