Harvard Business Review kicks off each issue with a brief article called Forethought. But the piece it ran there last July is causing some afterthoughts in the M&A community.
In "Discipline and the Dilutive Deal," two Boston-based Bain & Co. consultants argue that dilutive mergers — those that immediately depress the acquirer's earnings per share — have gotten a bad rap.
Their study of 98 acquisitions between 1996 and 2000 showed that "companies making dilutive deals actually outperformed those making accretive deals." And overwhelmingly so, with 47 percent of dilutive transactions creating companies that beat their peer group's stock-price return one year later, while a mere 34 percent of accretive deals fared as well.
How could that be, when dilution often reflects a buyer's overpayment for a target? "In a word: discipline," write the authors, David Harding, a director in Bain's corporate transaction practice, and Phyllis Yale, managing director of the Boston office. On one hand, Wall Street's "suspicion of dilutive deals places enormous pressure on executives to be rigorous in both analyzing and executing mergers" — a pressure they believe brings out the best in many CFOs. On the other hand, "the market's embrace of accretive acquisitions" creates a lax environment, "raising the likelihood of sloppiness in analysis and tardiness in execution."
Does that mean Harding and Yale are recommending that companies seek out dilutive deals? "In some cases we are; in some we're not," Harding tells CFO. Value often can be created "in the case of stodgy, low-growth companies trying to buy high-growth companies" — a common formula behind dilutive deals. In such cases, the acquirer can combine a rational strategy, proper due diligence, strong synergies, and motivated managers to win the day. Indeed, Bain finds those four qualities to be prevalent in the 14 dilutive "outperformers" it identified in its research, which was conducted among $1 billionplus acquisitions. (In all, 34 percent of the deals, whether dilutive, accretive, or neutral, were judged outperformers--as measured by an average stock-price return after one year surpassing that of industry peers by more than 10 percent.)
Kellogg Co.'s $4.6 billion purchase of Keebler — a major winner among 2001 deals, even though dilutive by 36 cents a share — is featured in the HBR article, which Kellogg CFO John Bryant calls "quite accurate" in its depiction of Kellogg's deal-making strengths. The acquisition of Keebler's cookies and crackers, which was not supposed to be accretive until 2004, has already created savings totaling about $120 million this year, he says, up from earlier estimates of $80 million.
But its strong performance was hardly a surprise to analysts, who focused more on the deal being 1 cent accretive in cash terms, after goodwill amortization of 37 cents, notes Bryant. And EPS-dilutive deals are rather common in the food industry, where brands leave a large intangible element in the price. Further, the street valued Keebler above $50 a share — and saw a bargain in Kellogg's $42 price.
As for Bain's thesis that dilutive deals instill discipline in managers, the empirical basis for this turns out to be thin. For his part, Kellogg's Bryant doesn't think his company would have been any less disciplined had Keebler been an EPS-accretive deal. Of the notion that dilutive deals drive managers to work harder, the CFO says: "I don't know what work, if any, [the Bain consultants] did to tease that out of the analysis." Still, the need to pay down debt — for a time reaching $6.8 billion — did lead Kellogg to improve cash flow. "That gave us 6.8 billion reasons to work it out," says Bryant, and cash soared to $935 million by September 30, up from $857 million in all of 2001.
Whatever the reasons for the stellar performance of dilutive deals, the real recommendation in Bain's article, asserts Harding, "was to move beyond the shorthand that dilutive is bad and accretive is good" — a view that especially infects CFOs, he says, noting that many "will not do dilutive deals, period."
Some CFOs who tend to avoid transactions dilutive to earnings are puzzled by Bain's conclusions. "I'm not sure how overpaying results in a better deal," says Sean Creamer, CFO of Baltimore-based Sylvan Learning Systems, who calls the Bain researchers' conclusion a decidedly "counterintuitive notion."
Bain's success story for dilutive deals also runs smack into major academic objections — including that from a resident Harvard Business School expert in M&A accretion and dilution.
"What these guys are saying is that if you're a marathon runner, you're better off starting five miles back, because you'll run a little bit harder," says Gregor M. Andrade. The author of a Harvard working paper titled "Do Appearances Matter? The Impact of EPS Accretion and Dilution on Stock Prices," Andrade concludes that dilutive deals produce "slightly negative returns," and that the difference between dilutive deals and the somewhat-better-performing accretive ones is "too small to be economically meaningful."
His research was managed quite differently — eliminating, for example, all management or other factors except accretion or dilution — but he's still stymied by Bain's finding of that high dilutive-deal success rate, which represents "a very economically meaningful quantity." According to the professor, "the conclusion flies in the face of intuition," as well as his own findings. And he worries that executives might be led to seek out dilutive deals, when the evidence is that whether a deal is dilutive gets too much attention in the first place.
"I can see where he's coming from," responds Bain's Harding. The Bain article "simply took a provocative stance on this to break through the conventional wisdom." In a way, he suggests, his research agrees with the academic view that other elements are more important than accretion versus dilution. "Of all the reasons to do a deal," he says, that "probably shouldn't be in the top five."
As to suggestions that the cash-accretive status of some EPS-dilutive deals should have been noted in Bain's article, Harding points out that only 4 of the 14 dilutive successes were, like Kellogg-Keebler, cash-accretive. But had the article focused on the cash element, he concedes, "the remarkable headline does get muted."
Just a Street Story?
For Richard Leftwich, a professor at the University of Chicago's Graduate School of Business, the issue runs deeper than deciding which short-term metric — EPS or cash accretion — should apply. Reasons for a merger's success or failure "tend to be very idiosyncratic" and have "very little to do with accretion or dilution," he says. "From a theoretical perspective, there's no way it matters. It's a Street story. It's not an academic story."
But what about Wall Street, where CFOs must still play if they are to sell investors on their deals?
In Kellogg's case, Prudential Securities food analyst John McMillin agrees that investors did overlook EPS dilution to focus instead on cash accretion and the bargain price, so the deal got a good review. McMillin, though, does think accretive deals often are unrealistically lauded. In his industry, "the company that made the most accretive acquisitions is now out of business. Their name was Borden, and they just bought junk."
On the other side of the coin, McMillin learned to disregard the dilutive-is-bad philosophy from the August 2000 purchase by spice maker McCormick & Co. of European seasonings firm Ducros (pronounced "du-CROW") in a dilutive deal. "I thought McCormick had absorbed too much, and paid too much. But the reality is that, despite my fears, the deal has enhanced McCormick's strength and rewarded it with a higher multiple," he says. "Some might argue that I'm now eating Ducros."
Roy Harris is a senior editor at CFO.
Is Dilution a Delusion?
Some deals that outperformed their industry's stock-price return despite an initial per-share earnings hit.
*In first year after completion.
**Accounted for as a pooling of interests; no goodwill amortization.
Sources: Bain & Co., based on analyst reports.
EPS Dilution Amount
|Georgia Pacific/Fort James|
Consolidated Natural Gas
|Rohm & Haas/ Morton|