Peter Drucker has observed that investments which yield less than the true cost of capital destroy shareholder value. Robert Heller examines how companies fall into the trap by overpaying for 'strategic acquisitions'.
Glaxo's monster bid for Wellcome - win or lose - is a powerful sign of the times. Faced with acute competitive pressures, giants have customarily sought mammoth acquisitions or mergers, arguing that, the larger the critical mass, the greater the competitive advantage.
As Damon Runyon observed, the race isn't always to the swift, nor the battle to the strong, but that's the way to bet it. If continuity is the aim, you can't argue with Runyonese logic. But if the object is to enhance shareholder wealth, the outcome must hinge (as in all gambling) on the stake and the odds, as well as the play.
Last month's column referred to Peter Drucker's view that companies 'destroy' shareholder wealth unless they obtain yields higher than the cost of their capital. He's referring to the concept of Economic Value Added: the basic EVA definition measures the difference between (a) the cost of borrowed money and equity and (b) the return on that capital.
The crucial point is that equity costs more than debt - because investors require a total return on their money which equals or betters what's available elsewhere. When Roberto C Goizueta started to transform Coca-Cola so wondrously, he calculated its cost of equity as 16% - around double its profitability. Coke was thus eating its own flesh.
Goizueta promptly corrected that cannibalism. If you don't cover the true cost of capital, the share price, so painful histories show, will languish over time. IBM is, as usual, a conspicuous and cautionary sob-story. It returned heavily negative figures for EVA in 1991 and 1992, even though operating profit was still positive. That both signalled and explained the concurrent collapse in shareholder value.
Many mega-mergers of the past have similarly never broken free of the straitjacket imposed by over-paying for acquisitions. Yet the EVA calculation is never carried out, either by management, or by analysts and commentators. One analyst remarked, for example, that Dalgety's £442 million petfood buy from Quaker Oats was done 'at a good price'. At 22 times operating profit, the question arises, good for whom?
At a 16% cost of capital, Dalgety would have to generate £70 million of operating profit after tax just to break even. That's a massive task for management, even with the scale economies of an increased European market share (from 8% to 21%) to play with. The target will never be achieved - not visibly, that is. The shape of the petfood interests will change, ploughback will alter the capital side of the equation, and everyone will forget the deal, anyway - including the investors.
Mergers and acquisitions are essentially financial deals, however. They succeed or (at least as often) fail according to their monetary outcome. Yet the argument for Dalgety, or Glaxo wooing Wellcome, or Cadbury Schweppes picking up Dr Pepper, is presented by management in strategic terms - and applauded in those terms. As Henry Mintzberg has shown conclusively, though, such strategies customarily stumble over the most obvious hurdle: man's inability to read the future.
Moreover, strategies have fashionable cycles. Today, the fashion is to concentrate on core businesses. So Glaxo doubles its bets on ethical pharmaceuticals; Dalgety seeks to swap crisps, snacks, sauces, flour and baking mixes for petfoods; Quaker Oats, the petfoods vendor, focuses on cereal products and 'good-for-you' drinks; and so on. Yesterday's fashion, however, was to diversify to reduce dependence on core businesses - that's why Dalgety filled its supermarket basket.
Likewise, Volvo bought its food, beverage and match interests to protect its vulnerability as a specialist car and truck manufacturer: it's now conducting a giant fire sale of the very same interests to focus on cars and trucks, where the future is now seen to lie. The old fashion spread portfolio risk but weakened management's ability to control and direct. The new fashion strengthens the management, but concentrates the risks.
The strategic argument, however, is that risk is actually lowered by raising market share - that, as Number Two, Dalgety is better placed with half the Mars market share than with a mere sixth. But its brands still trail far behind Pedigree and Whiskas. The huge question is whether Dalgety can catch up the leaders, by better management and marketing - by organic growth - and thus gain a positive EVA.
Spectacular organic growth justified Glaxo's original concentration on ethical drugs, shedding all else and achieving a marvellous EVA, with an unprecedented upsurge in shareholder wealth. That's unrepeatable with portfolios acquired, not organically, but at premiums over inflated market prices. At Coke, note, Goizueta ruthlessly dropped businesses with negative EVAs. By that test, many of today's acquisitions would and should be grounded.
Concentrating on what you do best is theoretically great strategy. But Drucker's right: paying above the true cost of capital to raise the strategic stakes leads directly to capital destruction - especially when you're second-best (let alone worse).
Robert Heller was founding editor of Management Today.