Throwing Away Billions: Warning Signs on the Road to a Bad Acquisition

A big purchase can initially propel the buyer forward, but it may foil future growth as well as complicating financial reporting.

The Mellanox officers in Yokne’am.
Ofer Vaknin

The initial public offering of AppDynamics, an American software company that analyzes the performance of apps and servers, was expected to yield $1.7 billion. The first flotation of the high-tech company in 2017 didn’t go through in the end. However, two weeks ago, in what looked like a high-speed chase in a movie thriller, the managers of Cisco Systems closed a deal to buy the company a day before it was scheduled to receive the pricing for its public offering.

The surprise didn’t end with the IPO cancellation, but with the amount AppDynamics shareholders received from Cisco – $3.7 billion, more than twice the amount the company had hoped to raise by offering its shares to the public. Cisco shareholders will be requesting an explanation for such a gap.

The aim of shareholders in both the purchasing company and the one being acquired is to maximize their yields, but whereas in the latter the math is relatively easy, it is much more complicated on the side of the buyer. This depends on the acquiring company's future plans and its ability to float extra value following the acquisition. However, high purchase costs, such as those paid by Cisco for AppDynamics, should set off some alarm bells.

A large acquisition is a significant milestone in the life of a company. It can provide it with a large market segment, giving it a competitive edge which can contribute to its future growth. On the other hand, it can hamper future growth and curtail its profitability, as well as complicating future financing. Thus, shareholders should study the acquisition in depth and understand what its potential is, what warning signs it poses and what ramifications the deal has for the future of the company.

After an official announcement of a deal between two publicly traded companies, the shares of the purchased company spike, approaching levels concordant with the purchasing price. It’s harder to predict what happens to the buyer's shares. This will depend on an analysis of the acquisition, and on the expectations and concerns of investors. Such an analysis must examine many aspects of the deal in financial and business terms, as well as the deal’s closing price.

When bad things happen to good deals

“First of all one has to understand the rationale of the deal from the perspective of the buyer, and how it fits in with its existing business, as well as assessing the chance that the expectations driving the deal will in fact be realized,” says Guy Levi, a fund manager at Excellence Provident Funds. “There can be many reasons for buying, such as wanting to enter new markets, wishing to attain power vis-à-vis suppliers, acquisition of technology in lieu of in-house development, driving out a competitor and others,” adds Levi. He stresses that it’s not always easy to understand the advantages of a deal, particularly in the realm of technology. Two years ago the Israeli company Nova Measuring Instruments, which deals with metrology solutions for the semiconductor industry, acquired ReVera Inc. Analysts couldn’t figure out the reason behind this acquisition and thought that Nova was concerned about ReVera’s technology. "They now realize this was a very good deal,” says Levi.

In cases where it’s hard to discern the reasons for the deal, one should take into account that while risks are higher, some sales have a more intuitive logic behind them. For example, Frutarom is known for its numerous acquisitions. In 2016 it bought eight companies for a total of $245 million. Through these acquisitions, the company is expanding into new markets. Moreover, its longstanding experience in assimilating plants and new subsidiary companies allows it to create operative synergies by combining production facilities, R&D systems, sales and marketing apparatuses, supply chains, acquisition and management operations.

The fact that Frutarom is a serial buyer provides good odds for successful mergers, but there are warning signs that should be heeded when examining a possible acquisition. These are the main points to be considered:

The price

A company may be purchasing a successful and growing business, but one can’t disregard the price it pays for it. A lower price would enable it to divert funds towards development, marketing, sales or other acquisitions, which could provide a further lever for the company’s growth. Therefore, the ones affected by an expensive acquisition are the shareholders. It’s difficult to valuate a company, so the main way to achieve this is through assessing indices such as the ratio between its estimated worth and its annual revenues and profits.

Usually, these indices are relative. They are compared with other deals in the same area, or with other companies that are traded on the stock exchange. These comparisons can drive up the price of a deal. The acquisition process must also be accounted for: Sometimes competition between prospective buyers can raise the price of the purchased company and a buyer should examine whether this is warranted.

