John DVThis past Monday was another “Merger Monday,” or maybe we should call it “Merger Madness.” Or even “March Madness.” In any case, a total of three deals worth over $37 billion were struck on Monday.

First up Sherwin-Williams announced a deal to acquire Valspar at over an $11 billion valuation. That’s a lot of paint! Markit, a financial services company, is teaming up with IHS in a $13 billion deal. Finally, Marriot and Starwood are joining forces in a $13.6 billion deal to create a mega hotel chain.

Mergers and acquisitions have become a popular tool of late for companies trying to overcome the growth obstacle. 2015 was a record year for them. The last record was set in 2007 during the last bubble.

While investors get excited about the prospects of a takeover, especially if they own shares in the acquired company, we should be wary about what this means for the stock market.

Mega deals might look good on paper, but upon closer examination, they may flash a host of red flags.

When a company makes an acquisition it books the revenue from the acquired entity from that day forward. But, it does not readjust prior periods to reflect what the combined entity would look like had the merger occurred in the past.

That makes the revenue growth look a lot greater than it really is.

In order to find out what the “organic” or sustainable revenue growth is, you have to dig into the notes of the SEC filings, which very few people do. What’s more, the acquiring company could deem the acquisition “immaterial,” and not even report those numbers to investors. So it could become very difficult to really figure out what’s going on with the financial statements.

In order to keep the growth rate up, companies need to make bigger and bigger acquisitions. They risk not only overpaying, but also opening a whole can of worms. There are many ways to mask a slowing business by using acquisition accounting.

For example, these big mergers expect to have cost synergies. “Synergy” is a fancy word for firing people. When companies do this they take charges and build reserves to handle layoffs, closing factories, and other reorganization activities. If they don’t use those reserves, they may reverse them at a later date to artificially boost earnings.

They also create goodwill, which is the excess cost of the acquisition above and beyond the acquired company’s fair market value. But, goodwill can be misleading. It’s an estimate. It may also contain normal operating costs that an aggressive management could stick in the goodwill account and keep off the income statement. That’s another unsustainable boost to earnings.

Big acquisitions also overstate cash flow. Companies get the benefit to their operating cash flow from collecting on receivables and selling inventory. But, the cost of the acquisition is an investing cash outflow. Most people fail to include this in the free cash flow calculation.

Once the growth slows and the benefits go away, big acquirers are often exposed for having weak cash flow. Then they get pummeled in a bear market when all of these financial shenanigans become obvious and access to financing for larger and larger acquisitions dry up.

What’s more is that the odds don’t even work for making a big acquisition. According to McKinsey, the large consulting firm, 70% of mergers fail.

If you know the odds are so much against you, then why do it?

The mega mergers may be a result of trying to find growth late in a market cycle. It is the last gasp to beat numbers before the bull market runs out of steam. When the steam runs out, everything comes crashing down. The executives get rich, many people lose their jobs, and investors are left holding the bag.

We look at all of these red flags and more in Forensic Investor. In my experience, huge deals bring huge problems. While none of these companies may be guilty of aggressive accounting, it does show that they need very large deals to boost their growth.

When the environment is less friendly and capital dries up, each of them risks being exposed for poor financial performance. The size of these deals reaffirms my belief that the end of this bull market is near.

John Del Vecchio
Editor, Forensic Investor 

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John Del Vecchio
In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.