Episode Transcript
The Finance Ghost: Welcome to episode 245 of Magic Markets. Moe and I have just finished our recording for our premium show this week where we looked at Keurig Dr. Pepper and their acquisition of JDE Peet’s. I’m afraid none of these names roll off the tongue, but the names that will be familiar to you, certainly in the coffee space, would be stuff like Jacobs, Douwe Egberts. Those both sit inside JD Peet's. Keurig Dr. Pepper buying themselves a big international footprint. And that means that we want to talk about big corporate mergers this week because it's interesting, Moe, and generally speaking - because they don't work!
Mohammed Nalla: Ghost, I love how you lead with “they generally don't work” - I'm sure if we scratch hard enough, we're going to find some deals that at least make sense. But the overarching theme is that when there's lots of corporate activity, it tends to happen when there's a theme running or maybe there's some sort of exuberance in the market. Maybe the cost of money is too cheap. And that's when you find large companies actually going out there looking to make acquisitions. Sometimes they work out, sometimes they don't.
And again, we're not going to give away what's in the premium show for our premium subscribers with regards to Keurig Dr. Pepper buying JD Peet’s, but this week we want to actually unpack: when do Mergers & Acquisitions happen? What do those opportunities and risk matrices look like? What are some of the main reasons why a lot of these deals tend to fail?
So I've got some case studies I'm going to mention. One we can unpack in detail. But probably the most famous one out there that's quite topical at present would be Kraft Heinz, because that was Berkshire Hathaway's - probably their worst investment. That was a company or two companies that were squashed together. Kraft was one business, Heinz was another business. They sold the whole story around synergies, cost savings and the like. And in fact, why that is topical today is that just around a month ago the company actually said that they were now exploring splitting that out into two separate companies yet again. So I think that would be a nice case study that we can unpack.
But Ghost, let's maybe start off with why do these deals actually happen? What are some of the key pitfalls? You've got a history in corporate finance, so I think you've probably got some decent perspectives on some of this from your on-the-ground experience.
The Finance Ghost: Yeah, look, a lot of these perspectives are probably not going to be super favourable on some of the deals that we see out there.
I think there are two acronyms that are quite relevant here. One is OPM, Other People's Money. All bankers understand that one. And then there's another one, KPIs. Now, KPIs are how people get paid and OPM is how they use money to get paid.
Basically what ends up happening far too often - obviously not every transaction, not every company, etc. - there are way too many corporate executives who look at this and say, well, we can go and do some big M&A. Why? Because I have this lovely KPI that says I need to go and grow revenue. That's the most dangerous one. When you see ridiculous stuff like “just grow revenue, it doesn't matter how you do it” - there's only one outcome there. People are going to go and do transactions, end of story. They're going to consolidate revenue, they're going to go buy revenue, literally and then get their bonus.
And if the KPIs are not well structured, you get the situation where you're actively incentivising management to actually go and do risky transactions to grow the business, not care too much about return on capital and bluntly not care too much about what happens seven or 10 years down the line. And this is the alignment problem that is just prevalent in corporate to such a large extent where you have corporate execs who don't necessarily have much of their wealth tied up in the shares of the company they are running, but they earn a big salary and big bonuses from that company and then they go and invest it elsewhere.
You're driving really bad behaviour around maximising short-term earnings and not caring too much about the long-term impact on value. It's the exact opposite of what you want as an investor. So unfortunately, that tends to be the base ingredient for trouble. But even when you get really amazing long-term investors involved Moe, you still get situations, as you said, Kraft, Heinz. There's actually a great quote from Buffett where he says “It certainly didn't turn out to be a brilliant idea to put them together, but I don't think taking it apart will fix it.” Typical Buffett kind of statement there. And that's unfortunately the truth. These companies, these big mergers, if they go wrong, they go badly wrong and they're not so simple to solve.
Mohammed Nalla: Yeah, indeed, Ghost. I mean, I love those two acronyms, OPM, KPIs, because it really does get to the nub of the issue, which is when you're looking at why these deals happen, it's inevitably an assortment of that. And it happens when you're in a bull market, maybe money is easy and in those kind of constructs you've got market leaders that maybe just want to buy or scale their capabilities, or you've maybe got market laggards who see their competitors rushing straight past them. So they're looking for shelter, they're looking to justify their existence, and so they go out there to try and acquire a target and then just basically try and build their way into scale to remain relevant.
