Irrational Decisions

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Microsoft recently acquired LinkedIn for $26.2 billion in cash. Analysts have noted that the acquisition may turn out to be another flop because of the premium paid, LinkedIn's unprofitable assets, and the absence of any clear path for leveraging the target company's capabilities. Consider these points:
  • Microsoft's buyout price of $196 per share values LinkedIn at 91 times the EBITDA over the last twelve months. To place that in perspective, Microsoft paid 46.7 times EBITDA for Skype and 40.7 times EBITDA for aQuantive. The latter has been a failure and nobody knows the value created by Skype. Put another way, Microsoft has paid $250 per average monthly visitor, and $60 for each of LinkedIn's 433 million registered users. Compare this with the $42 that Facebook paid for each of the 450 million active users of WhatsApp when the latter was acquired for $19 billion.
  • Last year (2015), LinkedIn lost $166 million on revenues of $2.99 billion. The net loss shows a poor trend, with the loss in 2014 having been $16 million.
  • There has been some talk of LinkedIn's potential to propel Microsoft's enterprise cloud software but no one has given a clear picture of how this might happen.
Just an year back, in July 2015, Microsoft wrote-off $7.6 billion of its deal with the Finnish mobile company Nokia. It was noted at that time that the handset business was almost worthless and Microsoft had overpaid for the intellectual property. It is worth remembering that in 2012, Microsoft wrote off nearly all of the $6.3 billion it had paid for the advertising agency aQuantive. And to date, there have been no signs of the $8.5 billion that Microsoft spent on Skype in 2011 paying off. In 2015, analysts had hoped that the current CEO would not repeat his predecessor's mistakes. That hope has been belied by the recent acquisition - do CEOs think alike?

Cut to 1999. That is right. All of 17 years in a world where a week is sometimes like eternity. Writing in the July - August 1999 issue of Harvard Business Review, Robert Eccles, Kersten Lanes, and Thomas Wilson said:

" Despite 30 years of evidence demonstrating that most acquisitions don't create value for the acquiring company's shareholders, executives continue to make more deals, and bigger deals, every year. There are plenty of reasons for this poor performance: irrational exuberance, enthusiasm built up during the excitement of negotiations, and weak integration skills. Many failures occur, though, simply because the acquiring company paid too much for the acquisition. It wasn't a good deal on the day it was made - and it never will be. Ultimately, the key to success in buying another company is knowing the maximum price you can pay and then having the discipline not to pay a penny more."

Corporate America has seen a literal procession of failed mergers and acquisitions in the last 50 years.
  • New York Central and Pennsylvania Railroad merged in 1968 to form Penn Central, then the sixth largest corporation in America. Just two years later, the company filed for bankruptcy protection, making it the largest ever corporate bankruptcy in American history at the time.
  • Quaker Oats acquired Snapple in 1994 for $1.7 billion ($1 billion too much, as noted by analysts). After just 27 months, Quaker Oats sold Snapple for $300 million, or a loss of $1.6 million for each day that the company owned Snapple.
  • Time Warner and America Online, touted as the "mother of all mergers" failed spectacularly after an astonishing $99 billion loss in 2002. In 2003, the company dropped "AOL" from its name and became Time Warner again.
  • Sprint acquired Nextel for $35 billion in 2005. The combined entity became the third largest telecom provider, after AT&T and Verizon. In 2008, the company wrote off $30 billion to impairment to goodwill, and the company's stock was given a junk status rating. Sprint has not made any profits in the last ten years.
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Why do managers make such irrational decisions? Part of the explanation can be found in the Hubris Hypothesis of Corporate Takeovers examined by Richard Roll in The Journal of Business Vol. 59 No. 2 April 1986.

" Hubris on the part of individual decision makers can explain why bids are made even when a valuation above the current market price represents a positive valuation error. Bidding firms infected by hubris simply pay too much for their targets. The evidence supports the hubris hypothesis as much as it supports other explanations such as taxes, synergy, and inefficient target management."

As Robert Eccles et al argue in their article, "the purchase price of an acquisition will nearly always be higher than the intrinsic value of the target company. An acquirer needs to be sure that there are enough cost savings and revenue generators - synergy value - to justify the premium so that the target company's shareholders don't get all the value the deal creates."

Despite knowing that synergistic benefits through market power, cost savings, process improvements, and financial engineering may be elusive if not altogether impractical, managers continue to make irrational decisions due to cognitive biases inherent in humans. Perhaps the way forward is to take a step backwards and seek objective evaluations based on reference class analysis - the "Outside View" proposed by Nobel Laureate Daniel Kahneman.

In a stunning revelation, the Nobel Laureate recollects, in Thinking, Fast and Slow, how inwardly focused forecasting can lead us astray. He recalls a textbook project that he was a part of in the 1970s. After completing a couple of chapters, the team members gather to discuss the time required for completing the project. The team consensus veers towards two years. An expert view, based on similar projects undertaken by others, provides an estimate of seven years minimum, ten years maximum, and most shockingly, 40% never completing the project. Despite this overwhelming evidence, the team decides to go ahead. The project takes eight years and when completed, has lost its relevance, with the original sponsor no longer being interested.

The next time you make an important decision, better look for the "Outside View."

Or, take a cue from this quote: "When someone says 'strategic,' the rest of us say 'too expensive.'"


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