Red flags for investments: “Transformational” acquisitions – Example Walgreen

Walgreen is one of the few large US stocks which looks good on my “Boss” Screen, with a consistently high ROE and low volatility. So I put it on my “priority” research to do list.

However,last week I dropped them from the list because of this.

Pessina had already hinted that his preferred exit would be via another merger rather than a fresh stock exchange listing: “If you do an IPO, you create financial value,” he said. “If you do a transformational deal, you create financial value and industrial value.”

Firstly, it is interesting that the seller makes this quote. Clearly, for him it was transformational as he transforms himself financially into a billionaire.

Secondly, if we look at some big “transformational deals in the past, we see that many of them fail.Some well known examples:

Daimler Chrysler
AOL Time Warner
RBS ABN Amro (Fortis, Santander, my all time favourite. everyone involved got screwed in the end))
Allianz Dresdner
Travelers Citicorp
Kraft cadbury
Vodafone Mannesmann

The list is endless. I actually don’t remember large “transformational” deals which actually worked well.

This aspect has not been unnoticed. A famous study by Bain showed that around 70% of large mergers fail:

Bain & Company M&A team leaders David Harding and Sam Rovit challenge the most common deal presumptions in Mastering the Merger: Four Critical Decisions That Make or Break the Deal (Harvard Business School Press, November, 2004) and found that while 70% of large deals fail to create meaningful shareholder value, 80% of the Fortune 100 companies have relied on mergers and acquisitions to fuel their growth over the past two decades.

The reasons are stunningly simple:

Bain examined over 50 case studies, analyzed 15 years of M&A data and surveyed 250 CEOs and senior executives about real-world successes and failures. They found that the top three reasons deals derailed were:

1. Ignored potential integration challenges (67%)

2. Over-estimated synergies (66%)

3. Had problems integrating management teams and/or retaining key managers (61%)

If we look at this article, Walgreen seem to rely heavily on point 2:

The deal will lead to cost and revenue benefits across both companies of $100 million to $150 million in the first year and $1 billion by the end of 2016, according to the statement.

Back to the Bain study. They identified a few critical success factors:

— Frequent acquirers outperform the pack – the more deals a company made, the more value it delivered to shareholders; the “frequent acquirers” outperformed the “never-evers” by a factor of two

— Frequent acquirers buy in good times and bad – frequent acquirers that bought constantly through both tough economic environments and boom times outperformed those that bought primarily in growth periods by a factor of 2.3; they also outperformed the “recession buyers” by a factor of 1.4

— Most successful dealmakers start small then ramp up – firms that focused on small deals on average outperformed those that made big bets by a factor of almost 6

In my opnion, Walgreen is unfortunately a very infrequent acquirer, to my knowledge it is the first acquisition outside the US and they only made one other acquisition in the US in the past few years. It rather looks like a desperate move to counter shrinking business in the US, which is never a good motivation to do a deal.

So despite the low valuation of Walgreen, this acquisition is definitely a “red flag” for any investor, as the chance for a positive outcome seems to be very low. However it looks like a great deal for KKR and Mr. Pessina. If you think about this, KKR and Pessina bought at boom prices in 2007 and seem to at least double their money after 5 years.

An additional remark on international expansion from retailers:Two of the best retailing companies of the world, Walmart and Tesco found out the hard way how difficult it is to transform local cometitive advantages into international markets. Walmart for instance failed in Germany, Tesco is still struggling in the US. As Bruce Greenwald said in “competition demystified”: All competitive advantages are local.

Summary:

Based on historical numbers, Walgreen would look like an interesting “Boss” investment. However the large acquisition completely changes the picture. As outlined above, the success rates of such “transformational” acquisitions are 30% or lower. And historical numbers do not not ho
ave a lot of predictive power in such situations
.

So without any special insider knowledge, one should generally stay away from such stocks which in my case would also be the advise for Walgreen.

Sure it can work out, but the odds are strongly against a positive outcome.

7 comments

  • I haven’t read the whole study but the notion that frequent acquirers outperform seems to me to reek of survivorship bias if you make that that assessment at the end of a period. The potential frequent acquirers that ran into trouble either disappeared through bankruptcy or some other corporate event or dropped into the infrequent group, skewing the frequent group to only companies with stellar economic performance.

    • Hi gilmour,

      it totally agree. “Acquisition machines” like Tyco, GE or RBS hit the wall at somepoint in time.

      Howver I think that comanies who from time to time buy smaller targets withi their core busienss area, for instance Total Produce, can really create value.

      MMI

  • I totally agree.
    When thinking about Walmart or Tesco and local competetive advantage you could also mention Delhaize (market leader in Belgium with a good business-model, but at the moment not so happy with their US-business).
    Concerning Kraft Cadbury i feel reminded of WB who said: “I feel poorer after this deal.”

  • #martin,

    of course if 70% fail, 30% succed. maybe Kraft is in the 30% ???

    MMI

  • Hi MMI,
    because with cadbury the 2 units have enough economies of scale each.
    I am satisfied with the performance since the aquisition but I think 2 years are too early to judge.

  • Martin,

    Kraft Cadbury might not be a faliure but it didn’t create value either. Why would they split the business again if it was a success ?

    MMI

  • Hi MMI,
    very good article.
    But I don’t know if Kraft-Cadbury is a failure. It gave Kraft the possibility to split into 2 businesses and there are synergies in distribution. Cadbury was no value aquisition but for growth. I am long Kraft and will wait how this plays out.

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