It’d be hard to find a subject about which more nonsense has been written recently than the “shopping spree” that telecom-equipment giant Lucent Technologies is apparently about to embark upon once Oct. 1 arrives. And while the topic is a little–okay, very–esoteric, the details are worth paying attention to, since they provide an object lesson in how the business press and corporate finance generally don’t mix very well.
The story, as related by the New YorkTimes and Business Week (among others), goes like this: Since being spun off from AT&T in 1996, Lucent has been unable to use its stock to acquire other companies, because accounting rules prohibit spin-offs from using the accounting method called “pooling of interests” until they’ve been independent for two years. “Pooling of interests” means this: Normally, if Lucent were to acquire a company, it would have to amortize–write down–the difference between the purchase price and the company’s book value (the value of its hard assets), a difference which is called “goodwill.” Amortizing the goodwill would take a chunk out of the company’s reported earnings each year. With “pooling of interests,” the deal ends up structured as a stock swap, or a “merger of equals.” No goodwill is involved, and the company takes no hit to reported earnings.
On October 1, Lucent will be two years old, and will now be able to use “pooling of interests.” As a result, the story goes, it’s going to start buying. Some of the biggest companies in the networking business have been touted as acquisitions, companies that Business Week suggested have been on Lucent CEO Richard McGinn’s “shopping list” for two years.
Now, McGinn may very well believe that the arrival of Oct. 1 will mean that hunting season is open. But if he does, he’s as confused about the economics of mergers as the reporters covering him are. “Pooling of interests” does not make acquisitions easier, cheaper, or more successful. At best, it makes no difference at all, and more often it actually destroys shareholder value. And only a single-minded, and simple-minded, focus on “reported earnings” could blind someone to that fact.
Here’s why. If Lucent buys Ascend for $8.2 billion, it’s going to have to spend $8.2 billion, whether in stock or in cash. So the cost of the acquisition is the same. (In fact, if the company issues extra shares to do a merger of equals, it may be more expensive than if it borrowed money to finance the deal, because the cost of equity capital is generally higher than that of debt capital.) And in both cases the company’s business after the acquisition will be the same. The only difference will be whether there’s a charge for goodwill amortization on the annual income statement or not.
Amortization is not a real cost. No money leaves the company as a result of it. The IRS will not reduce its tax bill on Lucent because of amortization, and Lucent’s cash flow will not decrease because of it. In other words, the real value of Lucent as a company–which is, crudely, the present value of its future cash flow–is unaffected by whether it uses “pooling of interests” or does a straight acquisition. If McGinn has been waiting until October to buy a company that he wanted a year ago, he’s been waiting for no reason at all.
And actually it goes further than this. Since money spent on an interest expense is not taxed, borrowing money to finance a cash acquisition–instead of pooling–would reduce Lucent’s tax burden, helping its bottom line. There’s also evidence that companies overpay in order to be able to do pooling of interests, essentially paying a premium for a tactic that is literally of no value.
The Times suggested that shareholders like pooling of interests because it protects that most important of measures: “earnings per share.” But all the academic research suggests that shareholders don’t care about accounting gimmicks, and that what they really pay attention to is the underlying cash flow. This is true in the aggregate, even if particular investors fall in love with “earnings.”
On the face of it, after all, there’s something nuts about the whole premise of these articles, namely that you can use “pooling of interests” to trick investors into liking an acquisition that they would reject if it were done with cash. In the long run, the market is not deluded by accounting rules. In the long run, the underlying fundamentals are what it will pay attention to. And actually, I suspect McGinn knows this, even if those writing about him don’t.