Why Didn’t the Market Like this Acquisition?

Acquisitions take up an enormous amount of time and resources to execute. Management teams, along with armies of bankers, lawyers, accountants and communications professionals, are swamped for weeks or even months with due diligence, negotiations and preparations for the public announcement. Everyone is excited about the deal and feels it’s a great move for the company.

Then the stock goes down when it’s announced and the company is left scratching its head and asking, “Why didn’t the market like this acquisition?”

The sell-side reports all spoke favorably about the acquisition. Investors are constantly asking the company about its M&A plans and seem to encourage the company to make acquisitions. And yet the stock still goes down even though the company clearly states how it believes the acquisition will be accretive and add value to the company.

Why does this happen? In many cases, it’s a function of merger arbitrage — investors shorting the stock of the acquirer and buying the stock of the target to capitalize on temporary pricing inefficiencies in the market. But not all acquisition targets are public companies, so there isn’t always an arbitrage opportunity, and yet the stock of the acquirer still goes down.

The other explanation is the past track record of acquisitions. Not the track record of any one company in particular, but of all companies. Every time a company reports a write-down in goodwill, it reminds investors that many acquisitions don’t create value for shareholders.

Some of the largest recent goodwill write-downs came from Hewlett Packard ($8.8 billion, primarily related to the Autonomy acquisition) and Microsoft ($6 billion, primarily related to the aQuantive acquisition). Goodwill represents the amount paid for an acquisition that is above the book value of the company being acquired. Although companies always go to great lengths to point out that goodwill write-downs are non-cash charges, that’s just a function of timing. At some point in the past, actual cash was paid for these acquisitions (or additional shares were issued), and the goodwill write-down is an acknowledgement that the expected synergies didn’t materialize and the company overpaid for the deal.

The good news is that the initial reaction is just that – an initial reaction. Over a longer period of time, if reported results show that a company is indeed getting the positive impact from the acquisition that it projected, then the stock price tends to recover and reflect the higher level of earnings, cash flow, etc. being generated.

When preparing to make an acquisition announcement, it’s a good time for all the parties involved to remind themselves of the words of Benjamin Graham, the father of fundamental security analysis:

In the short-term, the stock market behaves like a voting machine. In the long-term, the stock market acts like a weighing machine.

If the votes aren’t cast in your favor, don’t worry too much. The weighing machine will ultimately take control and assess whether the acquisition has truly created value for shareholders or not.