June 18, 2001

The Outlook

The Outlook

Few things are as gratifying to American consumers as finding a good bargain. Put a "sale" sign on just about anything and Americans -- among the most spendthrift of humans on the planet -- will find a reason why they need to purchase it. The psychology of this is simple: It feels good to pay less.

But in corporate America, things work differently. Consider the current environment for mergers and acquisitions. Although depressed stock prices have sharply reduced the potential selling prices of publicly traded companies -- the Nasdaq Composite remains down 50% from its March 2000 peak -- few corporate executives are finding bargains.

Last year, U.S. companies announced $1.75 trillion in mergers and acquisitions, according to Thomson Financial, and $789 billion through mid-June 2000. This year so far, the U.S. has seen about $356 billion in announced mergers, according to Thomson.

What explains this lackluster showing at a time when one would expect the corporate equivalent of an after-Christmas sale? Among the reasons: Some bankers say that potential buyers may be waiting for prices to drop further. For while stocks have slipped, they're still fairly rich based on historical levels. "Prices have fallen, but for opportunistic buyers and for financial buyers, not so far as to make it compelling," says Stephen Munger, co-head of global mergers at Morgan Stanley. Another problem is that it takes two to tango. Given lower stock prices, many potential target companies "don't view this as a good time to sell," says Frederic Escherich of J.P. Morgan Chase. Since most deals are friendly, targets ultimately dictate a good portion of the market's pace.

But looking at past stock-market cycles, it's pretty clear that the main reason why M&A activity has been quiet this year has to do with sentiment. History shows that M&A activity closely tracks the general level of exuberance in the stock market and confidence among business executives -- and not cheap prices.

When stock prices were rising and the economy seemed invincible, merger activity was strong. And a lot of that activity was "CEO-confidence-driven," says Mac Heller, co-head of global investment banking at Goldman Sachs Group. When stock prices fall, confidence plummets and so does the urge to merge.

All of this has led economists Andrei Shleifer of Harvard and Robert W. Vishny at the University of Chicago to conclude something extraordinary: Markets aren't rational. And because they aren't rational, they misvalue acquirers and targets. Corporate chieftains rationally respond to irrational markets, their theory holds.

In a recent study, the two economists theorize that acquisitions are driven entirely by the stock-market valuations of the companies involved. The economists posit that during stock-market rallies, companies rush to use their high-priced stock as currency to make acquisitions before the rallies end, and use cash to make deals when prices are lower.

But while many have found that buyers' stocks don't perform well after acquisitions, raising questions about the wisdom of mergers, what that analysis doesn't account for is what could have happened if the buyer hadn't made the purchase.

Look at America Online's purchase of Time Warner, for example: AOL's stock has been hurt since unveiling the blockbuster deal, but when looking at other Internet stocks, AOL likely helped its stock by acquiring Time Warner. "From our perspective, the central feature of this acquisition is not technological synergies, but rather the attempt by the management of overvalued AOL to buy hard assets of Time to avoid even worse returns in the long run," they note.

Sure, some buyers have stepped in to exploit the downturn, particularly in the Old Economy. In mid-November, Weyerhaeuser Co. made a $5.3 billion all-cash bid for rival Willamette Industries Inc., a 38% premium to Willamette's depressed stock price.

Robert Eccles of Advisory Capital Partners says of some companies: "If you think you have your act together, if you've done a rigorous job trying to calculate synergies, the companies that can do that are saying that's an opportunity."

Eventually, merger activity will likely pick up as companies get comfortable with the new stock-price levels. And now that stock prices are starting to firm and the high-yield bond market has reopened, that could happen sooner rather than later.

-- Steven Lipin

Write to Steven Lipin at steve.lipin@wsj.com¹

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