Mating Dance

SAN FRANCISCO (01/30/2000) - The stock market euphoria over the AOL Time Warner Inc. merger faded quickly. AOL's shares started falling the day the plan was announced, and within two weeks had lost 25 percent of their predeal value. But the AOL sag, whether it proves temporary or long-lasting, is an exception underscoring the general rule: Financial markets have been wildly enthusiastic about mergers and takeovers, which since the late 1990s have proceeded faster than ever before. The last year alone brought several huge combinations, any one of which would have seemed startling five years ago. Exxon-Mobil.

Daimler-Chrysler. MCI WorldCom-Sprint. WarnerLambert-Pfizer. And of course the continuing deals remaking the software and Net industries.

Shareholders, underwriters and executives have profited from the merger trend - which is intriguing, since their counterparts a dozen years ago profited from just the opposite business activity. In the mid-1980s heyday of Michael Milken and Henry Kravis, the financial excitement surrounded those who could break up companies and "realize their value" by selling them off in smaller pieces. And that was intriguing because it reversed the prevailing wisdom of the 1960s and 1970s, when conglomerates like ITT and LTV emerged and analysts believed that companies grew strong by piling on as many subsidiaries as they could.

So who is crazy here? Should markets reward new, expanded combinations - as in the 1970s, and again in the 1990s - or instead reward operations stripped to their lean essentials, as in the 1980s? Or do the shifts in market fashion reflect changes in the underlying realities? The old joke is, with three economists you'll get four opinions. After checking with half a dozen authorities, here are at least that many hypotheses for what is going on:

    Everyone is crazy. One East Coast professor, who is renowned for his studies of the economic impact of technology, essentially says: Don't ask me what's going on! "Investors seemed very excited about the AOL deal, and then the stock went down. I have no idea why any of this is happening."

    People are crazy, but they're not insane. "There is a very large element of fad and fashion" in the recent market premium for mergers, says Benjamin M.

    Friedman, a professor of economics at Harvard. He adds that he is generally skeptical about the supposed "efficiencies" or "synergies" that companies gain when combining already-large operations into behemoths. But in the current pro-merger climate, he says, even CEOs who themselves doubt the wisdom of a merger have strong reasons to pursue it. "What these people are trying to do is increase the valuation of their assets. If you are living in an era when the market is dominated by investors who think that merging is a dandy idea, then it is rational for you to pursue higher asset valuation through a strategy you may personally doubt." Moreover, he says, when there's a lot of merging going on, you risk being blindsided and taken over if you're not always trying to take over someone yourself.

    People are crazy, and the deals are the sign of a market top. Christopher Byron, columnist for the New York Observer and MSNBC, suggests that the recent slide in prices for companies that have staged takeovers, like AOL and MCI WorldCom, reveals the underlying illogic of the merger model. Through the 1990s, as WorldCom took over one company after another, "Wall Street began to view [its chairman, Bernie Ebbers], as defying the laws of gravity," Byron says. WorldCom's stock was valued very highly, compared to its revenues - like most Net companies. When it acquired companies whose shares had lower price-earning multiples, "Wall Street assumed that the simple fact of WorldCom owning it meant the earnings of the acquired company should get a higher multiple."

    In the last few months, reality set in, and WorldCom lost a third of its gains of the previous decade. AOL fell victim to a faster feedback cycle, Byron says.

    Investors figured out that the slower-growing partner, Time Warner, would make up four-fifths of the combined enterprise. How could the whole thing keep growing at AOL's rate?

    People are more rational than they seem, and they're making bets on the "network effect." Today's stylish academic concept is "network economics," which is a variant of the older ideas of industrywide standards and "increasing returns to scale." The clearest Net example is an auction site like eBay: The more people use the site, the stronger incentive each new customer has to choose this rather than any competitor, since buyers and sellers benefit by reaching the largest possible market.

    "The jury is still out on the question of whether this new 'network economics' will create advantages for very, very large firms," says John Zysman, of the Berkeley Roundtable on International Economics. So investors "are placing bets now," because the potential returns can be so huge.

    People are doing smarter mergers than before. Joseph Bower, a professor at Harvard Business School, says today's mergers are different in two crucial ways from those of the previous wave. Fewer of them are simple conglomerations, on the bigger-is-better principle; instead, "we're seeing mergers of things that people at least think are related, so there should be synergy." And if the alliance doesn't work out, it's much easier to undo than in the past. "Today if we see something that looks as if would make sense as a free-standing business, we'll spin it right off," Bower says - think of Microsoft with Sidewalk and Expedia - "whereas 20 years ago you wouldn't think of doing that."

    You've got to use money for something. Peter Temin, professor of economics at MIT, says that today's merger trend, like that of the early 1900s, is not as clear-cut as it may seem: "You have companies getting together and breaking up all the time. There were a number of supersize mergers at the turn of the century, some of which worked and some of which did not."

    The larger point he emphasizes is that merger waves are natural results of prolonged stock-market booms. Acquiring companies typically pay for the takeover with their own stock - and as their market value rises, they feel they have plenty to spend. And compared to other uses for the money, acquisition may seem to make the best strategic sense.

    "To some extent, they are buying other companies because they can't think of anything else to do," Temin says. "But it also can be a way of addressing perceived weaknesses in their corporate structure." For example, if your product range is not broad or flexible enough, during a bull market it is more attractive to buy a company that fills the gap rather than start a division on your own.

    People don't matter; interests rates do. The most mordant, and most unrebuttable, hypothesis about mergers comes from Christopher Byron: It begins and ends with interest rates. "Interest rates control the stock market," he says. "When they go down, the market goes up. When rates go up, the market goes down. That's all there is. It's been that way forever."

    This sounds obvious but has direct bearing on the merger trends. The late 1970s were a high interest-rate disaster; the prime rate hit 21 percent in Jimmy Carter's first term, which is why he didn't have a second. This depressed the stock market for a decade. "So, in the 1980s, you had these companies with strong balance sheets but very seriously depressed asset values," Byron says.

    "That gave rise to Mr. Milken" - and the broader wave of squeezing value out of companies that the general market, scarred by inflation, had underappreciated.

    And now we have the reverse: a decade of low inflation, more than a decade of strong stock prices, and merged companies that by all historic, rational, noncargo-cult standards are highly overvalued. If interest rates stay low forever, the high values, mergers and general good times can continue. If not ...

    Which of these hypotheses is correct? What makes this moment of economic history fascinating is that they're probably all partial descriptions of today's complex truth.

    James Fallows is the author of Breaking the News: How the Media Undermine American Democracy.

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