Commentary

Brian Harding

Formerly of James Capel Stockbrokers

"The share price effects of a growth strategy based largely on acquisitions are examined for a broad spectrum of manufacturing companies."

As the 2002 R&D Scoreboard commentary showed, about 65% of all major acquisitions in the broad engineering sector were followed by long periods of share price under-performance. It was further demonstrated that UK companies in this sector spent between three and five times as much on acquisitions, per £ of sales, as their US counterparts.

In this article the share price effects of a growth strategy based largely on acquisitions, are examined for a broader spectrum of manufacturing companies including IT hardware, electronic & electrical, chemicals, pharmaceuticals & biotechnology and health in addition to the engineering, automotive and aerospace & defence sectors dealt with earlier. These sectors in total account for about 75% of all the R&D undertaken by UK companies. Most importantly, the relationship between investment, (Capex plus R&D), and acquisition spending is examined and UK and US practices in this area are compared.

The article is based on data relating to UK and US companies in the above eight sectors drawn from the US and UK R&D Scoreboards. There are 79 quoted UK companies, each of which meets a minimum turnover requirement of $100m in the year 2001. The US data is derived from 665 quoted companies in matched manufacturing sectors, with the same minimum turnover requirement. The article is divided into three sections:

Section 1 deals with the relative popularity of acquisition spend and organic investment in the UK over the period 1997-2001.

Section 2 examines the relative share price performance of high acquisition intensity companies.

Section 3 contrasts UK and US experience with respect to the use of acquisitions as a means of achieving corporate growth.

The Relative Popularity of Acquisition Spending and Organic Investment in the UK 1997-2001.

Table 1 contains outline details of the total investment, (R&D plus Capex), and the total acquisition spend undertaken by the 79 UK companies over the five year period 1997-2001. It should be noted that this study has identified a total of 684 acquisitions where the consideration has been disclosed. A further 308 acquisitions were also completed in this period without disclosure of consideration and these are necessarily excluded from the analysis; they will not be material in financial terms or the consideration would have had to be disclosed.

From table 1 it can be seen that, over the period, total acquisition spending was equivalent to 209% of total investment. The data on acquisition spending is, however, inherently very variable. Firstly, there is a strong cyclical element in the market for corporate control. Maximum expenditure tends to occur when the economy is buoyant and the price of making an acquisition is relatively high. Activity falls away in periods of economic difficulty when share prices and the cost of making an acquisition tend to be lower (see the data for 2001 above and The R&D Scoreboard 2002). This phenomenon relates to the desire of acquirers to use their own paper when their share prices are high, and the reluctance of sellers to deal when prices are low.

Secondly, data on acquisition spending varies very sharply between companies. In particular, it is conceivable that the overall comparisons shown in table 1 above could be distorted by one or two exceptionally large deals. The two largest deals made over the period 1997 to 2001 are the acquisition of SmithKlineBeecham by Glaxo for $75.9bn in 2000, and the acquisition of Astra by Zeneca for $34.6bn in 1999. The arbitrary exclusion of Glaxo from the data shown in table 1 does result in a fall in the overall ratio of acquisition spend to investment spend, but only from 209% to 175%. If both Glaxo and Zeneca are excluded from table 1, there is a further but smaller fall in the ratio, from 175% to 153%. It appears that the data displayed in table 1 is not, therefore, unduly sensitive to the inclusion or exclusion of a small number of companies which have completed very large deals. combined.

Lastly, acquisition intensity is examined by sector. The pharmaceutical and health sector was by far the most acquisitive with spend in this area almost equal to 56% of sales. (Even after the arbitrary removal of both GlaxoSmithKline and AstraZeneca, acquisition intensity in the sector was 35%). The other three sectors ranged from 8.5% to 19%. In any case acquisition spending exceeded investment in R&D plus capital spend in every sector group (see table 2).

The Relative Share Price Performance of High Acquisition Intensity Companies in the UK

For each of the 79 UK companies in the study, an acquisition intensity figure was computed by summing acquisition expenditure over the period 1997-2001 inclusive and dividing this by the aggregate turnover recorded over the same period. These companies were then ranked by acquisition intensity. The top 30 companies accounted for 75% of all acquisition expenditure. For each of these top thirty companies the date of completion of the largest single acquisition was ascertained, and the share price performance from this date was compared with the FT All-share Index over the same period. On this basis 70% of all companies making a major acquisition under-performed the All-share Index*. The largest acquisition target had, in all cases, sales of more than 15% of those of the acquiring company.

It is worth noting that high acquisition intensity companies are well distributed across all four sector groups used in this analysis. Of the total of thirty, six are in the IT hardware, electronic & electrical sectors, six are in pharmaceuticals & biotechnology, three are in the small chemicals sector, and fifteen are in the large engineering, automotive and aerospace & defence sectors.

It is also worth noting that, in many cases, the extent of the underperformance was very severe with the share price dropping by as much as 99%. In fact, for companies contemplating a large acquisition, the downside risks not only include the 70% chance of under-performance but the scale of under-performance is, on average, larger than that of out-performance with an average decline against the All-share Index of 42%, compared to an average improvement against the All-share of 25% for the 30% of cases where there is out-performance. The under-performance of high acquisition intensity companies contrasts with the relative share price out-performance of high investment intensity companies, for which positive, statistically significant correlations have been discerned¹.

