firm with which it is considering merging. In addition, assume that the larger firm has a P/E ratio of 25:1 and annual earnings of $1 million, with 1 million shares outstanding. Each share sells for $25. The target firm has a lower P/E ratio of 10:1 and annual earnings of $100,000, with 100,000 shares outstanding. This firm's stock sells for $10. The larger firm offers the smaller firm a premium on its stock to entice its stockholders to sell. This premium comes in the form of a stock-for-stock offer in which one share of the larger firm, worth $25, is offered for two shares of the smaller firm, worth a total of $20. The large firm issues 50,000 shares to finance the purchase.
This acquisition causes the earnings per share (EPS) of the higher P/E firm to rise. The EPS of the higher P/E firm has risen from $1.00 to $1.05. We can see the effect on the price of the larger firm's stock if we make the crucial assumption that its P/E ratio stays the same. This implies that the market will continue to value this firm's future earnings in a manner similar to the way it did before the acquisition. The validity of this type of assumption is examined in greater detail in Chapter 14.
Based on the assumption that the P/E ratio of the combined firm remains at 25, the stock price will rise to $26.25 (25 × $1.05). We can see that the larger firm can offer the smaller firm a significant premium while its EPS and stock price rise. This process can continue with other acquisitions, which also result in further increases in the acquiring company's stock price. This process will end if the market decides not to apply the same P/E ratio. A bull market such as occurred in the 1960s helps promote high P/E values. When the market falls, however, as it did at the end of the 1960s, this process is not feasible. The process of acquisitions, based on P/E effects, becomes increasingly untenable as a firm seeks to apply it to successively larger firms. The crucial assumption in creating the expectation that stock prices will rise is that the P/E ratio of the high P/E firm will apply to the combined entity. However, as the targets become larger and larger, the target becomes a more important percentage of the combined firm's earning power. After a company acquires several relatively lower P/E firms, the market becomes reluctant to apply the original higher P/E ratio. Therefore, it becomes more difficult to find target firms that will not decrease the acquirer's stock price. As the number of suitable acquisition candidates declines, the merger wave slows down. Therefore, a merger wave based on such “finance gimmickry” can last only a limited time period before it exhausts itself, as this one did.
With its bull market and the formation of huge conglomerates, the term the go-go years was applied to the 1960s.34 When the stock market fell in 1969, it affected the pace of acquisitions by reducing P/E ratios. Figure 2.2 demonstrates how this decline affected some of the larger conglomerates.
Figure 2.2 Third Merger Wave, Conglomerate P/E Ratios 1960, 1970. The End of the Third Merger Wave Was Signaled by the Dramatic Decline in the P/E Ratios of Some of That Era's Leading Conglomerates. Source: Peter O. Steiner, Mergers: Motives, Effects and Policies (Ann Arbor: University of Michigan Press, 1975), 104.
Under accounting rules that prevailed at the time, acquirers had the opportunity to generate paper gains when they acquired companies that had assets on their books that were well below their market values. The gains were recorded when an acquirer sold off certain of these assets. To illustrate such an accounting manipulation, A. J. Briloff recounts how Gulf & Western generated earnings in 1967 by selling off the films of Paramount Pictures, which it had acquired in 1966.35 The bulk of Paramount's assets were in the form of feature films, which it listed on its books at a value significantly less than their market value. In 1967, Gulf & Western sold 32 of the films of its Paramount subsidiary. This generated significant “income” for Gulf & Western in 1967, which succeeded in supporting Gulf & Western's stock price.
Some believe that these accounting manipulations made fire and casualty insurance companies popular takeover targets during this period.36 Conglomerates found their large portfolios of undervalued assets to be particularly attractive in light of the impact of a subsequent sale of these assets on the conglomerate's future earnings. Even the very large Hartford Insurance Company, which had assets of nearly $2 billion in 1968 (approximately $13.9 billion in 2014 dollars), had assets that were clearly undervalued. ITT capitalized on this undervaluation when it acquired Hartford Insurance.
Another artificial incentive that encouraged conglomerate acquisitions involved securities, such as convertible debentures, which were used to finance acquisitions. Acquiring firms would issue convertible debentures in exchange for common stock of the target firm. This allowed them to receive the short-term benefit of adding the target's earnings to its EPS valuation while putting off the eventual increase in the acquirer's shares outstanding.
The decline of the conglomerates may be first traced to the announcement by Litton Industries in 1968 that its quarterly earnings declined for the first time in 14 years.37 Although Litton's earnings were still positive, the market turned sour on conglomerates, and the selling pressure on their stock prices increased.
In 1968, Attorney General Richard McLaren announced that he intended to crack down on the conglomerates, which he believed were an anticompetitive influence on the market. Various legal changes were implemented to limit the use of convertible debt to finance acquisitions. The 1969 Tax Reform Act required that convertible debt be treated as equity for EPS calculations while also restricting changes in the valuation of undervalued assets of targets. The conglomerate boom came to an end, and this helped collapse the stock market.
Little evidence exists to support the advisability of many of the conglomerate acquisitions. Buyers often overpaid for the diverse companies they purchased. Many of the acquisitions were followed by poor financial performance. This is confirmed by the fact that 60 % of the cross-industry acquisitions that occurred between 1970 and 1982 were sold or divested by 1989.
There is no conclusive explanation for why conglomerates failed. Economic theory, however, points out the productivity-enhancing effects of increased specialization. Indeed, this has been the history of capitalism since the Industrial Revolution. The conglomerate era represented a movement away from specialization. Managers of diverse enterprises often had little detailed knowledge of the specific industries that were under their control. This is particularly the case when compared with the management expertise and attention that are applied by managers who concentrate on one industry or even one segment of an industry. It is not surprising, therefore, that companies like Revlon, a firm that has an established track record of success in the cosmetics industry, saw its core cosmetics business suffer when it diversified into unrelated areas, such as health care.
Trendsetting Mergers of the 1970s
The number of M&A announcements in the 1970s fell dramatically, as shown in Figure 2.3. Even so, the decade played a major role in merger history. Several path-breaking mergers changed what was considered to be acceptable takeover behavior in the years to follow. The first of these mergers was the International Nickel Company (INCO) acquisition of ESB (formerly known as Electric Storage Battery Company).
Figure 2.3 Merger and Acquisition Announcements, 1969–1980. Source: Mergerstat Review, 2014.
After the third merger wave, a historic merger paved the way for a type that would be pervasive in the fourth wave: the hostile takeover by major established companies.
In 1974, Philadelphia-based ESB was the largest battery maker in the world, specializing in automobile batteries under the Willard and Exide brand names as well as other consumer batteries under the Ray-O-Vac brand name. Although the firm's profits had been rising, its stock price had fallen in response to