Mergers have certainly taken center stage highlighted by the recently announced $57 billion acquisition of Gillette by Procter & Gamble. As I alluded to in my December Willingdon Views, Expectations for 2005, I had an inkling that consolidation could emerge as an important theme in 2005. With the recent flurry of announced deals it seems that this prediction might be coming true.
Why is this happening and what does it mean?... The reasons why Mergers & Acquisitions (M&A) activity is heating up has implications for the overall market, especially for the relative performance between large cap and small cap stocks. Over the last five years small cap stocks have dramatically outperformed large cap stocks. As evidence, the Russell 2000 small cap index is up 14% over the last five years while the S&P 100, representing the 100 largest stocks in the S&P 500 by market cap, is down 25%. Forecasting when this relative performance might reverse is a topic for endless debate. At the same time, a few interesting things are happening below the surface of the M&A headlines. If we look at the economic landscape today and develop a sense of what will drive success over the next several years, there are several factors that point toward accelerating consolidation.
It’s a global economy… Globalization creates many challenges and opportunities for corporations to achieve ongoing cost efficiencies while developing new sources of growth. Success in these two areas requires financial strength as well as economies of scale in manufacturing, procurement, and distribution. Expansion into the exploding economies of China and India require attributes enjoyed by only the largest multinational behemoths. Ultimate success in these rapidly growing economies requires patience and deep pockets. The ability to invest in infrastructure and local relationships, with the realization that these investments will only bear fruit years or even decades in the future, is not readily found. Only the strongest multinationals have the financial strength or commitment to invest for such a long time without reaping short-term economic benefit.
With increasing global competition… With global competition intensifying in virtually every industry, innovation becomes critical to future earnings growth. The success Apple has had with its iPod MP3 player is an excellent example. Innovation requires intellectual talent, which is certainly not exclusive to large organizations, but innovation also requires perseverance and perseverance requires financial strength, which usually comes from strong cash flows derived from a broad and well established product portfolio. These characteristics are usually more common at larger companies.
The proposed combination of Procter & Gamble and Gillette will have over 20 individual products with over $1 billion in sales. This product breadth provides tremendous potential for innovation through line extensions and through cross-polinization of technology and creativity.
With overall economic growth expected to slow on a global basis this year, my sense is that the economies and advantages of size will become increasingly important, making M&A activity a key determinant of performance in the equity market this year.
But there is a downside to M&A… Unfortunately, not all corporate combinations create value for shareholders. Shares in Hewlett (HPQ), for instance, are down 17% since its announcement to acquire Compaq in the third quarter of 2001. During this same time frame the S&P 500 is up approximately 3%. In my opinion, there are two keys to evaluating the success of these combinations. First, and most obvious, management will have to do an excellent job reducing costs through eliminating redundancies and achieving economies of scale. Second, and less obvious, but perhaps more important in the long-run, management will have to demonstrate that there are synergies of innovation. The critical question therefore becomes - Can the new corporation leverage its combined intellectual and technological expertise in order to produce more innovative products and services? The answer to this question will go a long way toward determining the ultimate value added to shareholders.
