Rule #1 Question of the Week: How Do You Calculate the Big 5 After a Merger or Acquisition? (Part I)
Q:
Hi Phil,
I have read your entire book and today finished your entire BLOG! I have also read your recommended book "Good to Great" to help me figure out how to do a better Management (4M) evaluation.
How do we calculate the BIG FIVE numbers after an important merger or acquisition, for example the acquisition of Gillette by Procter and Gamble. It seems like financial information and chart can no longer be obtain for Gillete (G) on Investools and MSN. Do we need to do some merging of financial data before we calculate our big five? Do we need to calculate the big 5 of Gillette before the acquisition?
In calculating the sticker price, we need to know the Growth Rate and Future PE. Will the acquisition affect the estimation of the growth rate? Is the historical PE for PG still be meaningful in estimating the future PE?
I hope this email is short enough for you and will not affect your snowboarding. Happy 2007! :)
Regards,
Yap
A:
This is a really interesting question. Before I get into the Big Five after a merger, let's talk about what happens in most mergers, because I think we're in for a lot of them in the next few years.
Most mergers are bad ideas. So our starting point when we see a business we like merging with another business is that this is a bad thing until proven otherwise. So you see "merger", you should think, "Oh oh, here comes trouble for my Rule #1 business" until you have a good reason to think that the merger was neutral to good.
Let's think about it:
You're running a good business and you want to acquire another business. Why would you do that?
You are already running a business that has a wonderful moat, a nice Big Five, and you're doing a good job. So why mess it up by having to absorb someone else's payroll, 401K program, distributors, product lines, real estate leases, debt, obligations, lawsuits, employees, managers... did I mention employees and managers?
What are the chances that this acquired business's employees and managers are as good as yours? You da bomb business in your world, so it's not like you just bought the NY Yankees. You just bought the second string team. Somebody is going to have to do a lot of retraining and firing to get this group of second stringers up to Rule #1 standards. That takes time and money, and that time and money used to go toward growing your business.
So one reason CEO's like to buy someone else is to get bigger. For a lot of CEO's, bigger is better for them, even if it isn't better for the investors or employees or products or environment or economy.
You merge, you instantly get bigger revenues, and that means the CEO needs a bigger paycheck.
Gotta get those stock options and make more money in half a day than my lowest paid employee makes in a year. Not my fault. It's what the market is paying for my talent and genius. Look at how I grew this thing. I deserve it. And now I gotta to fly around to all my manufacturing plants. Oh yeah. Gotta get a jet. Gotta get a G-5. With leather. And I'm so busy now that I need a limo and a driver. Gotta. Gotta have a bigger staff with lots of capital letters. Oh yeah. Gotta have staff meetings in Sun Valley. And company retreats in Palm Springs with entertainment by The Rolling Stones and Stevie Wonder. Oh gotta gotta because we're so big now.
Gotta do what the big guys do, or they won't think I'm a big guy.
And here's the best part. The business not only gets big, it gets complicated. Now the board has no idea what's going on. They just hope you do. So now you can intimidate and b.s. the board. Gotta do that. That's just too much fun. Hey, it's fun to be king!
Ahhh, so that's a reason to buy someone else -- you can get CEO toys -- power, autonomy, jets, perks, parties.
Yeah, okay -- you grow your business by buying new customers. Sometimes. But usually the customers you bought were the same customers that you were gradually taking away from your inferior competition. That's where your growth was coming from. Now you bought them. Growth slows down. ROIC goes red. Book value looks good until you subtract the goodwill, and then it looks bad. Earnings take a hit. But sales are awesome! Look at how big we are.
This isn't always the case. Sometimes a merger is a good idea. Sometimes it gives you a whole pile of new customers to sell a new product to. Sometimes it brings in technology you want that makes you more competitive. Sometimes it brings in talent you couldn't get any other way.
But most often mergers are a bad idea. As Mr. Buffett says, when a manager with a great reputation takes over a business with a mediocre reputation, it's usually the business whose reputation remains intact.
Whole Foods just announced that they made a deal to buy Wild Oats. They've been beating up Wild Oats in every market where they compete. Wild Oats doesn't have the same quality management, store designs, distribution relationships, pricing power or awesome employees. It's second string. Which is why I was into owning Whole Foods instead of Wild Oats. Now they are going to merge and Whole Foods is going to have to bring all those Wild Oats stores up to Whole Foods standards. The market liked it. WFMI shot up 10% on the news.
In this case the market might be right. It might not take that much to bring Wild Oats stores to a better standard, and it doubles the number of stores. That makes it more difficult for Trader Joe's to gain ground and easier for people to stay out of Safeway. WFMI might be making a fast move to become more dominant quickly, and it gets rid of a pricing competitor -- so perhaps the margins will stay higher longer.
So here is a case where the motivation for the buy out is to eliminate competition to preserve margins. Since WFMI has only a brand moat to keep their prices high, getting rid of a similar business that was trying to compete by lowering prices might be a good move. We'll see.
The big question is this: What did the merger do to the market value of WFMI?
More on this in a day or two.
Now go play.
