CORPORATE FINANCE
LESSON 40:
CASE STUDY
Merger Mayhem
Why the latest corporate unions carry great risk
By Leslie P. Norton
Investors Beware
It’s time to say a few discouraging words about the proposed
union of Citicorp and Travelers. Forget for the moment that
Citicorp chieftain John Reed and Travelers boss Sandy Weill
have proven themselves to be among the most capable
managers in Corporate America. The fact is that their planned
merger, like most mergers undertaken over the past two
decades, has a better than even chance of failing to pay off for
shareholders.
To begin with, consider the purchase price. To get control of
Citicorp, Travelers will fork over shares valued at something like
$72 billion. Based on Citi’s earnings of $3.6 billion last year,
Travelers would be getting a 5% return on its investment. Even
using Citi’s expected earnings for this year of $4.28 billion,
Travelers’ return amounts to only 5.95%.
That’s about equal to the return on a 30-year Treasury bond.
And let’s face it, the risk involved in trying to get a consistent
return out of Citicorp over the past few decades has proven far
greater than the risk that the U.S. government will fail to meet
its bond payments.
It wouldn’t be outlandish for Travelers to aim for a 10% annual
return on its Citicorp investment, which is about what folks
traditionally expect from the stock market. But to achieve that
10% payoff, Citicorp assets would have to earn $7.19 billion,
twice what it earned in 1996. And forget about the earnings Citi
would need to match last year’s 33% return on the S&P 500
index.
However exciting the Travelers-Citicorp union may seem, it’s
hard to figure out how it will boost profits appreciably. Reed
and Weill say their planned corporate marriage is not about cost-
cutting. They do hope to increase revenues by cross-selling,
which probably means that Citicorp branches will someday try
to peddle lots of Travelers insurance policies, not to mention
stocks and mutual funds from Travelers’ brokerage unit. But do
you really think this merger is going to double or triple the
profits on Citicorp operations any time soon? The same
question could be raised about the proposed BankAmerica-
NationsBank deal and the BancOne-First Chicago merger.
One person skeptical about the Travelers-Citicorp marriage is
Mark Sirower, a professor at New York University who recently
published The Synergy Trap, a book that’s highly critical of
mergers in general. Of the Citicorp-Travelers plan, he says, “I
don’t buy the cross-selling and the financial supermarket idea.
Sears Roebuck tried it, American Express tried it. We’ve had a
lot of failures where people try to push more product out
through a high-cost delivery system. Does the Citi and Travelers
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deal change any industry structure? Does it limit buyer choices?
Supplier choices? Will it make it harder for other people to
enter?”
At first glance, the answer to all those questions appears to be
no.
A possible explanation for Weill’s willingness to pay such a high
price for Citicorp may be that he feels Travelers stock is an over
inflated currency. If that were the case, the rational move for
him would be to spend, spend, spend, as long as his stock
continues to fly high. And Weill has done exactly that by
acquiring Salomon Brothers last year and Citicorp this year.
No one is suggesting that Travelers shares are as overvalued as
those of Cendant, the acquisition machine whose shares fell
nearly 50% last week on news of accounting irregularities. But if
the history of mergers is any guide, the smart thing for Citicorp
shareholders to do may be to sell immediately, or shortly after
the Travelers deal is completed.
Sure, investors get all excited about mergers because the share
price of an acquired institution surges when a deal is an-
nounced, and, in fact, Citicorp’s price jumped 37 5/8, to 180 1/
2, on news of its betrothal to Travelers. It traded recently near
157. Sometimes the share price of the acquiring company rises
too, as was the case with Travelers, climbing from 61 11/16
before the merger announcement to a recent 63 5/16.
That’s usually a good sign. Yet studies show that frequently,
investor enthusiasm for mergers dissipates. Most of the
research indicates that between 60% and 80% of mergers are
financial failures. In some studies, failure is defined as
underperforming in the stock market, while other studies define
it as not delivering promised “synergies” through cost reduc-
tions or profit increases.
The consulting firm McKinsey & Co. reviewed 115 acquisitions
in the U.K. and the U.S. done in the early 1990s and found that
60% of transactions failed to earn returns greater than the
annual cost of the capital required to do the acquisitions. Just
23% of the transactions were rated successful by this measure,
and the rest didn’t qualify as either successes or failures.
Then there was last summer’s study of bank mergers by Keefe
Bruyette & Woods. The firm found that of the eight largest
bank mergers announced in 1995, six underperformed Keefe’s
bank-stock index from the day before the mergers were
announced to last July 16. Two of the worst laggards were
Wells Fargo-First Interstate and Fleet-Shawmut, each of which
trailed the index by 40%. The other four losers were CoreStates-
Meridian, PNC-Midlantic, Fleet-NatWest USA, and First
Union-First Fidelity. The winners were Chase-Chemical and
First Chicago-NBD, but even they outperformed the index only
modestly.
