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How not to start an acquisition.

Why Food Lion shares tanked 35% following the Hannaford announcement.

Wall Street just adores a good acquisition. In the past few years, the stock price of acquiring companies generally shot up immediately following announcements of major industry deals. Most recently it was Safeway/Randall's. Before that, it was Safeway/Dominick's. Kroger/Fred Meyer, Albertson's/American Stores and Fred Meyer/Ralphs + Quality Food + Smith's.

So why did Food Lion shares plummet 35% right after the company announced the buyout of Hannaford Bros., considered to be a strong operator by most in the industry? The explanation is part substance and part poor communication. We'll discuss the substance side of the issue this month and the communications snafus next month, along with the long-term strengths of the deal beyond the myriad short-term issues.

First of all, unlike the old TV game show, the price was wrong. The price paid was nothing less than stratospheric: 12 times Hannaford's next 12 months' operating cash flow, compared with the maximum of nine times previously paid for companies such as Vons. The nine times would even give the deal the benefit of the doubt by excluding Hannaford's losses from its online venture, HomeRuns, on the assumption that it will be divested quickly.

Thanks to the exorbitant price, as well as the dearth of synergies that will be discussed later, the acquisition is 22.5% dilutive to Food Lion's earnings per share (EPS). Dilutive acquisitions are a big no-no to Wall Street. So is a down year, which Food Lion will likely have, to the tune of 11%. We look for earnings per share of $0.55 in 2000 vs. $0.62 in 1999.

The deal would have generated better economics but still some dilution had Food Lion not been penalized by having to do a "purchase" transaction--which creates the extra expense of goodwill amortization--rather than a "pooling." For technical regulatory reasons the foreign ownership of Delhaize disallowed pooling treatment.

So why did the stock go down 35% when EPS were diluted only 22.5%? Because investor psychology became deadly.

The investment community perceived that Delhaize and Food Lion had been manipulated by the investment bankers into overpaying in the bidding process, as well as fearing further dilutive acquisitions. Delhaize has said, with admirable candor, that it is pushing Food Lion to expand through acquisition more rapidly and will finance that acquisition if need be. Delhaize has also noted that it has a mission larger than short-term economics--which is to catch up with Ahold and others as a global food retailer.

There is also the matter of turnover of the shareholder base. A potent though often misunderstood killer of stock price is the redefinition or reperception of a company's story into a different school of investing.

In this case, Food Lion instantly transformed from a "growth at a reasonable price" profile to a "deep value" story, and as always the selling camp exited more quickly than the buying cohort came in.

Psychology further suffered from the recognition that Food Lion's significant open-market share repurchase program would have to be suspended (for regulatory reasons) while the Hannaford deal is pending FTC approval. Even after consummation, Food Lion is unlikely to pursue buybacks for some time because the debt rating agencies would not look kindly upon it, making Food Lion's borrowing cost higher. The agencies would rather see, and it would be more prudent for Food Lion to execute, application of free cash flow to debt paydown of the large post-acquisition debt load.

Now, let's go beyond the numbers and stock market psychology to the limited strategic and operating fit between Food Lion and Hannaford. The problem is that in this case, unlike the Safeway/Randall's acquisition, there are only modest synergies.

Hannaford is already a super-efficient, high-margin and well-managed company (except for its recent Southeastern market entry). Food Lion can do little to improve on Hannaford's operation.

At the same time, Hannaford has structural weaknesses in the Southeast that have dogged it from day one. These include flawed and costly real estate, along with awkward and diffuse positioning/focus and without leadership in either low price (indeed having lost the game here to Food Lion) or service/perishables. Yet Hannaford will have to continue as a separate identity and operation because the big locations do not work as Food Lion units. Therefore, it is not likely that there will be the usual in-market acquisition savings from cutting redundant advertising, field supervision and overhead.

We sense, too, that there could be cultural frictions. How smoothly will Hannaford's New England, hard-charging, Harvard Business School, strategic-planning orientation mesh with Food Lion's Southeastern, promotion-from-within operations tilt (though the company has sharp professional management types too)? Will the Harvard MBAs accept that at the new company they are the Duke or Wake Forest of the North?

Gary M. Giblen is managing director of NationsBanc Montgomery Securities, a subsidiary of BankAmerica Corp.
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Title Annotation:Food Lion acquires Hannaford Bros
Comment:How not to start an acquisition.(Food Lion acquires Hannaford Bros)
Author:Giblen, Gary M.
Publication:Grocery Headquarters
Geographic Code:1USA
Date:Nov 1, 1999
Words:817
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