The Aftermath of the Merger Mania
JOHN E. LANGDON
Hundred! of thousands of dollars are lost annually in Canada through careless investment. Fraudulent and worthless securities are being constantly poured on to the market to trap the unwary. A general observance of this simple maxim will assist in the reduction and elimination of this economio waste—
‘BEFORE YOU INVEST—INVESTIGATE’
IN EVERY period of prosperity and inflation, stock promoters are busy. But promoters do not confine their activities to forming new companies to exploit new ideas. They are just as ready to make their profit in another way; such as by taking two or more existing companies and joining them together to make one company.
This is what is known as a merger.
Mergers come about in many ways. Usually there will be found in the background, directing operations, the figure of the promoter, who, rightly enough, expects to be paid for his services. But it cannot be said that all the merger promotions launched ujxjn Canadian investment seas have been soundly or even honestly designed and built by these usually well-paid promoters. In what follows we are chiefly concerned with the promotional merger rather than those mergers effected by men in an industry who link their fortunes together without asking for public stock subscriptions.
The years 1900 to 1910 were prosperous years in Canada, and in that period several score large mergers or combines were launched in the Dominion. Many of these have stranded on the reefs and have been salvaged only at great cost. Others have disappeared from view entirely. A few of them stand today among Canada’s greatest corporations. But most of even the successj ful ones stand as monuments to the good managements they have had, rather than to promoters’ zeal.
Again from 1925 to 1928, when things were going well in Canada, when an unenquiring investment public was hungry for securities, when the growth of big business dictated the development of big businesses, when the promoter’s only problem was where could he buy an idea or a company and not where could he sell it. there was another era of merger mania in Canada. Today these mergers are going through the testing period. Some are coming through strongly; others are already crumbling.
The investing public is learning that there is no magic in mergers; that a merger per se is not necessarily right or wrong; that the ! stocks or bonds of a merger, offered to the j investor, have to be subjected to all the I rigorous tests that would be applied to the securities of any single company.
Few investors in this country have not at one time or other purchased the securities ! of a Canadian merger. Sometimes the investment has turned out to be gilt-edged. Probably more often it has not.
It stands to reason that the securities of all mergers cannot be ranked as either a safe or an unsafe outlet for investment funds. Many merger stocks have been highly profitable such as those of Montreal Light. Heat and Power Consolidated, Imperial Tobacco Company of Canada, Steel Company of Canada, Bell Telephone Company of Canada, and The Moore Corporation. For every successful merger, however, there are two or more that have failed.
Irrespective of past history, Canada will continue to have mergers. Their securities will be offered to the investing public. The same glowing promises will be made, and the ! record of failure and success in the future ! probably will not differ much from that of . the past decade or two.
It is, therefore, valuable for investors to study the general financial record of the merger movement in Canada.
Up to date. Canada has had some 200 large mergers, covering nearly every field of economic activity, which the public
has been asked to support through the purchase of securities. The Golden Age of consolidations was between 1925 and 1929, when over sixty mergers were brought into being. With the record of these companies to go on, it is possible to deduce general conclusions bearing upon the gxxl and bad features of mergers..
HTHEORETICALLY, consolidation of a group of companies in allied lines makes for the most profitable employment of capital. Actually, such is not always the case. The pathway of mergers is strewn with blasted hopes.
There are two broad classifications of mergers—those to achieve mass production, and those to achieve mass distribution. The former was the type prevailing in the earlier part of this century, when production on a large scale was regarded as the panacea for all industrial ills. The latter is a more recent development, brought along by the realization that with production on a low-cost basis, further gains in profit, aside from a normal increase in sales, are to be had only from more economical distribution.
Mergers have developed their own lingo. There are horizontal, vertical and circular mergers. The first is the more common, and in it a group of companies in the same line of business are merged and competition is eliminated or reduced to negligible proportions. The second type links together a number of companies engaged in different steps in the production of commodity from raw material to finished goods. The last covers the acquisition of businesses whose types are allied to the parent company and whose results can be improved under consolidated operation.
