Evaluating M&A Decisions

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Many management teams see mergers and acquisitions (M&A) as a guaranteed path to business expansion and increased profits. Yet poorly executed M&A has proven to be one of the fastest ways companies can destroy shareholder value.

To understand how to evaluate M&A decisions, we can turn to Michael Shearn's "The Investment Checklist" (2011), where he provides a thorough framework for assessing whether a company's acquisition strategy will create or destroy value.

Understanding how management thinks about acquisitions offers one of the few concrete ways to reduce uncertainty when evaluating companies, as past acquisition patterns often indicate whether future M&A will create or destroy value.

Shearn divides companies into three distinct categories based on their acquisition spending patterns.

Find the "Acquisitions" line item in the Investing section of the cash flow statement and divide it by cash flow from operations (CFO). This percentage tells you how much of the company's operating cash goes toward buying other businesses.

Here's the breakdown of each category based on their acquisitions-to-CFO ratio:

If we compare the three examples from Shearn's book using the acquisitions-to-CFO ratios from 2000 to 2010, we can see that:

Each approach can work, but acquisition-heavy strategies introduce significantly more risk, including debt accumulation, overpayment, and integration difficulties.

Understanding why management pursues acquisitions helps identify problems in their thinking and decision-making process. Companies typically cite two primary reasons, though the actual motivations often differ from stated goals.

Reason #1: Increasing Business Size

The first reason involves simply increasing business size. CEOs and CFOs with large egos want to run bigger companies, regardless of value creation.

These executives often become disconnected from daily operations, spending time with investment bankers who pitch acquisition targets. Eventually, they drift toward unrelated businesses, pursuing deals for excitement rather than strategic purpose.

Even successful businesses fall into this trap, with Coca-Cola (beverage manufacturer) once buying a shrimp farm and Gillette (razor and personal care company) acquiring an oil business.

These acquisitions nearly always destroy value because they distract management from core operations. Companies typically divest these businesses later at substantial losses.

Of course, acquisitions can make sense when companies buy similar businesses with overlapping customer bases, allowing them to leverage existing expertise rather than starting from scratch.

Reason #2: Operational Synergies

The second stated reason centers on improving the acquired business through operational synergies. Management believes that combining two companies will create efficiencies neither could achieve alone. These synergies fall into two categories:

Revenue synergies:

Cost synergies (usually easier to realize):

Now, when you hear management utter the word "synergy" during an acquisition announcement, you should be extremely skeptical. It's far easier to put numbers on a spreadsheet than to actually realize these cost savings or revenue opportunities in the real world.

For example, when Cedar Fair acquired Paramount Parks in 2006 for $1.24B at 10.6x trailing twelve months (TTM) EBITDA, management justified the high price by projecting $20-30M in synergies. These savings would supposedly reduce the acquisition multiple from 10.6x to 8.5x EBITDA.

However, on February 2009, Cedar Fair's CFO disclosed $16M in impairment charges entirely due to the Paramount acquisition. By 2010, CEO Dick Kinzel admitted that Paramount's performance remained "below expectation."

Clearly, the synergies that looked achievable on paper proved much more difficult to capture in reality.

Synergies are least likely to materialize when the merged businesses serve different customers or operate in unrelated areas.

Roll-ups, where companies consolidate fragmented industries, face similar challenges. Most roll-ups across funeral homes, medical practices, auto dealerships, food service, and waste disposal have failed to create value, with many going bankrupt after taking on excessive debt.

Regardless, some synergies do materialize when the customer base remains consistent. For instance, Kraft successfully acquired General Foods because both served similar grocery shoppers.

Shearn identifies seven specific criteria for evaluating whether M&A decisions will succeed or fail. These tests help investors assess both past performance and future acquisition risk.

Acquisitions within the same industry significantly improve odds of success.

For example, when Hewlett-Packard bought Compaq in 2002, both operated as computer manufacturers. Management projected $2.4B in first-year cost savings and achieved $3.7B, exceeding targets through genuine operational improvements.

When businesses acquire outside their core competencies, management lacks the expertise to solve problems that inevitably arise. They risk becoming distracted as they attempt to understand the new business.

Things like improving customer experience in the core business get placed on the back burner while time is spent combining operations, merging cultures, and aligning systems. If the acquired business runs into problems, the parent company may not have the internal resources to solve them.

John Mackey of Whole Foods Market learned this lesson after acquiring a catalog vitamin business in 1997:

The vitamin business was eventually liquidated after Whole Foods couldn't fix catalog-specific challenges.

Successful acquirers invest substantial time understanding targets before buying them.

For instance, Danaher, a global life sciences and diagnostics innovator, generated 25% annual returns over 20 years through 2010 by studying industries thoroughly before entering.

Before acquiring medical technology companies, Danaher spent three years conducting over 400 customer interviews plus numerous discussions with experts and competitors.

Their acquisition process includes several key steps:

Cisco followed a similar philosophy, often developing products internally before acquiring competitors. This process helped them understand whether building or buying made more economic sense while gaining deep knowledge of the target's capabilities.

The clearest indicator of acquisition success is whether customers remain after the deal closes. This metric varies significantly by industry, which affects acquisition risk.

Medical disposal companies like Stericycle enjoy high customer retention regardless of ownership changes. Customers rarely switch providers once established.

In contrast, advertising agencies face contract renewals every two years with high turnover rates. When agencies acquire competitors, customer defections often destroy the anticipated value.

You should monitor retention rates for at least three years post-acquisition to determine if the acquiring company successfully maintained the customer base.

Acquisitions frequently destroy company culture, driving away valuable talent.

Cisco learned this lesson after acquiring StrataCom in 1996, where aggressive sales acceleration led to losing both sales and 30% of employees.

The company completely changed its approach for future acquisitions. When Cisco acquired Cerent Corporation in 1999, employees arrived to find new business cards, bonus plans, health insurance, and computer access ready on day one. In six months, only 4 of 400 employees departed.

Whole Foods Market takes a different approach, always respecting the people who work for companies they acquire. They often promote employees from the acquired business to create a climate of trust. There's no attitude of arrogance on the part of the acquirer, which often causes the most talented employees to leave.

Put simply, companies that communicate early and respect acquired employees see better retention and integration success.

Management teams consistently overpay for acquisitions, destroying shareholder value regardless of operational success. Several situations increase overpayment risk:

When reading historical articles about a business or archived conference calls, look for examples where management walked away from acquisition targets due to price or other factors. This may be a positive indicator that they are disciplined acquirers.

Write down how much management paid for an acquisition and note whether they used cash, stock, or debt. What multiple did they pay for the business, such as enterprise value to EBIT, EBITDA, or free cash flow (FCF)?

If the business is paying a high multiple, then management expects the acquired company's earnings to grow significantly. The lower the multiple paid, the more room management has to make mistakes in their future projections.

Shearn provides the example of Penn National Gaming, which over 10 years acquired six casino businesses that generated combined EBITDA of $454M for a going-in multiple of 7.2x EBITDA, lower than the 8.6x average that competitors paid for their casino acquisitions.

By 2010, the EBITDA of these six businesses remained slightly above $454M, meaning Penn still paid only 7.2x. Most competitors saw the EBITDA of their acquired casinos decrease 10% to 40% from original levels, effectively raising the multiple they paid.

Lastly, how companies finance acquisitions indicates risk tolerance and alignment with shareholders:

Each financing method creates different outcomes. Cash preserves flexibility, debt amplifies both gains and losses, and stock transfers value based on whether the acquirer's shares are over or undervalued.