Given the high prices being paid in recent acquisitions, it seems
CEOs aren’t thinking about what these deals mean for
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shareholders. That’s the contention of Chicago merger consult-
ant John Lafferty. “You rarely see any discussion about the
commitment of capital and what the returns on that capital
are,” he says. “Return on investment is the ultimate standard
management is held to. There are always alternate uses for a
company’s capital, such as buying in its own shares or raising
the dividend.” In fact, Citicorp’s buyback program isn’t expected
to continue after the merger with Travelers.
As illustrated by Sandy Weill’s involvement in the Citicorp deal,
even some of the best merger men in the business seem willing
to accept fairly puny returns these days, perhaps because they
have no choice if they want to make acquisitions in today’s sky-
high stock market. Another name that comes to mind in this
regard is Ed Crutchfield, the guy who has made his Charlotte,
North Carolina-based First Union into the nation’s sixth-largest
bank, largely thanks to his ability to arrange and execute
mergers. Despite all Crutchfield’s acquisition prowess, by just
about anyone’s lights, his purchase of Philadelphia-based
CoreStates last year looks risky. First of all, the $16 billion
pricetag is more than five times CoreStates’ book value. How
on earth is Crutchfield going to earn an acceptable return on this
deal?
Given CoreStates’ earnings of $813 million last year, the return
on First Union’s $16 billion outlay amounts to 5.3% — about
the same as a certificate of deposit. True, First Union has talked
about wringing out $250 million in annual cost savings, and, if
in place last year, that would have brought the annual take to
$1.1 billion and increased the return — to 6.8%. But to get a
10% return, Crutchfield will have to more than double what
CoreStates’ operation earns. That’s not easy in a slow-growth
economy or in a mature industry like banking.
A look at some other big mergers raises similar questions.
WorldCom, for example, plans to pay about $35.3 billion in
stock for MCI, based on its recent stock price. That’s almost
three times the value of WorldCom’s own common equity. The
combined organization is expected to post losses, and
WorldCom hasn’t announced any plans for cost savings.
Lafferty sees MCI earning $740 million this year, suggesting a
2.1% return on WorldCom’s acquisition price. To earn 10%,
MCI’s earnings would need to rise fivefold, to $3.5 billion.
“For this deal to be even minimally acceptable, you have to get
earnings on the MCI assets up by over $2 billion,” Lafferty says.
Among other recent shockers is Household International,
whose plans to gobble up Beneficial Corp. were overshadowed
by the announcement of the Travelers-Citi merger the previous
day. Household is buying Beneficial for roughly $7.7 billion in a
stock deal. Beneficial earned about $254 million last year, which
indicates that before cost savings, Household is getting a 3.3%
return on its investment. For the current year, Beneficial’s
earnings are expected to rise to $300 million, making for a 3.9%
return. Beneficial’s chairman has said he can cut annual costs by
$450 million through the merger, for a total of $750 million, or
a 9.77% return. That’s great — if he can deliver. And even then,
9.77% is a lot less than what the S&P 500 has been posting
lately.
Wall Streeters, of course, are quick to dispute the contention
that most mergers don’t pay off. Lehman Brothers strategist
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Jeffrey Applegate recently wrote that he expects merger activity
CORPORATE FINANCE
to add to corporate profits across the U.S. Smart strategic
mergers, Applegate reasons, should expand a company’s market
and let it shed redundant operations. Also, he points out that
fragmented industries are likely to continue consolidating,
potentially increasing profit margins at electric utilities, regional
banks, energy exploration outfits and computer-services firms.
Corporate chieftains, too, argue vehemently in favor of mergers.
Leo Hindery, chief executive of the cable giant
TeleCommunications Inc., has done about 150 transactions in
his lifetime, including about 45 since he came to TCI in
February 1997. Hindery chafes at hearing statistics that suggest
well over half of all mergers are financial flops. “I believe more
than half are successes!” he exclaims. “Look at General Electric,
which has done thousands of transactions. I can recall just two
failures in their history, and one is Kidder Peabody. I know
more about deals than anybody alive, and I believe most are
successes.”
Others bristle, too, including Ed Crutchfield of First Union.
“The endgame will be a handful of huge financial-services
companies,” says Crutchfield, who has overseen some 80
acquisitions over the past 13 years. He believes that some
company officials could probably execute mergers more deftly;
in too many cases, for example, he thinks employees are kept in
the dark for too long after a merger is announced. But like
Hindery, he believes the academics’ numbers are lying. “It’s
nonsense to say a merger doesn’t add value. If you look at
acquirers over one to two years, it may not look like a good deal.
