Automatic Sprinkler Corporation
In the 1960s, one company was truly creative in financing its acquisition program. It used a convertible preferred stock that paid no cash dividend at all (convertible preferred stock is similar to a convertible bond in that the preferred dividend is a fixed obligation of the company. But neither the principal nor the preferred dividend is considered a debt, son your company can usually skip a payment with greater freedom. Of course, in this example, the stock paid no cash dividend at all). Instead, the conversion rate of the security was to be adjusted annually to provide that the preferred stock be convertible into more common shares each year. The older pros in Wall Street shook their heads in disbelief over these shenanigans.
Automatic Sprinkler Corporation (later called A-T-O Inc. and later still, at the urging of its modes chief executive officer Mr. Figgie, Figgie International) is a good example of how the game of manufacturing growth was actually played during the 1960s. Between 1963 and 1968, the company’s sales volume rose by over 1,400 percent. This phenomenal record was due solely to acquisitions. In the middle of 1967, four mergers were completed in a twenty-five-day period. These newly acquired companies were all selling at relatively low price-earnings multiples, and thus helped to produce a sharp growth in earning per share. The market responded to this growth by bidding up the price-earnings multiple to over 50 times earnings in 1967. This boosted the price of the company’s stock from about $8 per share in 1963 to $73 5/8 in 1967.
Mr. Figgie, the president of Automatic Sprinkler, performed the public relations job necessary to help Wall Street build its castle in the air. He automatically sprinkled his conversations with talismanic phrases about the energy of the free-form company and its interface with change and technology. He was careful to point out that he looked at twenty to thirty deals for each one he bought. Wall Street loved every word of it.
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| Chinatown Old Buildings. Photo by Elena |
Mr. Figgie was not alone in conning Wall Street. Managers of other conglomerates almost invented a new language in the process of dazzling the investment community. They talked about market matrices, core technology fulcrums, modular building blocks, and the nucleus theory of growth. No one from Wall Street really knew what the words meant, but they all got the nice, warm feeling of being in the technological mainstream.
In the 60s conglomerate managers found a new way of describing the business they had bought. Their shipbuilding businesses became “marine systems.” Zinc mining became the part of the “protective services division.” And if one of the “ungentlemanly” security analysts (somebody from CCNY rather than Harvard Business School) had the nerve to ask how you can get 15 to 20 percent growth from a foundry or a meat packer, the typical conglomerate manager suggested that his efficiency experts had isolated millions of dollars of excess costs; that his marketing research staff had found several fresh, uninhabited markets; and that the target of tripling profit margins could be easily realized within tow years. To this add talk of breakfast and Sunday meeting with your staff, and the image of the hardworking, competent, go-go atmosphere is complete.
Instead of going down with merger activity, the price-earnings multiples of conglomerate stocks rose higher and higher. Prices and multiples for a selection of conglomerates in 1967 are shown in the following table:
Security, 1967 (high prices, price-earnings multiple), 1969 (low price, price-earnings multiple)
- Automatic Sprinkler (A-T-O Inc.) 73 7/8; 51,0. 10 7/8, 13.4
- Litton Industries 120 1/2, 44.1; 55, 14.4
- Teledyne Inc. 71 1/2, 55.8. 28 1/4 14.2
- Textron, Inc. 55. 24.9. 23 1/4, 10.1.
The music slowed drastically for the conglomerates on January 19, 1968. On that day, the granddaddy of the conglomerates, Litton Industries, announced that earnings for the second quarter of that year would be substantially less than had been forecast. It had recorded 20 percent yearly increases for almost an entire decade. The market had so thoroughly come to believe in alchemy that the announcement was greeted with disbelief and shock. In the selling wave that followed, conglomerate stocks declined by roughly 40 percent before a feeble recovery set in.
Worse was to come. In July, the Federal Trade Commission announced that it would make an in-depth investigation of the conglomerate merger movement. Again the stocks went tumbling down. The Securities and Exchange Commission and the accounting profession finally made their move and began to make attempts to clarify the reporting techniques for mergers and acquisitions. Perhaps weak parts do not a strong whole make. The sell orders came flooding in. These were closely followed by new announcements from the SEC and the Assistant Attorney General in charge of antitrust, indicating a strong concern about the accelerating pace of the merger movement.
The aftermath of this speculative phase revealed two disturbing factors. First, conglomerates were mortal and were not always able to control their far-flung empires. Indeed, investors became disenchanted with the conglomerate’ new math; 2 plus 2 certainly did not equal 5 and some investors wondered if it even equaled 4. Second, the government and the accounting profession expressed real concern about the pace of mergers and about possible abuses. These two worried on the part of investors reduced – and in many cases eliminated – the premium multiples that had been paid for the anticipation of earnings from the acquisition process alone. This in itself makes the alchemy game almost impossible, for the acquiring company has to have an earnings multiple larger than the acquired company if the ploy is to work at all.
The combination of lower earnings and flattened price-earnings multiples led to a drastic decline in the prices of conglomerates, as the preceding table indicates. It was the professional investors who were hurt the most in the wild scramble for chairs. Few mutual or pension funds were without large holdings of conglomerate stocks. Castles in the air are not reserved as the sole prerogative of individuals; institutional investor can build them, too. An interesting footnote to this episode is that by the 1980s deconglomeration came into fashion. Many of the old conglomerates began to shed their unrelated, poor-performing acquisitions in order to boost their earnings.
Many of these sales were financed through a popular innovation of the 1980s, the leveraged buyout (LBO). Under an LBO the purchaser, often the management of the division assisted by professional deal makers, puts up a very thin margin of equity, borrowing 90 percent or more of the funds needed to complete the transaction. The tax collector helps out by allowing the bought-out entity to increase the value of its depreciable asset base. The combination of high interest payment and larger depreciation charges ensures that taxes for the new entity will remain low or nonexistent for same time. If things go well, the owners can often reap windfall profits. William Simon, a former secretary of the Treasury, made a multimillion-dollar killing on one of the earliest LBOs of the 1980s, Gibson Greeting Cards. The LBO wave accelerated dramatically during the late 1980s. Of course if economic conditions turn sour, the high interest costs are likely to place the new entity in considerable financial jeopardy. The early 1990s witnessed the financial fallout from the explosion of some of the most poorly considered leveraged buyouts, conceived during the 1980s.