Some writers believe that the economic forces behind the consolidation movement are irresistible; that the results already achieved are sufficient to demonstrate that the advantages of free competition, from the point of view of the people as a whole, are outweighed by those of co-operation.
Different branches of economic effort profit from unification in different ways and in different degrees. In manufacturing, the chief savings which mergers can bring are in the handling of materials, the use of larger machinery, the better division of labor, the virtual integration of successive processes, the more efficient making and marketing of by-products, the better geographical division of functions among different plants, and the joint expenditure of large sums of money on research.
Other advantages that are always sought and sometimes gained are almost universal in their application. These include largescale buying and selling, more even distribution and stabilization of activity among different operating units, the more effective use of advertising and selling methods, the lower cost ot capital, higher priced management, closer regulation of output, and the elimination of the abuses that almost invariably arise under conditions of severe competition.
The Merging Process
lHESE are the theoretical benefits of a merger. But more often than not these benefits are thought of only after the promoter has optioned different companies and starts putting them together. During the 1925-1929 period, when new capital was to be had without difficulty, the promoter reaped a harvest in taking options on
properties, creating mergers and selling out to the investment banker, who was anxious to get new securities to sell to the public, more especially when they were backed by established companies.
With all the apparent advantages of a merger, one might reasonably ask, why such a large percentage of unsuccessful consolidations? Every case must provide its own answer, but there are certain broad generalities to be observed. In the first place, many Canadian mergers of recent years were not justified by economic exigencies. Secondly, there was a tendency to capitalize on a basis out of line with the earning power of the organization. And thirdly, it has been found that the sum total of two or three inefficient managements is not one good management but one exceedingly bad one. Then, many a consolidation has started out under the most favorable auspices but, due to uncontrollable factors, has met with reverses.
One cause of failure is often present. This is plain, ordinary greed. Let us trace through a typical promotional merger of the worst but very common sort. It is purely a hypothetical case.
The promoter goes to all the big companies in, let us say, the florist industry. We mention this industry because there has never been a big merger in it. He says to the different proprietors:
‘‘Let us merge in one company all the big greenhouses from coast to coast. We’ll be able to get a virtual monopoly of the flower trade; we’ll be able to hire better managers and better scientific experts; we’ll buy our seeds and bulbs in larger quantities and save money; we’ll eliminate useless price-cutting; we’ll do joint advertising that none of you can afford now; we’ll establish a research laboratory; we’ll operate our own glass plant and our own tile-pot plant; we’ll run our own retail outlets later on.” etc., etc., endlessly.
Finally the promoter gets the ten biggest florists to come in. They agree that a fair price for each company will be 25 cents per bloom of annual output or something like that. But one of the companies holds out for 30 cents per bloom, so the price will probably have to be raised for all of them in order to induce this one company to come in, or perhaps the promoters will give the hold-out a secret bonus on the side. At last the promoter has all his options signed up. They call for payment of $1,000,000 of cash.
Then he goes to the investment banker. The investment banker says, “I’ll give you $200.000 for your options.” The investment banker then decides to sell $1,500,000 of bonds, Class A stock or preferred stock, the proceeds being divided something like this:
To the original owners............. $1,000,000
To the promoter ....................... 200,000
Cost of selling stock ................... 150,000
Ixgal and other expenses ......... 50,000
Cash profit to investment banker 100,000
In addition, there will be an issue of, say, 100,000 shares of common or possibly of so-called Class B stock, which will be split various ways, some going to the banker, some to the promoter, some to the original owners, and some to the people who buy the bonds or senior stocks. This Class B stock will probably be listed, and may sell for, let us say, $5 a share or another $500,000.
This means a total market capitalization for the merger of $2.000.000 as against the price originally paid the owners of the different companies—who held out for all they thought their plants, were worth and possibly more—of $1,000.000.
