Tuesday, 31 March 2009

M&A thinking may still be common, but does it make sense?

One of the principles of free market Capitalism is that the strong will devour the weak. And, in many cases this happens with a solid underlying financial and commercial logic. However, although the strong may devour the weak, this is no logical basis to infer that the mere act of devouring creates strength. Consequently, and all too often, Merger & Acquisition has been used by weak businesses to shore up or disguise their own lack of genuine strength.

Let us look at the mega M&A deals in the pharmaceutical sector announced in early March.

From The Times March 10, 2009

Takeovers rarely a tonic for pharmaceutical groups
Ian King: Business Commentary

Faced with some unpleasant ailments, the pharmaceutical industry's biggest players are reaching for a familiar old remedy in the medicine cabinet — M&A. In January Pfizer splashed out $68 billion for Wyeth, yesterday Merck agreed to pay $41.1 billion for Schering-Plough and last night Roche looked set to buy the 44 per cent of Genentech, the biotech giant, that it does not already own for $46.7 billion. ………

………….. The question is what happens next in the industry. With company values depressed, because of recent market falls, the big fear for executives is that they miss out on a wave of industry consolidation and, as a result, are pushed down the global pecking order.

This is why shares in GlaxoSmithKline fell yesterday. As the industry's second-biggest player, it is under more pressure than most to do a big deal, despite the protests of Andrew Witty, its chief executive, that he is not interested in M&A. It is also why shares in AstraZeneca and Shire Pharmaceuticals rose sharply. They, with Bristol-Myers Squibb, are all possible targets in any round of deals taking place soon.

Yet the scepticism of Mr Witty and others who are constantly being told that they need to do a deal, such as Novartis and Sanofi-Aventis, looks well-founded. The majority of mergers and takeovers destroy value and, in the case of the drugs industry, M&A activity has conspicuously failed to deliver the promised returns. This is because, more than most, pharmaceuticals is a “people” business, with scientists at its heart. Cost-cutting after a big merger or takeover, although giving earnings a short-term boost, is not compatible with research and development programmes stretching out over decades.

In any case, many big drug companies are already incredibly bureaucratic. Making them even bigger will not solve this problem. For that reason, it is to be hoped that Mr Witty will stick to his guns, concentrating not on delivering a small number of highly profitable blockbusters but on a larger number of less profitable new products. In doing so, Mr Witty will, rather like users of GSK's Nicorette quit-smoking gum, need formidable powers of willpower. He will face intense pressure to do a deal from investment banking advisers in the next few months.

Our emphasis in bold.

Ian King's inciteful article highlights once again how “investment banking advisers” are seen to be trying to steer company policies in directions for which the only certain benefit is to themselves. And, once again, some executives are described as being in fear of them, this time of being “pushed down the global pecking order”.

GSK, under Andrew Witty’s predecessor, the gifted and radical leader Jean-Pierre Garnier, was transformed from a monolithic, over-centralised, bureaucratic, under-responsive battleship into its current form as a well co-ordinated fleet of highly responsive, flexible, agile, and enterprising, commercially acute, gun-boats. J P Garnier left GSK able to generate a consistent and sustained stream of new products and consequent profits – no longer gambling on occasional massive windfalls. His legacy, so well understood by Witty, is substantial Comparative Competitive Strength, with very high changeability embedded in both depth and spread. This is Common Sense – but anathema to the “me-first-get-rich-quick” mentality of the “investment banking advisers” – what a surprise.

Why does anybody spend any time at all listening to people whose advice will deliver virtually guaranteed benefits to themselves but highly uncertain prospects for those acting on their advice?

Suppose a smartly dressed person turns up at your front door and tells you that they have an amazing and exclusive deal for you? They say that they are an Estate Agent (let’s forget any prejudices, please) and that because of their special and privileged relationship with a Mortgage Provider they can enable you to become wealthier by buying a bigger house whilst remaining within your current means – just like that!

And you, like an idiot, agree.

It seems reasonable that the house deals and the mortgage deal will be handled by the Estate Agent; that you pay some “arrangement fees”, and even that your payments although unchanged are now guaranteed only for a fixed period. And now you have a property that is “worth” 25% more than your previous home – you have become more wealthy!

However, it may have escaped your attention that you now own only 20% of the apparent equity in your new house compared to the 35% you held in your old home. The good news is that should property values rise, your equity level will increase disproportionately – you have “leverage”. The bad news is should property prices fall, then you could end up right where you started, or worse. The very bad news is should interest rates rise, then after your fixed term expires, you may face payment levels you cannot sustain and disaster.

The only certain winners in this scenario are the instigators, the Estate Agent, and their financial backers, the Mortgage Providers. The instigators take a slice of your money whilst ensuring that you take all the increased risk.

Wouldn’t you have to be an idiot to fall for such a deal?
Can you imagine that anyone might be stupid enough to do that?
That cannot be Common Sense – can it?

Now if we substitute “Investment Banking Adviser” for the words “Estate Agent” and “Investment Funds” for “Mortgage Provider” we might recognize the story on a larger scale – and if we swap “executive” for “you”, we complete the match. The instigators take a slice of the Shareholder’s money whilst ensuring that the Shareholders take all the increased risk.

Wouldn’t the executives have to be idiots to fall for such a deal?
Can you imagine that any shareholders might be stupid enough to support that?
That cannot be Common Sense – can it?

Well – hundreds of them did – tens of thousands of you did.

It was not Common Sense – commonality did not make it sensible – it never does.

The only way out from this madness is to return to a solid focus on tangible wealth creation – to get back to Common Sense. The only reliable indicator of tangible wealth is deep underlying sustained long term profitability – the investment criteria upon which Warren Buffet patiently, steadily and lengthily, built his own and many other’s fortunes. But, because history takes too long, you cannot spot the tangible wealth creators in advance – or can you?

The most reliable determinant of massive financial strength, potentially solid wealth, is Excellence. Robust academic research has proved beyond reasonable doubt that the very best businesses in the world can deliver financial returns that are 50% to 100% better than the average. Take care here about which is the chicken and which is the egg – it is being the very best in every aspect of what they do that delivers the exceptional financial results of these businesses – it is not the money that makes them the very best, that is simply an outcome of being the very best.

Whilst Excellence is a well researched concept its connection to superior financial performance and long-term business growth and sustainability is not widely understood, especially in the financial sector. Consequently the application of the thinking and disciplines needed for Excellence is patchy at best and far too many business leaders think that being Better than Average is good enough. Furthermore, many cannot tell the difference between Big and Excellent – maybe psychologists can help us understand whether these sad souls confuse “global pecking order” with “pecker order”?

If you want to know more about all this, how you can spot the tangible wealth creators in advance and why Common Sense pays off handsomely, please have a look at our website where you will find out about - Competitive Strength, what this is and why it is crucial to financial performance – and about Changeability, the essential attribute for Excellence.

Capitalism or .... Common Sense is brought to you by Steve Goodman and Tony Ericson. It is one of our "Excellence Quartet" of blogs promoting the cause of Excellence as the key to prosperity. Each blog has a new article each month using a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques. You can read the other three blogs at “Exceeding Expectations", "You're having a laugh ... Seriously?", "Business Bloop of the Month Award".

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