The Folly of Large Acquisitions

One of my portfolio management rules deals with use of free cash flow.  I have a hierarchy of how I would like managements to use cash and free cash flow:

  1. Pay down debt; eliminate preferred stock.
  2. Grow existing business organically.
  3. Do small acquisitions adjacent to what the firm is doing, that improve marketing efforts, technology, lower costs, add new geographic markets, add complementary products and services, etc., and then grow those organically.
  4. Buy back stock when it is under the conservative estimate of what the company is worth.
  5. Pay dividends at a level where you can grow them in the future at a reasonable growth rate.
  6. Do a large acquisition that does not materially change the business model, at a fair price.
  7. Do a large acquisition that does not materially change the business model, at a sugar daddy price.
  8. Buy back stock at the current market price regardless of valuation.
  9. Do a large acquisition that materially changes the business model, at a fair price.
  10. Do a large acquisition that materially changes the business model, at a sugar daddy price.

In one sense, aside from step one, this list goes from hardest to easiest.  There are many who think they can add value easily through financial engineering.  Financial engineering means more debt, and that is what led us into this crisis.  I like the companies I own to run with a reasonable margin of safety, but not a huge margin of safety.  Financial engineering is the easiest strategy around, and the rewards of using it are limited.

It’s hard to grow a business organically, particularly in an environment like this where demand is not growing.  The best managers still find ways to grow, without resorting to huge mergers.

Small acquisitions can be very wise for large companies, if they can use the new resources to improve their overall organic growth.

But that’s not the way that lazy, self-aggrandizing CEOs think.  “We need more scale.”  So overpay for a competitor.  For similar companies, there are always cost savings, perhaps some market power, but rarely any other advantages.  Realize the government will be watching more closely, and that there will be some intra-firm rivalry for a few years.  I’ve been there, and I know.

What’s worse is when the CEO decides for a large change in strategy in order to grow faster, and pays a sugar daddy price for a rapidly growing company in a very different business, where the synergies with the existing business are questionable.

I avoid companies that do big acquisitions, unless it is like Buffett, where he does not overpay, or like Exxon/Mobil, where the companies are so similar the it does not matter.

Thus the foolishness of Hewlett Packard.  They had a great culture, and lost confidence in their ability to innovate.  They brought in a series of poor managers — Fiorina, Hurd, Apotheker… it would have been better for the company to sell their PC division to Compaq, rather than buying Compaq.  Hurd manipulated the accounting results.  Apotheker has scores to settle, and wants to beat Oracle, though beating Oracle might have been core for SAP, it should not be for HPQ.

Avoid buying companies that are acquisitive; it is a road to losing money.

Full Disclosure: long ORCL