When 1 + 1 < 2

When 1 + 1 < 2

When 1 + 1 < 2

Aug. 8 1997 3:30 AM

When 1 + 1 < 2

Today's "consolidation" mergers make no better economic sense than yesterday's conglomerations.

"We look at it like this: The big fish eats the small fish and the small fish eats the shrimp. You buy or get bought. It's a law of economics," Vice Director Shi Jianping of the Shanghai Rubber Belt Co. told the Wall Street Journal earlier this week. Merger mania, you see, is sweeping the People's Republic. Soon, instead of hundreds of small companies all making identical rubber belts there will be one giant company making all the rubber belts. It'll be just like the market for PC operating systems in the United States.

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As it happens, Shi Jianping's description of today's China sounds quite a bit like today's United States. Mergers and acquisitions are back in a big way, and the new buzzword is "consolidation." Since 1995, M & A activity has risen to record levels, both in terms of raw numbers and size. Telecommunications, defense, aerospace, mass media: In all these industries the number of players has been significantly reduced over the last three years. Emboldened by a new approach to antitrust law at the Justice Department and Federal Trade Commission--one that suggests that unless you're doing something that will immediately raise consumer prices, it's A-OK with them--giant companies that previously would never have imagined merging have tied the knot. This rediscovery of the art of the deal makes it seem like the 1980s all over again.

Except that in some interesting and important ways, it isn't. In the first place, a much higher percentage of these mergers and acquisitions are taking place within, rather than across, industries, which is why we hear a lot more about consolidation and a lot less about synergy or conglomeration. Instead of USX buying Marathon Oil in a desperate attempt to diversify into a business it hadn't proved it couldn't run, we have Boeing buying McDonnell Douglas, British Telecom buying MCI, and Raytheon buying Hughes Electronics. In addition, the vast majority of M & A activity today is friendly. The big fish may be eating the small fish, but the small fish seem more than happy to be eaten. In this new win-win world, there's something almost unseemly about hostile takeover attempts.

Of course, that only makes it all the more interesting, and the more telling, when they occur.

Union Pacific Resources is an independent oil and gas driller, which means it specializes in getting as much out of a given field's reserves as possible. It used to be part of Union Pacific Corp., the transportation giant that laid railway track across the United States. As part of its desire to focus on its core, UP spun off UPR two years ago. The oil company is blessed with very little debt, but it's grown relatively slowly since the spinoff, because it doesn't have many reserves and lacks the wherewithal for massive exploration projects.

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Enter Pennzoil. Or rather, re-enter Pennzoil. Pennzoil makes ... well, Pennzoil motor oil. It also owns Jiffy Lube--oil changes/motor oil; is that synergy or consolidation? And it has a growing oil-and-gas exploration business. Two years ago, Pennzoil approached Union Pacific with an offer to merge, figuring its extensive reserves would fit well with UPR's intensive drilling. But Union Pacific rebuffed Pennzoil (actually, it was more a simple failure to call back than an explicit rejection). And so Pennzoil turned itself around, selling off less profitable fields, expanding its exploration business, strengthening Jiffy Lube. Last year the company turned its first profit since 1993, and earnings for the last quarter were up sharply--much more sharply than UPR's--over the year before. Not surprisingly, that's when UPR decided to come a-calling.

A little more than a month ago, UPR announced a tender offer of $84 a share--a 41-percent premium over Pennzoil's previous closing price--including a commitment to buy 50.1 percent of Pennzoil's shares at the offer price. If UPR were to gain control, it would buy up the remaining shares at market price. More than 60 percent of Pennzoil's shares were tendered by the deadline. Game over, right?

Not quite. Pennzoil's management and board of directors vehemently opposed the takeover. They insisted the company's long-term value was much greater than $84 a share, and that UPR was trying to pick it up before the effects of the turnaround had been felt by investors. And Pennzoil has a "poison pill" provision, which means that as soon as 15 percent of the company's shares are acquired by a hostile bidder, every other Pennzoil shareholder gets to buy newly issued Pennzoil shares at a substantial discount. Obviously, that would make any buyout attempt prohibitively expensive.

Now poison-pill plans and other scorched-earth strategies to frustrate takeovers--like the sale of valuable assets or the assumption of insane levels of debt--seem to violate the principle that those who own the company, the shareholders, should be able to decide what to do with it. If we want shareholders to think like owners and not speculators, taking away that power hardly seems the answer.

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On the other hand, the way tender offers are structured almost guarantees they'll be accepted. If you're one of the few shareholders who doesn't tender her stock, UPR is only going to pay you the market price for your shares, and you have no guarantee that will be more than $84. What that really means is that any company with the financial ability to launch a tender offer--and given the ease with which financing can be found, that means essentially any company--can bring about the dissolution of its target. A study in the 1980s, in fact, found that four out of every five tender offers resulted in the target being absorbed by one firm or another.

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F or free-market purists, there's nothing wrong with this. If a company's management hasn't done right by its shareholders, takeovers are an appropriate remedy. For these believers in the efficient market, a company's stock price always reflects its true value. There's only one problem with this: It makes no sense.

In a market of 10,000 stocks, short-term prices will rise and fall for an infinite variety of reasons, very few of which have anything to do with a company's real productivity or value. Dell Computer, for instance, would be at least five times as hard to acquire today as it was a year ago. But only a fool--or a Chicago School theorist--would say that Dell is five times as valuable to the economy today as it was a year ago. Placing the entire future of a corporation in the hands of arbitrageurs, which is what a tender offer amounts to, is the worship of property rights run amok. Yet how to come up with a solution that would protect long-term shareholder rights while making tender offers less automatically successful? Wasn't it Warren Buffet who suggested a 100 percent capital gains tax on any investment held less than a year? That might work.

Most scholarly studies of hostile takeovers show they have little or no impact on productivity, profitability, or on the acquiring company's long-term stock price. Plenty of wealth is redistributed, but it's not really clear that any is created. Although bidders tend to portray themselves as rescuing ailing companies--UPR said it was reacting to "a decade of broken promises and poor performance" at Pennzoil--in fact they almost uniformly bid for profitable, healthy companies that the market, for one reason or another, is undervaluing. The new American vogue for mergers may be making the economy stronger, though the jury is still out on that question. But in a hostile takeover, it seems pretty clear, one plus one generally doesn't equal three. Often, it doesn't even equal two. Hard as it may be to remember in a bull market, society doesn't get any richer when UPR exchanges its cash for Pennzoil's shares. Of course, investment bankers, lawyers, and speculators do.