I think that's quite important, try and see what the underlying ethos is. We're not saying all deals are bad. Sometimes deals are really quite valuable to the overall ecosystem that these companies do operate in.
But I want to touch on another point here, Ghost, because quite often you're going to hear this word: synergies. That's the favourite one out of the management playbook saying if we smash these companies together, we're going to get cost synergies. That's the easy one. And unfortunately it's not quite as easy as that because again, let's use Kraft Heinz as an example and I'm going to now use this time to unpack that, because this is a deal that came together, I would say, fairly recently. It's around 10 years ago when 3G Capital and Berkshire Hathaway combined Kraft Foods with HJ Heinz. And the ethos or the investment thesis here was cost synergy driven, right? And what they were looking at here is they're saying if we move these two companies together, we can actually exact some cost discipline that comes through and that unlocks value and it becomes earnings accretive over time. Now, if that was the investment thesis, fast forward 10 years, what actually went wrong?
Interestingly, in this particular case study, that cost discipline actually turned into what I would say is under-investment in brands and innovation. And again, industry headwinds, the normal secular headwinds that packaged foods have actually faced over that time period. Then on top of that, remember when you're merging companies, you're going to have lots of concern around competition. The authorities sometimes may need to rule to say, can this deal actually go ahead? So inevitably, as part of certain deals, they're going to actually want you to divest from certain brands. That also tends to erode some of the overall investment thesis.
With Kraft Heinz, what eventually happened is that the company just continued to underperform. Go and have a look at that share price - it's absolutely dismal. And then, like I say, around a month ago, they announced that they now want to split into two focused companies. So again, just look at how the narrative changes. The initial narrative was if we put these two different companies together, we're going to get the cost synergies to come through. Now they're saying we didn't get the cost synergies to come through, so it's better off if we actually split these into businesses that are a lot more focused on their core products. And again, that kind of tells you what went wrong.
The TL’DR here at the end of the day is that I would be very wary of these deals that come through with those words cost synergies, because quite often I think management teams tend to overestimate how much efficiency they can actually extract out of the business. And that comes at the cost of actually running the business, running the brands well, that arguably could have happened under the original use case in the first place.
The Finance Ghost: Again, you have the agency problem, right? It's very easy to just put a big round number in a slide deck. And I've seen this stuff in practice. I know exactly how these calculations happen internally is the CFO gets tasked to go and find some synergies and an underling somewhere now has to go and do the analysis and they go and check online well, what's the sort of typical percentage synergies that you need to get? Oh, it's x percent of costs. Well, we should manage that if we just squint and round up and don't forget, we'll only need one person who does this and one person who does that. And by the way, the other CFO will obviously lose their job, it can't possibly be me. So we'll save a lot of money there.
And you can see I have an overly skeptical view on this stuff. But it's because this is what happens in practice. There are some really great transactions that happen out there. We've seen examples of them that work very well. Let me think of one off the top of my head. How about Spur and RocoMamas? I think that's worked out pretty well for Spur. And the reason that's worked out well for Spur is because they bought something they understand, in a market they understand, in a way they understand, which is to partner with the people who built it, roll it out, get an exit down the line. It's when you start to see stuff like that - entrepreneurs selling the business into a management team that can bring scale. Now that's a synergy I can get behind because that is something that the management team of the thing being sold probably wouldn't have achieved by themselves.
When you see stuff like a pathway to control - we'll buy a portion of you now and a portion of you in years to come - that's fine. When you see blockbuster mergers that make the front page and it's “corporate exec team buys another corporate exec team” and the management team involved get accelerated options so they don't really care and the independent board has to say, well, this is a good idea or not. And they just go hire someone to opine on whether it's a good idea or not - and remarkably, it's often a “good idea” Moe, I wonder why that happens in practice? I mean, it just - this stuff doesn't work. And it is that agency problem again. If you're going to go and invest in companies that are doing lots of transactions, I would honestly say go and have a look at how invested the management team is in the shares.
That's why I always look at director dealings. It tells you so much. And people love to poo poo that stuff and just say no, it doesn't really matter. People sell shares for lots of reasons. Yes, sure, they do sell shares for lots of reasons. But if they loved the company and they were very involved, they probably wouldn't, because guess what? I don't sell shares in my little business that I'm growing. We don't sell shares in what we do together. It just doesn't happen because we're all-in on it. That's how this game works when you're running a business where you are fully aligned with the business, but you get into the listed company space and it's just a different story altogether.
