On The Changing Face Of M&A In A ZIRP World
Sluggish global economic growth means many public companies will have to rely on mergers and acquisitions to generate earnings growth in 2013 and beyond (FCX aside that is). ConvergEx's Nick Colas notes that the academic discussion of whether such a strategy adds “Real” value to shareholders has shifted in recent years. From an unequivocal “No, never…” to a more qualified, “It really depends,” this discussion will grow more critical as industries from financial services to manufacturing to commodity producers evaluate their long term prospects. The key to this question, at least to Colas' thinking, is in the analysis of barriers to entry/exit and true economies of scale. The right answer to the “Does M&A add value” question is much more about business strategy and competitive analysis than any blanket statement about the merits of buying or selling assets.
The Stage Deli in New York, right in the heart of the Theater District, closed last week after 75 years of continuous operation. A true landmark of midtown Broadway, all manner of famous (and many not so famous) patrons frequented the restaurant during its long run. Sufficiently notable, or notorious, guests got a sandwich named in their honor. Press accounts of the closure mentioned a decline in overall business as well as rising rents. I walked by last night after work. All the chairs and tables are still there, and the now-bolted front door has two pieces of ruled paper taped at eye level. They read “CLOSED” and “THANKS FOR 75 YEARS.”
Just a block away, the Carnegie Deli – long time archrival to the Stage – continues to do a reasonable trade. For years the two eateries based their competition on the quality of their pastrami. That’s a thinly sliced piece of brined and smoked beef, just in case you aren’t familiar with the fine points of deli meats. As it turns out, however, the critical difference between the Stage and Carnegie was far more prosaic. The former rented its space; the latter owns the building in which it operates. The Carnegie will be there until some development company offers them $100 million for the building. Which at the current pace of development in midtown is about 5-7 years away.
It often pays to think about public company strategy through the lens of privately owned enterprises, so let me pose this question: why didn’t the Carnegie and Stage Delis merge before the demise of the later? I can see the pitch book for the Carnegie Deli management clearly. It goes something like this:
- Big Idea/Cute Code Name. We, your investment bankers, would like to present Project “Pickle Barrel.”
- The Set Up. For several years your primary competitor for the casual dining deli customer – The Stage Deli (Code name “Little Pickle”) – has been operating at or near breakeven. We understand they will be forced to close before year end.
- The Pitch. We believe Carnegie Deli (Code name “Big Pickle”) should consider an acquisition of Little Pickle before it goes into liquidation.
- Substantial Brand Leverage. Although both restaurants are within a block of each other, we believe there are substantial growth opportunities for each brand. The “Stage” brand could be leveraged either through franchised or company owned store formats to a host of regional markets. This would leave the Carnegie brand for expansion into prepared foods, sold through specialty markets and direct to consumer. This two-pronged approach is ideal to leverage the $150 billion/year “Comfort Food” market, which has grown at 11% compounded for the last five years.
- Economies of scale would be immediate. Big and Little Pickle currently have highly duplicative business practices. Cost savings in the purchasing of raw materials, HR, back office, legal and accounting functions, and other non-value-added services would be immediate.
- The Math. We believe that Little Pickle would be willing to sell for less than $10 million, with earn-outs over the first three years of combined operation. Cost savings (outlined above) would be at least $3 million annually. Payback would therefore be three years (likely less) and the “Upside” of the growth strategy comes for free!
Of course, this isn’t the way things went, and for good reason. The bottom line – or one of them, anyway – is that many customers looking for a pre or post theater dinner simply do not want 3,000 calorie servings of brined, smoked and cured meats. Both the Stage and Carnegie feature eye-poppingly large servings of pastrami, corned beef and other offerings as their signature dishes. The market has changed, probably forever.
In a very real sense, what has happened to delis in midtown is occurring all around the world and in a variety of industries. Here’s how all this comes together:
- Managing slow growth and/or cyclical industries is a unique managerial skill set. And it is rare. When global GDP growth is +3-5% annually, larger public companies can routinely pick away share from smaller private enterprises and show 6-8% revenue growth. That is more than enough to cover the inherent cost creep imbedded in most companies’ business practices. Earnings growth at 10-12%, and all is right with the world.
When global growth slows that positive fundamental erodes and, in some cases, collapses. Layer on other factors such as incremental regulation, and the cost creep continues even as revenues stagnate. And, as I noted with the humble deli, consumer tastes are always changing, requiring a flexible approach to marketing and product development. The management skills used in “Growth” mode become obsolete, and ferocious attention to cost containment and targeted market share growth becomes the order of the day.
- Chief Executive Officers, Chairmen/women, and Boards are struggling with this fundamental right now in every developed market and in almost every industry around the world. How do we grow? How do we keep Wall Street convinced that we are a “Growth Story?” By now all these constituents understand that global economic growth will not be returning to the heady levels of the 1990s or 2000s for many, many years.
One answer is mergers and acquisitions. As the accompanying chart shows, M&A activity in the United States may be cyclical but there is always an underlying level of activity. Last year saw almost 10,000 transactions (of all sizes) and $1.6 trillion in value change hands. According to FactSet, the twelve months ended October 2012 the number of U.S. M&A transactions are down 6.7% to 9,371 and considerations are 19% lower to $736 billion.
- It’s tempting to throw something in here about how the Fiscal Cliff is dampening the spirits of Boards and CEOs – it’s an “M&A Cliff!” But that’s not really the point. M&A is now simply much more important to corporate strategy than at any point in the last 30 years. Again, that is because global growth – that tide that lifts all boats - is much slower than historical norms.
Over the past 20 years, the academic literature on M&A has shifted from condemning most transactions as “Value destroying” to a more nuanced perspective on the process. Companies that do large “Bet the farm” transactions don’t tend to fare as well as those which execute on smaller purchases. The latter is a strategy; the former is a bet. To my thinking, there are two factors which are still under-represented in a thorough analysis of what makes for “Good” rather than “destructive” M&A.
- The barriers to entry/exit for the business. M&A is expensive both in terms of shareholder capital and management’s time. You want to make relatively certain that the benefits of the transaction accrue to the current and future shareholders of the enterprise that undertakes the transaction. Unfortunately, in industries where barriers to entry are low, that isn’t always the case. This, by the way, is yet one more reason why you don’t see NYC restaurants merging. Why bother, when any landlord will lease you a wide array of space?
At the other end of the size spectrum, consider the global auto industry. I was on the investment banking team at the old First Boston which smashed together Daimler and Chrysler in the 1990s. It turned out to be the automotive equivalent of AOL/Time Warner. One critical reason: global auto capacity is always +150% of demand. The industry employs far too many people for local governments to allow for enough plant closures. As such, returns on capital in the industry are always low for mass-market cars.
- “Real” economies of scale. Somewhere in every investment banker’s pitch to an M&A client is the statement “1+1=3” or “10” or “100.” It is the veracity of this statement that truly drives long term value creation. DaimlerChrysler failed in no small part because the business never integrated its design and manufacturing processes enough to bring that calculus to bear on the bottom line. And in an increasingly “Intellectual capital” driven world, it’s not the purchasing department or the back office which creates the value in M&A any more – it is the client facing staff and the executive suite and the product development team.
In summary, over the next 5-10 years M&A activity will be increasingly necessary to keep the tailwind of growth in almost every sector of the economy and capital markets. At the same time, the old models of analyzing such steps will have to change as well. “Additive to earnings” isn’t enough – that rubric may have worked in the past, but there’s a lot of mold on that chestnut. Now, M&A will have to dovetail more closely with fundamental business strategy. There’s just no other way to grow.