QUALIPORT
Danger: Acquisition In Progress

By Maynard Paton (TMFMayn)
March 19, 2001

Carburton Street, London -- If you consider a company's financial history to help judge its future performance, then beware of the company that has a penchant for acquisitions. More often than not, a company's acquisition spree eventually results in shareholder trouble.

Rather than be blinded by just a superior earnings record, long-term investors ought to consider how those earnings were created. In my opinion, the best businesses to own are those that have organically grown their business without recourse to merger and acquisition activity. The worst businesses to own are those who are constantly adding to and disposing of their operational interests.

There are three reasons why I prefer companies that have organic growth as the central plank of their historic record.

Buying a bad business

The obvious risk to any acquisition hungry company is that it buys a bad business. Just like the ordinary investor buying shares, there is always the chance of getting involved in plainly awful companies. While directors should have more insight into potential company purchases than private investors, the "bad business" risk is always present. 

Take Sema's (LSE: SEM) recent purchase of the US software firm LHS. Just a few months after the acquisition, Sema shares halved after it blamed a profit shortfall on LHS. Schlumberger (NYSE: SLB) has since rescued Sema shareholders, although the jury's still out as to whether Schlumberger has learnt any lessons from Sema's own experience.

Lack of financial clarity

When acquisitions are brought into the picture, the odds of misinterpreting a company's financial performance are greatly enhanced. As well as identifying the "underlying" turnover and profit performance, other calculations, such as the return on equity, can become very distorted.

There's also the ubiquitous exceptional charges to consider too, those all-too-familiar costs that relate to the corporate restructuring which occur after any substantial acquisition. But if the company has a hankering for acquisitions, are those costs truly exceptional?

All in all, the chance of missing a deteriorating financial performance is substantially increased by significant acquisition activity. The Qualiport speaks from bitter experience on this point: Rentokil's (LSE: RTO) purchase of BET is a good example.

Logistical problems

Acquisitions require integration. Management time is absorbed into logistical tasks and their attention can be diverted from the main business. And while their concentration is directed elsewhere, operational slip-ups can occur.

Take SSL International (LSE: SSL). It has had a busy few years recently, the former Seton Healthcare business merging with both Scholl and London International. While the management was busy restructuring their company, "capacity constraints and short-term supply problems" suddenly emerged earlier this year. All the corporate activity at SSL led to the logistical problems and two profit warnings.

Past glories

The stock market is littered with companies that have stumbled after their growth-by-acquisition strategies unravelled.

Conglomerates Hanson (LSE: HNS), Tomkins (LSE: TOMK) and Invensys (LSE: ISYS) (née BTR) all had "growth" investors spellbound fifteen years ago, only to disappoint investors when their acquisition opportunities dried up a few years later. In more recent times, former "growth" stocks Photobition (LSE: PHB) and Stagecoach (LSE: SGC) ventured into that graveyard of UK companies, the US, as part of their respective acquisition strategies. The purchase of one or two US businesses later, various operational headaches and hefty share price de-ratings quickly followed.

Exceptions

There are a handful of companies that do provide exceptions to the rule. Certain participants in the media industry have proved masters of the growth-by-acquisition strategy, while the banking sector also has a handful of renowned consolidators. There's also the odd company that has a proven acquisition history in areas not typically associated with successful M&A activity, engineer Halma (LSE: HLMA) being a good example.

Of the Qualiport companies, PizzaExpress (LSE: PIZ) has been focused the most on organic growth. In the past, it's only bought other (franchised) PizzaExpress restaurants and the small Café Pasta business, the latter (unsurprisingly) having to be totally revamped after its initial trading troubles. The other Qualiport members, Emap (LSE: EMA), Lloyds TSB (LSE: LLOY) and MMT Computing (LSE: MMT), have all relied on varying degrees of acquisitions in the pursuit of profit growth. I think it's no real surprise that, of the Qualiport four, PizzaExpress has generally had the highest stock market rating.

Summary

A central theme of successful stock market investment concerns minimising corporate uncertainty. Avoiding companies that have a liking for acquisitions goes a long way to reduce the chances of a profit mishap. While not eliminated entirely, organically growing companies should have fewer logistical issues and accounting question marks compared to their acquisitive counterparts. It's no coincidence that, with the exception of the notable Halma, the three other contenders for Qualiport status (Carpetright (LSE: CPR), Games Workshop (LSE: GAW) and Latchways (LSE: LTC)) all have acquisition-free histories.

More: Rentokil & BET: We spot the slowing sales growth | Contenders for Qualiport status | SSL: Watching and Waiting