There was one example this last week that I'll just mention, then I'll let you put me out of my misery here. And that's Truworths, not because they're doing big transactions, it's because they had multiple directors who sold shares under the excuse of rebalancing their portfolio. If you look at a Truworths share price chart, you'd also rebalance your portfolio as far as possible in the other direction. They are famous for having one of the worst examples of executive pay versus share price performance and nothing ever seems to improve there. It's a mystery to me.
Mohammed Nalla: Ghost, I'm going to take you off your soapbox now, right, because I mean, at the end of the day, I think…
The Finance Ghost: You're going to regret doing this topic with me, aren't you?
Mohammed Nalla: Look, the point you raise is very valid and I want to actually add an additional dimension to it is that sometimes management is incentivised, but those incentives are actually asymmetric. They might just get call options on the stock. And again, that's not the right incentive because then it's effectively just allowing them to take the risk with OPM - Other People's Money - and if it actually works out well and good, and if not, well, it doesn't actually cost them anything. So I think to your point, you've got to actually look at how much skin does management actually have in the game and are they selling shares? Are they buying shares? If you really believe this deal is going to be so value-accretive, you should be increasing your shareholdings if you're going to back your strategy. Quite often you do see some behaviour of rent extraction and that's unfortunate.
But I want to pivot from that because you've raised some examples where this has worked. Spur and RocoMamas, both decent brands in South Africa. For me, it boils down to two different strategies. And I'm going to give you two examples that work under both of them, because we're not here to just poo poo M&A. What we are saying is that it can work if you're merging companies where the scale makes sense. They're very similar. It's a homogenous product and you can actually get efficiencies of scale to come through. And a good example of that was the merger of Exxon and Mobil back in, I think it was the late 1990s, maybe early 2000s, because that was a deal which at the time was pretty large, it was around $80 billion. I know that pales in comparison to the numbers we talk about today, but remember that was 25 years ago and that actually merged two of the US's biggest oil majors. Now, why does this actually work is that there was a clear overlap in terms of what is their target market - oil is not technically that complex, it's a homogenous product on the other side - and so you're going to get the scale synergies that come through your production, through your logistics. They're also complementary assets, with regards to your geographies, your reserves. And so all of that played towards that deal, making a lot of sense.
And that is why I say if there's a merger, if it's a company that's effectively operating in its same vertical and you're just looking to get the scale play come through, that could be a worthwhile strategy.
Now another example where it's completely different and this could be a company that goes and acquires something that they don't have, but it puts together components that make sense. Now what I mean when I say this, a good example here would be when Disney actually acquired Pixar, and that was around the mid-2000s, around 2006, there and thereabouts, and they bought Pixar for around $7.5 billion dollars. And again, interesting one, are you paying cash? Are you only paying with your shares? How are your shares priced? They bring a whole bunch of nuance into it. But what I want to land on here is what was Disney actually buying? Disney was weak with regards to some of the animation output, certainly with regards to the newer age stuff, Pixar's animation was a lot more slick, a lot more polished. And so Disney was looking to buy the quality. But what did Disney actually have? Disney had brand cache, Disney had distribution. They had the ability to make money across the value chain through its products, its toy lines and so forth. So this was basically bringing in a new angle, a new avenue, new IP and a new know-how, very importantly, into a giant of a company called Disney.
That's why that deal also made a lot of sense at the time. I would put those two as successful deals that have happened.
Now we've mentioned Kraft Heinz, how disastrous that actually was. But remember, sometimes bad deals don't happen. And my last example here would be quite recently, I think around two years ago, Kroger, that's a US retailer, looked to buy Albertsons and again I raised some questions around should Kroger actually be buying Albertsons? Now the deal was actually blocked on antitrust grounds, so thankfully the deal didn't actually happen. Pay attention here because when you're going through this process, sometimes management get quite caught up in those KPIs you've mentioned and they sometimes tend to underestimate the regulatory risk that goes through that. And then they go down this long and very expensive road of advisors and consultants. I can almost picture that junior analyst you are mentioning now plugging it into ChatGPT: what is the extent of cost synergies I can get? Please make this a McKinsey-esque type slide. I can picture that happening, right?
The Finance Ghost: Oh, my brain just hurts thinking about it. It's horrible.
Mohammed Nalla: The point, Ghost, is that these companies go down this long and expensive roads. They haven't done their homework properly and then in some instances the regulator puts a stop to that, but not until the company's actually spent a lot of legal money and a lot of management consultant money.