Financing

Even when the deal is not costly, it’s very important to examine the way it is financed, including the ratio between debt, shares and cash flow. A deal involving a transfer of shares, while impoverishing the company's shareholders, does transfer some of the risk to shareholders of the purchased company. This can offset the risk inherent in the fact that the purchasing price was too high due to high market prices, since if the value of the company drops, the actual value of the deal will be lower accordingly. High leverage can impose a burden on a company for an extended period. Therefore, one must look at the overall debts of the company, as well as its capability of servicing these debts. Ultimately, if the company runs into trouble in repaying debts, shareholders will suffer as well. Taking on a debt can affect a company’s credit rating, possibly imposing limits on it, such as putting a lien on its assets.

Synergies

Synergy is a bombastic word used by companies to justify acquisitions. One should distinguish between operational and technological synergy. When two food marketing companies merge and save on operational costs, such as providing their products to retailers, they are operationally synergistic. In this case, their power vis-à-vis food manufacturers is increased, allowing them to buy products at lower prices and improve their profitability. Technological synergy is more difficult to analyze without professional knowhow and a familiarity with the technology of both companies. In such cases, investors face higher risks, since the success of the merger depends on company's ability to incorporate the technology, coupled with concerns that the new development might fail.

Often, when speaking of synergies, people mean increasing supplies and product diversity. A company can increase its attractiveness to customers and increase its sales while cutting marketing and sales personnel. In such cases investors should see whether marketing people have the required expertise for marketing the new products. For instance, when a company selling printers buys a company making 3-D printers, its customers change and its marketing methods change accordingly. The difficulties may be larger than they appear at first.

Differences in size

Sometimes a deal is not too costly and the markets are doing well, with the acquired company assimilating into the activities of the purchasing company. However, a different hurdle may present itself: The buyer is not the suitable company for making the deal. A company can double the number of its employees, branches and customers overnight. However, the CEO and the company’s marketing, finance and distribution systems may not be up to the job, lacking the right knowhow. They can lose control over the company’s functions and find it difficult to attain the required operational synergy.

Cultural gaps

Last year, Mellanox completed its acquisition of EZchip for $811 million. In addition to the technological capabilities Mellanox acquired, which allow it to develop a new product and increase its sales, there was another positive aspect to the deal. The offices of the two companies in Yokne’am were separated by only 300 meters. Every organization has its own DNA and the risks of merging the particular characteristics of two companies cannot be offset, but the fact that employees of these two companies used the same jargon, went to the same universities and developed similar work habits were conducive to a successful merger. Conversely, if an American company merges with a Chinese one, there are high odds that the cultural differences would make the merger more difficult.

Key personnel

Many acquisitions come with a dependence on people familiar with the acquired area or with the ability to manage a complex system. For example, six months ago Teva Pharmaceuticals completed the acquisition of Actavis Generics for $37 billion, the largest purchase in the company's history. The person who was supposed to lead the merger was Teva Generics CEO Sigurdur Olafsson, who had set up and managed Actavis until 2013. He was very familiar with the company’s products and manufacturing facilities. However, two months ago Olafsson announced that he was leaving Teva, which could lengthen the assimilation process.

A further example can be found in the world of technology. The development of a product based on the knowhow of two companies requires an extended familiarity with their technologies, which requires the retention of key employees. If these employees are part of the purchased company, they can be retained as part of the deal, but a mechanism must be set up to ensure their commitment to the merger's success.

Cumbersome accounting

Acquisitions make financial reporting inconsistent. Nearly every item in the report changes, starting with assets and investments and culminating in revenues and profits. One-time expenses are added and reporting becomes cumbersome. Several acquisitions have involved accounting losses after it turns out that some of the purchased assets are worth less than what the buyer paid for them. Shareholders need to understand that after an acquisition, it becomes more difficult to follow financial reports, and they should do so with heightened attention.