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Corporate Mergers: How Big Is Too Big?

By Roger Conrad on October 5, 2012

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Since Thomas Edison threw the first switch in the late 19th century, there have been literally thousands of mergers between electric utility companies. Not one has failed to create a stronger entity.

It’s the rare industry, however, that can claim anything close to that. Rather, market history is replete with examples of highly touted deals that quickly went south. AOL/Time Warner, Sprint/Nextel, Daimler Benz/Chrysler, Worldcom/MCI and Lucent/Alcatel–the list goes on and on of high-profile deals that began with great promise and even greater hype, only to fail spectacularly once key assumptions proved wildly off base.

Even so, that checkered history hasn’t caused companies to stop pursuing new deals. In fact, the fourth quarter will feature several major tie-ups across a range of industries. Such action has spurred further speculation that even more deals are in the offing.

It’s entirely possible that forecasts of an increase in deal flow will prove accurate. The combination of conservative financial policies resulting from the downturn along with historically low borrowing rates means that companies are in their best shape in decades to consider deals. Meanwhile, the plodding economy has put pressure on corporate executives to boost profits in other ways, and cost-cutting by adding scale and eliminating overlap is a time-tested way to accomplish that.

By and large, the Obama administration has approved most corporate mergers, just as previous White Houses have. But they’ve also chosen to use their leverage as gatekeepers to impose conditions on deals to address antitrust concerns.

The notable exception in essential services sectors is, of course, AT&T’s (NYSE: T) bid to buy T-Mobile USA from Deutsche Telekom (Germany: DTE, OTC: DTEGY) last year. Rather than negotiate conditions, the Department of Justice and Federal Communications Commission (FCC) made it clear they saw a marriage between the second- and fourth-largest wireless companies as creating too much asset concentration. That, in turn, convinced AT&T to abandon the deal to avoid facing a further protracted battle.

Should Republican presidential candidate Mitt Romney win the White House in November, the 3-2 Republican FCC majority he’ll appoint to replace Obama’s current 3-2 Democratic majority may be more accommodative to mergers of large companies. But even if the incumbent is re-elected, the FCC is likely to approve T-Mobile’s latest merger move: An offer to buy MetroPCS Communications (NYSE: PCS).

This deal would unite two of the larger players in the prepaid wireless market. This is basically the low end of the market, and profit margins are considerably more compressed than they are for the high-end contract business increasingly dominated by AT&T and Verizon (NYSE: VZ). But joining forces will afford T-Mobile USA an opportunity to expand its business by increasing scale in a faster growing business than contracts.

The number of Americans using prepaid wireless service rose by 11 percent in the second quarter. That’s against a boost of just 1.1 percent in total contract customers nationwide. And T-Mobile USA’s own contract customer base continues to drop, with half a million more leaving in the second quarter, which is a rate of 2.2 percent per month.

The fact that a T-Mobile USA/MetroPCS merger would control 18.4 million of the country’s 74.5 million prepaid users shouldn’t attract too much scrutiny either. In fact, the new entity would not even be the biggest prepaid service provider. And the FCC is also likely to view the deal favorably because it strengthens the fourth-largest wireless company at a time when unmatched scale and financial power are rapidly widening the gap between AT&T/Verizon and the rest of the US communications services sector.

The FCC isn’t expected to rule on the deal until next year, which effectively defers the decision until the next administration. But based on the comments of industry executives in the wake of the announcement, investors should expect to see more deals in the coming months, and possibly a lot more if Washington is perceived to be in an agreeable mood.

Of course, the loser in this is the No. 3 wireless carrier Sprint (NYSE: S), which had been rumored to be preparing its own bid for MetroPCS. Such a deal would have added a fifth wireless technology to its network, further complicating a plan to bridge operating differences that continue to plague profitability. But not buying MetroPCS effectively leaves the company with few obvious ways to increase scale and improve competitiveness.

Will the new T-Mobile USA be able to compete in the long run against the Big 2? That remains to be seen, and the road ahead will not be easy, even with the firm’s advantages in the prepaid market. One thing, however, is for certain: The combined entity is in much better shape to do so than either party would be on its own. And that’s ultimately the key criterion for determining whether a merger is worthwhile. Bigger in this case is definitely not too big, at least from an investor standpoint.

Incidentally, that may not be the case for the proposed union of Airbus parent European Aeronautic Defence & Space Co (OTC: EADSY) with Britain’s BAE Systems Plc (OTC: BAESY). Backers hope to create a company large enough to compete with American defense giants Boeing (NYSE: BA) and Lockheed Martin (NYSE: LMT). A larger entity would potentially come with such opportunities as cost cutting by eliminating redundancies, greater muscle to win contracts, a pooling of technological acumen, and a stronger balance sheet.

But making that work also means dealing with the governments that have ownership stakes in these companies, as well as regulators who will be hyper-sensitive to any signs that a merger would increase layoffs at a time of rampant unemployment throughout Europe. Then there’s the problem of merging corporate cultures across national boundaries, a bridge too far for many deals in the past. Bigger just might be too big in this case.

A third major merger in the works is the potential combination of mining giant Xstrata (London: XTA) and its 33 percent owner Glencore (London: Glencore), a leading global commodities trading company. This combination has the obvious advantage of uniting hard assets with the expertise to sell them. But complications have emerged over the offer, particularly how many shares in the combined entity should be allocated to Xstrata shareholders.

The deal appeared to be slipping away up until a couple weeks ago, as major investors held out for a higher offer while Glencore seemed to balk. But that tension has abated now that Glencore has acted and shareholders appear to be in accord. But the deal still faces a final hurdle that could kill it: European Union approval. And given the size of the proposed combination, there’s no guarantee officials won’t find that bigger is too big, which will dash investor hopes and sink the shares of both companies.

The bottom line: Betting on industry mergers can be lucrative, provided we’re talking about financially healthy and growing companies selling at value-backed prices. But chasing a low-quality outfit just because you think there may be a takeover is rarely ever a good strategy.

There’s just too much risk that regulators will decide big is too big and ultimately scuttle the deal. The only merger candidates anyone should buy are those you’d want to own even in the absence of a deal. That way, your wealth still builds over the long term while you await the prospect of a faster payoff.

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