The Finance Ghost: Oh absolutely. There's always a consultant ready to fix whatever someone broke. That's just one of those things in life. Here's another example of a pretty good deal: Facebook - Instagram, that one worked out rather well for Meta. So it does work sometimes and I think you've raised an important point there, which is to say when it looks sensible, you're plugging a gap, you're buying something you don't have.
Here's another one that has been very successful is Bidcorp, which is the South African listed food service business. It used to be part of Bidvest. They have built this global powerhouse by doing lots and lots and lots of little bolt-on deals. They go and buy small things, regional specialists and they just keep on doing it and they get them for good prices and they roll them in and they use their systems and their management expertise and they really make it work very, very, very well. They have an excellent track record in doing this.
Sometimes you have market darlings of M&A that then do deals that are maybe - they bit off more than they can chew or they have a tough time. Afrimat has an incredible reputation for the deals that they've done in the South African market. But their recent transaction, Lafarge, has turned out to be quite a stress for them. I think they'll be fine, but that share price is down sharply because a bunch of things have happened at the same time that they went and did this one large deal. They really rolled the dice on this one and thought, well, we can get these cement etc. assets nice and cheap and all we need is some kind of improvement in South Africa for things to go really well. Well, we're still kind of waiting for that to happen.
So dealmaking is fascinating. It does capture the hearts and minds of investors. It makes advisors a lot of money. And it's almost the call option, right? It's the “what if” - it's the what if this is the one big blockbuster deal that really works. And sometimes it is, and other times it's Woolworths - David Jones, or it's Spar – Poland, or it's, take your pick, Famous Brands - Gourmet Burger Kitchen in the UK. There are a lot of examples. And what do all of those have in common? Offshore! So when you see South African companies doing large offshore deals, be afraid. Be very afraid.
Mohammed Nalla: Maybe the trade here, Ghost, is when you see lots of M&A activity, you go and actually buy the companies doing the advising. Go buy the banks. They're all over this like a rash. They make lots of money. You can't really go buy legal firms, they're not listed. But I mean, that would be a great trade as well.
The Finance Ghost: Well, that's why we own the US banks, right? Because that's exactly it, JP Morgan's getting - that's where the money sits in M&A, it sits with the advisors. 100%.
Mohammed Nalla: Indeed. It's also quite cyclical, right? And I want to maybe land on just a couple of key points just to wrap up the discussion. We've discussed how M&A activity can be quite cyclical, so when you see a lot of M&A activity, just be wary in terms of where you are in the economic cycle. What is some of the narrative behind that? Your point around management is 100% spot on. Just check the alignment, check the KPIs. Sometimes you find a very strong management team.
You mentioned Bidcorp, they've got a great track record. And again, that track record comes through in terms of them not overpaying for assets at the end of the day. Sometimes when there's market exuberance, when money's too cheap, when maybe you've got bad advisors, sometimes that goes out the window, so those raise a lot of risk flags.
And then the last dimension is, the one I actually mentioned is, what are you actually buying? Are you trying to cobble together and you're saying it's scale, it's cost synergies, but are you merging businesses that have very different products at the end of the day? Because if that's actually part of your narrative, it's not going to work. Are you actually merging companies that maybe have similar products? Kraft Heinz, if you want to use that as an example. But overestimating the amount of cost synergies you can have, I don't think it's a one-size-fits-all. I do think that every time you see M&A activity, the market narrative is pretty much you sell the acquirer, you buy the acquired company. That's how it tends to perform at the end of the day, usually because people are paying up, but that's not necessarily how it always lands.
I like your Meta example. Zuckerberg was buying a vertical he didn't own and eventually it's now made him very dominant in that social media space. And now I guess all he has to worry about is antitrust because they're not going to allow him to make any further acquisitions in some of those verticals.
Ghost, I think that's where I'm happy to wrap it up. I don't know if you have any fluff…
The Finance Ghost: Any fluff! Any fluff to add! Sho - this is going to be our last podcast together. Look at that. 20 minutes of us spitting insights, summarised as fluff. That's it from me. I'm done. I'm out. Thank you for listening to Magic Markets. I'm out.
Mohammed Nalla: That's a Freudian slip, unfortunately, Ghost, let's leave it there. It's been a long day. Let us know what you thought of the show. Hit us up on social media. It's at @MagicMarketsPod, @FinanceGhost and @MohammadNalla, all on X or can find us on LinkedIn. Pop us a note on there if you like Ghost’s fluff.
Until next week, same time, same place, thanks and cheers.
The Finance Ghost: Ciao!
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