Your survey period has to be longer.”
But some of the surveys cover more than a decade, and even
Crutchfield concedes that a few of his own deals have been
stinkers. In his haste to buy a Georgia bank after interstate
banking first began in 1985, for example, he bought without
fully inspecting the organization, and “cost ourselves a lot of
money,” he admits.
A lot of mergers go awry because the acquirer either pays too
much in the first place or doesn’t adequately mesh its opera-
tions with those of the acquired company. Either way, such
deals often end in a corporate divorce. In one study done in
1992, at least 44% of the companies that were acquired were
later sold off — often at a loss. The authors of that study,
Steven Kaplan at the University of Chicago and Michael
Weisbach at the University of Arizona, found that in nearly half
of those cases, the divestitures were decidedly unhappy events.
NYU’s Sirower says mergers frequently founder because
companies are unable to make changes that produce genuine
gains in advantage against other firms. In some instances, a
merger may make even rivals keener to compete. One recent
example of an unsuccessful combination is Quaker Oats’ ill-
conceived purchase of Snapple for $1.7 billion in 1994. Quaker
shares fell 10% after the deal, and then things got worse. Soon
afterward, PepsiCo and Coca-Cola said they would introduce
products to compete with Snapple’s noncarbonated drinks.
Quaker wrote down $1.4 billion of its investment.
It’s worse yet when the company pays a premium for its target.
“You’ve got to pay back that premium before you really start to
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 generate value as a result of the acquisition,” observes Martin
CORPORATE FINANCE
Sikora, editor of Mergers & Acquisitions.
And just about everybody makes mistakes. We can’t very well
write this story without mentioning the $1.6 billion purchase
of Telerate by Dow Jones & Co., which publishes Barron’s. Late
last year Dow Jones took a charge of $900 million to write
down the value of Telerate, and recently the company agreed to
sell the unit for $510 million to Bridge Information Systems.
Writedowns are not uncommon in the world of mergers — far
from it. Take Sony’s 1989 purchase of Columbia Pictures, which
proved to be a big headache, complete with an exodus of senior
managers and spiraling production costs. In 1994, Sony wrote
off $2.7 billion of its investment. The same year, Eli Lilly
bought PCS Health Systems for $4.1 billion. Last year, Lilly
wrote down the value of PCS by $2.4 billion.
In late 1995, Sweden’s Pharmacia purchased Upjohn, with both
firms expecting to benefit from combining their drug research
operations. But a series of missteps ensued. Executives
couldn’t agree on much of anything, so the company ended up
with “corporate centers” in Stockholm, Kalamazoo, Michigan,
Milan and London. Top managers left. The much touted
powerhouse in research and development failed to mesh. There
followed an earnings collapse and a new chief executive.
In the technology sector, there are lots of examples of merger
miscues, including AT&T’s 1991 purchase of NCR, and Silicon
Graphics’ acquisition of Cray Research. Among the banking
industry’s most visible flops has been Wells Fargo’s 1996
purchased of First Interstate. Wells paid a 26% premium for
First Interstate, only to see deposits slip away and to fall short
of earnings expectations last year. Now Wells itself has become
one of the most talked about takeover targets in the banking
industry. Eventually, the costs will be wrung out of Wells,
whether by its current management or by an acquirer like U.S.
Bancorp.
Some mergers fail because they are put together by financial
experts, not by the operations folks who actually have to execute
the merger plan. Says Hindery of TCI: “I’ve never tolerated a
circumstance where the deal people felt removed from the
operating people, because that’s a recipe for disaster.”
Perhaps that is one reason for the debacle that has emerged at
Union Pacific, the new poster child for merger problems. In late
1996, Union Pacific completed its purchase of Southern Pacific,
for $3.9 billion, creating the nation’s largest railroad company.
But since then, freight shipments have been snarled, making for
the biggest shipping logjam in history. In February, Union
Pacific said it would slash its dividend and raise $1 billion to
improve its system in Texas and the Gulf Coast. But those
solutions are still to come. Last month, Dow Chemical filed
suit against Union Pacific for breach of contract, claiming that
chronic disruptions in rail service have cost Dow $25 million in
lost revenue and extra shipping charges. Shareholders have filed
suit against the company’s officers. Since the merger, Union
Pacific stock has fallen 32% to a recent 55.
The troubles at Union Pacific caused Mike Dugan, an analyst at
Delaware Management Co., to advise his company’s portfolio
managers to sell Union Pacific stock, which they had owned for
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more than five years. “As late as October, when things were
falling apart, they promised everything would be back in order
come Thanksgiving and January,” Dugan recalls. “They
continued to deny there were problems, so the Street was
caught off guard.”
