Virtue of Merger

Virtue of Merger

Suppose we have two companies – the Able Circuit Smasher Company, an electronics firm, and Baker Typewriter Company, which makes typewriters. Each has 200,000 shares outstanding. It’s 1965 and both companies have earning of $1 million a year, or $5 per share.. Let’s assume neither business is growing and that, with or without merger activity, earnings would just continue along at the same level.

The two firms sell at different prices, however. Since Able Circuit Smasher Company is in the electronic business, the marker awards it a price-earnings multiple of 20, which, multiplied by its $5 earnings per share, gives it a market price of $100. Baker Typewriter Company, in a less glamorous business, has its earning multiplied at only 10 tomes and, consequently, its $5 per share earnings command a market price of only $50.

The management of Able Circuit would like to become a conglomerate. It offers to absorb Baker by swapping stock at the rate of two for three. The holders of Baker shares would get two shares of Able stock – which have a market value of $200 – for every three shares of Baker stock – with a total market value of $150. Clearly this is a tempting proposal, and the stockholders of Baker are likely to accept cheerfully. The merger is approved.

We have a budding conglomeratte, newly named Synergon, Inc. which now has 333,333 shares outstanding and total earnings of $2 million to put against them, or $6 per share (there are 200, 000 original shares of Able plus an extra 133,333, which printed up to exchange for Baker’s 200, 000 shares according to the terms of the merger. Thus, by 1966 when the merger has been completed, we find that earnings have risen by 20 percent, from $5 to $6, and this growth seems to justify Able’s former price-earnings multiple of 20.

Virtue of merger. Photo by Elena

Consequently, the shares of Synergon (née Able) rise from $100 to $120, everybody’s judgement is confirmed, and all go home rich and happy. In addition, the shareholders of Baker who were bought out need not pay any taxes on their profits until they sell their shares of the combined company.

A year later, Synergon finds Charlie Company, which earns $10 per share or $1 million with 100,000 shares outstanding. Charlie Company is in the relatively risky military-hardware business so its shares command a multiple of only 10 and sell at $100. Synergon offers to absorb Charlie Company on a share-for-share exchange basis. Charlie’s shareholders are delighted to exchange their $100 shares for the conglomerate’s $120 shares. By the end of 1967, the combined company has earnings of $3 million, shares outstanding of 433,333, and earnings per share of $6.92.

Here we have a case where the conglomerate has literally manufactured growth. Neither Able, Baker, nor Charlie was growing at all. Yet simply by virtue of the fact of their merger, the unwary investor who may finger his toock guide to see the past record of our coglomerate will find the following figures of earnings per share – $5.00 in 1965, $6.00 in 1966 and $6.92 in 1967.

Clearly, Synergon is a growth stock and its record of extraordinary performance appears to have earned it a high growth.

The trick that makes the game work is the ability of the electronic company to swap its high-multiple stock for the stock of another company with a lower multiple. The typewriter company can only “sell” its earnings at a multiple of 10. But when these earnings are packaged with the electronics company, the total earnings (including those from selling typewriter) could be sold at a multiple of 20. And the more acquisitions Synergon could make, the faster earnings per share would grow and thus the more attractive the stock would look to justify its high multiple.

The whole thing was like a chain letter – no one would get hurt as long as the growth of acquisition proceeded exponentially. Of course the process could not continue for long, but the possibilities were mind-boggling for those who got in at the start. It seems difficult to believe that Wall Street professionals could be so myopic as to fall for the conglomerate con game, but accept if they did for a period of several years. Or perhaps as subscribers to the castle-in-the-year theory, they only believed that other people would fall for it.

The story of Synergon describes the standard conglomerate earnings “grows” gambit. There were a lot of other monkey-shines practiced. Convertible bonds (or convertible preferred stocks) were often used as a substitute for shares in paying for acquisitions. A convertible bond is an IOU of the company, paying a fixed interest rate, that is convertible at the option of the holder into shares of the firm’s common stock. As long as the earnings of the newly acquired subsidiary were greater than the relatively low interest rate that was placed on the convertible bond, it was possible to show even more sharply rising earnings per share than those in the previous illustration. This is because no new common stocks at all had to be issued to consummate the merger, and thus the combined earnings could be divided by a smaller number of shares.

Sources: Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.