Joys and Jitters of Growth by Acquisition

 

In business, growth by acquisition is like the cool kid at the table – it’s flashy, ambitious, and enjoys an elevated status. However, investors beware of the upsides and downsides of this strategy.

I always say that offense is the best defense. For that reason, I like growth by acquisition companies. I am cautious however, because the advantages of this strategy come with risks, and not acquisitions are successful.

Joys of growth by acquisition

First the upsides. Picture this: a company eyeing expansion can snatch up another company to leapfrog in its evolution. Here are some perks of this strategy.

Accelerated Growth

Think of growth by acquisition as turbocharging a business. Instead of waiting for organic growth to kick in, acquiring another company speeds up the process to swiftly gain market share, customer base, or even new technology. Take Alimentation Couche-Tard’s many acquisitions, such as Circle K in 2003, that fueled its revenue from $1.3B in 2000 to over $68B in 2023!

Below is Alimentation Couche-Tard (ATD.TO)’s dividend triangle for the last ten years. Acquisitions fueled revenue growth, except at the onset of the pandemic, and led to rising earnings and, interestingly, steady and growing dividend increases.

ATD.TO's dividend triangle graph
Alimentation Couche-Tard – fueling growth with acquisitions

Diversification, Synergy, Efficiencies

A GPS is convenient and smartphone invaluable, right? A GPS on your smartphone is even better! Sometimes, two things just work better together. Acquiring a company in a different sector can bring diverse skill sets, products, or markets under one roof.

An example? Microsoft buying LinkedIn. By combining its tech giant with a professional network, it aimed to merge data and software, creating a synergistic blend for businesses and professionals worldwide. Another is Alphabet’s acquisitions, from YouTube to Nest, that expanded its reach way beyond search engines.

Also, integrating acquisitions can lead to efficiencies by optimizing resources by leveraging human resources, marketing, infrastructure, etc., and ultimately improve margins.

Find great stock ideas in our Rock Star list, updated monthly!

Competitive Edge

Snatching up competitors or companies that complement a company’s strengths can knock rivals off their feet.

When Sobeys, a Canadian grocery retailer, acquired Safeway’s Canadian operations in 2013, it expanded its market presence and increased its store count across Canada. The move intensified competition, putting pressure on Loblaws, Metro, and others, challenging their market positions and leading to shifts in pricing strategies and market shares.

Jitters of growth by acquisition

Let’s throw some caution into the mix. Growth by acquisition isn’t always clear skies and sunshine; it can get as stormy too. Here are the storm clouds looming over this strategy.

Financial Gambles and Rising Debt Load

While acquisitions can be tickets to growth, they can also burn a hole in your pocket. Overpaying for a company or underestimating integration costs can lead to financial headaches.

Large acquisitions mean adding debt to a company’s balance sheet. Too much debt can cripple a company, especially if it fails to show benefits from the acquisition. This is even more the case now with higher interest rates and a possible recession.

For example, Enbridge recently announced an acquisition of natural gas transmission assets. This move makes sense: it diversifies Enbridge’s operations to diversify from crude oil pipeline, and regulators are often more favorable to natural gas projects than to crude oil projects. The problem? Adding $19 billion more in debt is a lot, considering Enbridge’s already high debt level. It has to start paying down some of that.

Graph showing Enbridge's growing debt level since 2014
Rising and rising – Enbridge long term debt

Another example is Pfizer acquiring Seagen for $43 billion, now carrying $65 billion of long-term debt while its revenue and EPS are going down, not unexpectedly, due to lower sales related to Covid vaccines

Regulation Hurdles

Regulatory approval can delay, alter, and block acquisitions. It took over a year for Microsoft to convince regulators to approve its acquisition of Activision Blizzard (ATVI) due to concerns about competitive fairness, some raised by gaming rival Sony.

In Canada, regulatory approval took a while for Rogers to acquire Shaw, and it was only granted when Rogers agreed to sell off Shaw’s Freedom Mobile to Quebecor.

Other acquisitions are blocked by regulators. For example, Staples’s attempt to acquire Office Depot in 2016 was blocked by the Federal Trade Commission (FTC), which argued that it would substantially lessen competition in the market.

Find great stock ideas in our Rock Star list, updated monthly!

Cultural Clashes

Combining different company cultures, work styles, or values can lead to employee disengagement, conflicts, and a general lack of synergy. Culture clash can impede the integration of a newly acquired company.

Integration Nightmares

Integrating two companies comes with challenges and high stakes. Meshing operations, technologies, and teams can be a logistical nightmare. The merger of Daimler-Benz and Chrysler in the automotive sector initially appeared promising but struggled due to integration challenges, resulting in a split later on.

In the tech sphere, Alphabet’s purchase of Motorola Mobility in 2012 was a rollercoaster. While it brought patents and hardware expertise, it eventually led to selling Motorola to Lenovo for a fraction of the original price due to integration difficulties.

Integrating an acquisition is reflected in revenue growth, due to the added sales from the acquired company. A well integrated acquisition is reflected, eventually, in an increase in operating cash flow and earnings.

Making the best of this as investors

Having seen the joys and jitters of growth by acquisition, how do we, as investors, make the best of it. Trying to buy stocks at the right moment to take advantage of acquisition rumors, announcements, and approval is playing the market. In the end, this pursuit is like surfing a wave – thrilling yet precarious.

Growth by acquisitions companies can be some of the best investments you ever make, as long as you remain very careful. Some tips:

1 – Focus on companies with strong track record of successful acquisition and integration. Examples include ATD.TO, MSFT, AVGO, CSU.TO. I’d be a lot more wary of companies that have a history of taking a long time to digest their acquisitions.

2- Look for an integration that makes sense.

  • Is the company buying something it’s already good at like a competitor, or going into something it knows nothing about?
  • Is it expanding in a new geographic area?
  • Is it diversifying in products or markets that complement what they already do?
  • Are they integrating vertically by buying a supplier of their goods or retail stores that sell their goods?

Acquiring a company operating in a completely different industry or market can be pretty risky.

3 – Don’t invest in a company that has a weak dividend triangle. Chances are that it’s making acquisitions to save its business. See Detect Losers and Find Winners with The Dividend Triangle.

4 – When an acquisition announcement is made, the stock of the buyer company often goes down due to uncertainties about the deal: does it makes sense? Is it too expensive? How will it affect the company’s debt? This can be a good entry point to buy shares.

 

The post Joys and Jitters of Growth by Acquisition appeared first on The Dividend Guy Blog.

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