Wednesday, February 1, 2023

Bolt-on takeovers are better than betting the ranch

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Lex Populi is a new FT Money column from Lex, the FT’s daily commentary service on global capital. Lex Populi aims to offer fresh insights to seasoned private investors while demystifying financial analysis for newcomers.

Mergers and acquisitions generate headlines for companies, payouts for banks and limelight for executives. But savvy shareholders should be wary of big, flashy takeovers. Their contribution to value creation is highly questionable. Most appear to destroy long-term shareholder value.

Take Vodafone’s €190bn (£167bn) deal to buy the telecom assets of Germany’s Mannesmann in 2000. The deal remains the most expensive takeover on record. Vodafone stock has since lost 70 per cent of its value.

Or look at AB InBev’s deal to buy SABMiller in 2016 for $70bn. Shares in the world’s biggest brewer have never recovered.

Successful acquisitions are more likely to be small, low-key affairs. A master of what is known as the “bolt-on” strategy is UK-listed distribution group Bunzl. Since 2004, the group has completed 194 acquisitions. This week it confirmed revenues during 2022 would be 17 per cent higher than last year.

Bunzl specialises in distributing working capital items such as napkins for restaurants or needles for hospitals. It operates across the world and in many different sectors.

In a fragmented market, multiple small, family-run businesses are ripe for consolidation into Bunzl’s decentralised system. In the five years to 2021, the average size of a Bunzl deal has been £40mn. That is peanuts compared with the megamergers Lex usually writes about. But it has been lucrative for Bunzl shareholders.

Revenues from delivering everyday items has risen roughly in line with broader economic growth. Organic annual revenue growth has averaged 2.4 per cent since 2006. Bolt-ons provide a value-added boost. Growth rises sharply to 8.3 per cent annually once acquisitions are included.

The result is a healthy 19 per cent average return on capital invested. This is comfortably ahead of the group’s weighted average cost of capital of 6-8 per cent. As a result, Bunzl shares have returned 225 per cent over the past decade and have comfortably outperformed the FTSE All-Share index. Discipline is needed to maintain this performance.

When deals fail, it is usually because personally ambitious chief executives pay too much. Vodafone took over Mannesmann at a price that was an incredible 50 times earnings before interest, tax, depreciation and amortisation. These days, telecoms stocks are lucky if they can break into double-digit ebitda valuation multiples.

One benefit of Bunzl’s “think small” strategy is that price discipline is easier when there is a multiplicity of potential vendors. The company, a former maker of cigarette filters which was derided as “Bungle” in unhappier times, has typically paid between 6-8 times ebitda. It has maintained that throughout the cycle.

Bolt-on deals also have the advantage that they can be systematised. The purchaser establishes a routine of buying up smaller competitors, integrating them and cutting costs to raise margins.

Many acquirers start out with this plan but get carried away with the lure of bigger and bigger deals. Such has been the fate of many “roll-up” strategies, which are similar to bolt-on M&A but with a greater tendency to end in tears.

Take UK software roll-up Micro Focus. It built a sound reputation purchasing old software assets and taking out costs. That worked well until it bit off more than it could chew buying Hewlett Packard Enterprise’s software business for $9bn in 2017. As it struggled to integrate the company, investors sold up.

Big takeovers remain a temptation for company bosses. Highly paid bankers promote them adeptly. Executive pay deals contain elements that can be boosted with a big debt-funded takeover. After reaching record heights in 2021, big ticket M&A has been put on pause. It will eventually return. Shareholder caution is prudent.

PrimeStone chucks a rock

Activist investor PrimeStone seems to agree with Lex on big deals. It opposes plans by Brenntag, the world’s largest chemical distributor, to buy its number two peer Univar. PrimeStone thinks a bolt-on strategy would produce better returns.

Expensive takeovers are often justified on the grounds that they save costs or create revenue “synergies”, for example via cross-selling. But that depends on customers staying put. London-based PrimeStone is sceptical they will do so if Germany’s Brenntag combines with Univar of the US.

It is easy to see why a deal appeals to Brenntag management. Supply chain turmoil during the pandemic has boosted profits. That effect is now fading and shares have been slowly deflating. A major takeover could bring with it the chance to cut costs and push up margins.

But PrimeStone, which holds 2 per cent of Brenntag’s shares, thinks this logic is flawed. It believes a deal would instead trigger an exodus of customers spooked by the risk to their supply chains of swapping two suppliers for one. Some might defect to independent distributors. The activist says exactly that happened after Univar acquired rival Nexeo in 2018, erasing some $220mn of organic ebitda over the course of the years following.

PrimeStone, co-founded by ex-Carlyle executives, bases its views in part on the way chemicals are distributed. Bulk and speciality chemicals are handled differently. The latter tend to be distributed via exclusive contracts. The former are sold through more of a free-for-all. It is here that customer risk is concentrated.

The activist believes Brenntag should split itself into a bulk chemicals group and a speciality chemicals company. Pure play groups of the latter type command significantly higher ratings; IMCD and Azelis trade on 22 times forward earnings against Brenntag’s nine times.

Lex calculates that spinning off speciality chemicals would add around one-third to the current group value of €8.8bn. Over two-fifths of Brenntag’s profits originate from this division. Growth could then flow from smaller bolt-on acquisitions. Lex sides with tiny PrimeStone in its face-off with mighty Brenntag.



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