That may have been because Union Pacific originally was viewed
as a class act with a good track record, having swiftly absorbed
Chicago & Northwestern rail system in 1995.
Dugan asked the right question on behalf of at least one major
mutual fund he advises, the $1.1 billion Delaware Decatur fund,
which has a very strict dividend policy on the stocks it holds. If
there’s any suggestion at all that the dividend will be cut, Dugan
and analysts working for the fund recommend the managers
sell. At a meeting with Union Pacific officials, Dugan asked
whether the dividend was safe. “I thought it was a ridiculous
question,” he recalls. “I didn’t think it would be a problem. I
expected them to say the dividend was sacrosanct. But the
answer I got suggested the dividend was open to consideration.
You know, the way we think about dividends around here, it
should take a corporate Act of Congress to cut it. And I
thought, ‘Oh, my God. There is no percentage hanging on
here.’
Besides worrying about operational problems, investors in
merged companies may soon have to keep a wary eye on
Washington regulators. For the most part, government
intervention to block mergers hasn’t been much of a concern
since the early days of the Reagan Administration. But that
seems to be changing fast. Regulators undid the proposed
merger of the office supply chains Staples and OfficeDepot, and
now the union between defense giants Lockheed and Northrop
may be similarly stymied.
Bill Baer, director of the Federal Trade Commission’s bureau of
competition, says that right now 85% of the merger filings with
his agency don’t require special scrutiny. But that percentage is
sure to shrink as merger deals grow ever larger and various
industries become more concentrated. You can be sure that
antitrust cops will be a lot more active from here on in.
Although it’s not easy to tell which mergers will pique the
interest of Washington’s antitrust regulators, academics say
there are clues to which ones will benefit shareholders most.
NYU’s Sirower has documented that the shares of acquiring
companies whose prices fall immediately after a merger an-
nouncement usually continue to deteriorate, especially if the
acquirers don’t meet their timetable for delivering projected cost
savings and other supposed synergies.
Jerrold Senser, a money manager at Institutional Capital in
Chicago, puts a lot of emphasis on executives in the merged
company measuring up to prearranged performance goals. “I try
to set up specific benchmarks or targets for management, and if
they don’t stick to it, I leave the situation... . Many mergers do
fail, that’s the reality. But in some cases, they can work really
well.”
Sometimes, good old common sense does the trick. Says Rick
Lawson, a top-performing portfolio manager of Weitz Hickory,
an Omaha-based mutual fund, “I always look to see a couple
of things. Can I see sense in the deal itself? Does it seem
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synergistic? Sometimes, so many variables are going on I can’t

CORPORATE FINANCE
see everything that’s happening.”
Predictably, a fixit industry has sprung up around the issue of
busted mergers. The publishing industry has pushed out at
least two new books this year, including Joining Forces, by
Mitchell Marks and Philip Mirvis, which addresses the psycho-
logical aspects of making mergers work, and Winning at
Mergers and Acquisitions, by Mark Clemente and David
Greenspan, which focuses on improving revenue growth to
make mergers pay off. The American Management Association
has cooked up several week-long merger workshops, including
one on how to avoid wishful thinking and achieve true synergy
in mergers and acquisitions. Some consulting firms also offer
computer programs to help mergers succeed.
One old hand at this industry is Alfred Rappaport, a former
Northwestern University business professor who with Carl
Noble, another Northwestern professor, founded Alcar, a
Skokie, Illinois, consulting firm. The outfit sells software to
help companies model the financial impact of corporate events
like mergers. It’s now run by Noble’s son. A separate consulting
company of the same name, based in San Diego, still advises
companies directly on how to make mergers succeed, and this
firm employs Rappaport, who is now a professor emeritus at
Northwestern.
The disasters at Sony, Union Pacific and Upjohn make it clear
that buying a company is one of the most dangerous things a
chief executive can do. But the reality is that Sirower, Lafferty
and various academics probably overstate the failure rate of
mergers somewhat. Like most transactions on Wall Street,
mergers offer high reward along with high risk. A study by
McKinsey & Co., for instance, found companies that do succeed
at mergers beat the stock market by 50%.
And now, at last, some of the risk in mergers may be shifting
to those investment bankers who arrange corporate marriages
and rake in huge fees — whether the marriages work out or not.
Last week, a Federal court in Oakland, California, began hearing
arguments in the case of Daisy Systems, now defunct, against
Bear Stearns. At issue is whether investment bankers have a
fiduciary duty to the clients they advise. Before long, when a
merger fails, fast-talking investment bankers who oversell deals
or mislead buyers might feel the pain right along with share-
holders. That should make tomorrow’s merger disasters a little
bit easier to bear.
Notes

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