1 - See DTI Capex Scoreboard 2001.

A Comparison of UK and US Investment Practice over the Period 1997-2001

This comparison is based on data taken from the IT hardware, electronic & electrical, chemicals, health and pharmaceuticals, engineering, automotive and aerospace & defence sectors. The only requirement for inclusion was that the companies concerned should have minimum sales of $100m and a minimum R&D spend of $1m ($2m in 2001). The source documents were the R&D Scoreboard for the UK and the IRI Industrial R&D Scoreboard for the USA. There are 79 UK and 665 US companies which fulfil these size criteria. The analysis is effectively based on a complete enumeration of all the major companies operating in the above sectors. The 79 UK companies completed 684 acquisitions over the period 1997- 2001², (an average of almost 9 per company). The 665 US companies completed 1931 acquisitions over the same period (an average of only about 3 per company).

2 - A further 308 acquisitions, almost certainly very small, were completed in the UK without disclosure of consideration. The corresponding figure for the US was 1824.

There are substantial differences in investment culture between different sectors within both the UK and the USA. For example, the UK pharmaceutical industry spends about three times as much as the engineering sector, per £ of sales, on R&D and Capex. There are also substantial differences in the relative importance of various industrial sectors between the UK and the US. For example, of the 665 US companies in the study, 343 (about 52%) are in the IT hardware, electronic & electrical sectors. The corresponding figure in the UK is 25%. For these reasons the results have been analysed by sector and by year first, and only then aggregated so as to provide the clearest possible comparison between UK and US investment practice.

In table 4 below are set out the investment intensities, by sector and by year, for both US and UK companies:

It can be seen that, in every year and every sector, (with the sole exception of the pharmaceutical sector), US companies invested more relative to sales than their UK counterparts. US investment intensity (pharmaceuticals excluded), is equal to 132% of the average UK level. Whilst international comparisons are inevitably difficult, there is nevertheless, a substantial difference in cumulative investment intensity between the US and UK.

In table 5 below we set out acquisition intensities, by sector and by year for both US and UK companies.

From the above table it can be seen that UK companies frequently spent more, per £ of sales, on acquisitions than their US counterparts. The position is effectively reversed vis a vis investment where US companies have generally higher investment intensities. This is an important point since, broadly speaking, growth by acquisition is associated with share price under-performance in two cases out of three, not only in the UK but also in the USA³.

The idea that American companies are less inclined than their UK counterparts to pursue growth by acquisition is powerfully corroborated when the distribution of companies by size (sales) is examined. For both countries, and for the four sector groups which have been used throughout this study, companies were divided into three groups: those which accounted for less than 1% of their relevant sector sales, those which contributed between 1% and 5%, and those which accounted for more than 5% of relevant sector sales. The results of this analysis are set out in figure 1.

See M. L. Sirower, ‘The Synergy Trap’ 1997

It will be noted that, in 2001, 89% of US quoted companies each contributed less than 1% of their relevant sector sales. The corresponding figure for the UK is 50%. The position is wholly reversed when considering companies which accounted for more than 5% of sector sales. About 15% of British companies were in this position whereas only 3% of American companies contributed more than 5% of sector sales. If anything, the UK is in a more advanced state of consolidation than the USA, so that US manufacturing has the greater potential for acquisitions and might have been expected to show a higher, rather than a significantly lower, propensity to grow by acquisition. Further work is needed to understand why this should be so.

Conclusion

One key ratio for any comparison of UK and US investment practice is the acquisition spend per £($) of investment spending. Any difference in investment practices will show up most clearly in this ratio, despite the intensely variable nature of the acquisition component. We therefore tabulate below (table 6) the UK and US acquisition spend per £($) of investment spending over the period 1997-2001 inclusive.

From the above table it will be seen that, in terms of acquisition spend per £($) of investment spend, UK companies exceeded US companies in four years out of five – and always by a large margin. In the last year, the UK spent slightly less than the US per £ of investment. Overall, UK companies spent three and a half times as much on acquisitions per £ of investment as their US counterparts. When the probability of under-performance attaching to a major acquisition is of the order of 70%, reliance on growth by acquisitions will, on average, produce disappointing results for shareholders. Even if the US data is adjusted to the same sector sales mix as the UK, the result is that UK companies still spent three times as much as US companies on acquisitions per £ of investment.

The above findings are broadly based in the sense that the UK and US companies, included in the study, account for about 75% of all R&D undertaken by quoted companies. The findings are also persistent.

Any suggestion that the nature of UK acquisitions is in some way broadly different from those undertaken by US companies is countered by the fact that acquisition under-performance rates (i.e. long run under-performance, in terms of total shareholder return after a major acquisition), are virtually identical between the two countries at around 66 – 70%.

No criticism is intended either of acquisitions per se, or of any particular acquisition. The importance of acquisitions is acknowledged as a means of removing poor management and in some other highly specific circumstances. Indeed, 30% of large acquisitions are associated with share price out-performance. It is a matter of degree and of risk. When the probability of under-performance attaching to a major acquisition is of the order of 70%, over-reliance on growth by acquisition will, on average, produce disappointing results for shareholders.