The question arises: Does $1,000,000 of
tesorted assets acquire an additional value tf $1,000.000 simply because they are in one jtompany? Will they have increased earning Enver to justify such advance in value?
’ The answer is now being written in the lase of dozens of companies, and, unhappily ¡¡or investors, it is in most cases. No.
Why Merger Earnings Decrease
NOT all mergers have been financed on any such insane basis. But many of them have been worse than this purely hypothetical example.
One may ask why it is that investors will buy the securities of a merger whose assets have been so grossly inflated in value. Usually it is because of an attractive balance sheet or record of earnings.
It is, of course, very simple for the promoters or bankers to put out a balance sheet writing up the value of the assets. Writing up assets is often perfectly proper. A man operating a private business may carry his property at $200.000 on his books, but its real value may be $400,000. And in a balance sheet presented to the public it would be proper to value those assets at $400,000. But the process is also capable of much abuse.
Of course, when the securities are offered there will be presented to the investor a consolidated earnings statement indicating what have been the combined earnings of all the companies in the few years prior to the merger. And usually an estimate will be given of what the earnings are expected to be ‘‘after giving effect to economies that are contemplated.”
Why is it that so often the earnings of the merger company fail to come up even to the combined earnings figures shown in the prospectus, much less to the larger earnings projected? The reasons vary.
Sometimes the big business proves less efficient than the small family businesses.
Sometimes it is because the merger has been put through just at the peak of prosperity in the particular field served. The men in the business have been glad to sell out just before the tide turned against them.
In most cases the consolidated earnings 1 accounts are shown “after allowance for non-recurring charges." But for every j dollar of charges that do not recur, there is j usually another dollar of charges that has j not been allowed for.
A frequent cause of disappointing earnings is that most mergers undertake a programme of expansion, and if this programme is not skilfully directed the losses on new plants and new products may offset most of the established earnings available.
Finally, another reason why some mergers fail to earn what is promised for them is , that the establishment of one large company | out of the major units in the field opens up Í opportunities for a host of new and smaller independents to come in and take a share j of the business. These independents either ' have to be bought out or they remain a : disturbing competitive factor.
Management and its previous record warrants the closest examination by the ; investor who contemplates purchase of a ; merger security. Without the proper leader' ship, all other favorable factors are minimized. Permanent prosperity cannot be enjoyed by any merger that is not operated by a management fully alive to its responsibilities and capable of handling the affairs of the enterprise.
Responsibility of the investment house sponsoring the enterprise also warrants the consideration of the investor. Those bankers associated with the financing of successful mergers should receive a greater share of the investor’s confidence than those whose flotations have worked to the disadvantage of the investor.
Obviously there is no formula telling the investor what merger securities he may 1 or may not purchase with confidence. Knowj ledge of the management and those directing j the affairs of the company, and faith in the ! bankers back of the merger, are primary ¡ essentials before investing.
The main thing is to avoid being bitten by j that particular bug which makes so many investors think that a company is bound to be successful simply because it is big.
Some Successful Canadian Mergers
Canada Backers 1927 Good Management Imperial Tobacco 1912 ( hxxl Management Montreal Bower 1918 Gtxxl Management Sherwin-Williams 1911 lood Management Moore Corporation 1928 Good Management Steel Co. of Can. 1911 ( Icxxl Management Canada Cement 1909 Good Management Dominion Textile 1909 Good Management Some Unsuccessful Canadian Mergers Company Merged Reasons for failure What Happened Asbestos Corporation............ 1925 Overea pi t al i za t ion ; un w ise Reorganized management Canada Baving..................... 1928 I.oss of [X'rsonal touch in Receivership management Canada Power and Bapcr...... 1928 Overcapitalization; overReorganized expansion of industry; investment banking management Canadian Department Stores 1927 Excessive price paid for Bought from liquidator by declining businesses I’. Eaton Co., Ltd. Consolidated Food Broducts 1928 Unsound financial manageReorganized under new ment; poor merchandizing managers British Empire Steel.............. 1920 Extravagant capitalization Reorganized and operation