Custom Search

Merger Tactics

In recent years, most mergers have been agreed upon by both parties, but occasionally, an acquirer goes over the heads of the target firm`s management and makes a tender offer directly to its stockholders. The management of the target firm may advise shareholders to accept the tender, or it may attempt to fight the bid in the hope that the acquirer will either raise its offer or throw in the towel.

The rules of merger warfare are largely set by federal and state laws6 and the courts act as referee to see that contests are conducted fairly. We will look at one recent contest that illustrates the tactics and weapons employed. Outside the English-speaking countries hostile takeovers once were rare. But the world is changing, and the nearby box describes a recent takeover battle between Italian companies.

Blades, Batteries, and a Fifth of Gillette

Back in 1988, when Kraft Inc. decided to unload its battery subsidiary, Gillette Co. was tempted. But the bidding went up and up and out of Gillette`s reach. Kohlberg Kravis Roberts & Co. eventually bought the battery maker ¤ it was Duracell, of course ¤ for a seemingly extravagant $1.8 billion.

After eight years of due diligence, Gillette has finally agreed to fork over stock valued at more than $7 billion for the very same Duracell International Inc. Just as KKR now looks shrewd, rear-view analysts may snicker at Gillette for buying dear what it could have had then for, let us assume, only $2 billion in stock.

In fact, Gillette shareholders should thank their lucky stars the earlier deal didn`t happen. In share-for-share acquisitions, what you are getting is only half the picture; what you are giving up is just as important. The standard analysis values such deals according to the dollar value of the target, but that approach is flawed. The key question isn`t whether Duracell is worth $7 billion, because Gillette isn`t giving up $7 billion. It is giving up a part ¤ in this case 20% ¤ of itself.

Schematically, Gillette is trading razor blades for batteries (not bucks for batteries), and the results can be very different. Since 1988, for instance, the blade business, at least under Gillette`s management, has performed much better than batteries. While Duracell`s stock has quadrupled, Gillette`s has multiplied eight times. Thus if Gillette had in fact made that ¬ cheap ­ $2 billion acquisition, it would have acquired a jack rabbit but given up a prize thoroughbred. The passed-over purchase back then would have cost Gillette more than one-third of its stock; today, it is buying the same business for only a fifth of its stock.

Clearly, taking a pass was the right move. Duracell was cheap in 1988, but Gillette was cheaper. And shopping with inexpensive currency, meaning issuing undervalued stock, amounts to selling the company (or a piece of it) on the cheap.

Going forward, the same analysis holds. The imputed dollar value of the deal will forever drift with Gillette`s share price; the one constant is that each shareholder is trading away one-fifth of his interest in the old Gillette. Whether Duracell will be worth it, a subject no analyst has addressed, is what matters.

Such deals are manna for investment bankers (and bound to wind up in B-school texts) because you need to size up two businesses instead of one.

On balance, the blade business is more distinct, and better, than batteries. But how much better? Duracell for one-fifth of Gillette works out to this: For each dollar of Gillette earnings that shareholders are giving up, they are getting roughly $1.30 in cash earnings from batteries. Blades should trade at a premium, but this one is steep. That premium, of course, reflects the current very high price of Gillette`s stock, which in turn reflects a view that Gillette will forever keep profit growing twice as fast as its sales. Gillette`s managers wouldn`t come out and say that 34 times earnings reflects unwarranted optimism, or even a bull-market joie de vivre, but if that is what they thought, trading part of their company at that price for a cheaper one would be a smart move. And that is what they are doing.