Operating Performance and Free Cash Flow of Asset

Buyers

Steven FreundAlexandros P. PrezasGopala K. Vasudevan

(Financial Management 32, 2003, 87-106)

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Introduction (1/2) Motivations: 1. Asset sales have become increasingly common in rece

nt years.• Fuji Xerox purchase of Xerox's Chinese operations for $550 million• Univision Communications purchase of USA's television stations for $

1.1 billion.

2. Most researchers concentrate on the seller's stock price reaction to the announcement of the asset sales. We focus primarily on the buyer's operating performance following the purchase.

Contributions:1. We believe this is the first article to examine the operat

ing performance of asset buyers following a purchase.

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Introduction (2/2) Contributions:2. We provide evidence on the free cash flow

hypothesis for asset buyers. 3. We also assess the implications of the fit and

focus hypotheses for asset buyers. 4. We examine a sample that is much larger than

most previous studies.

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Literature Review and Hypothesis Development (1/4) The positive announcement period stock

returns of asset sellers.

1. Fit Hypothesis: The assets are worth more to a buyer, and the buyer is he

nce willing to pay more for them. Alexander, Benson, and Kampmeyer (1984); Jain (1985); H

ite, Owers, and Rogers (1987); and Maksimovic and Phillips (2001).

2. Focus Hypothesis: Firms that divest unrelated lines of business and focus on

their core lines tend to see increases in market value. Berger and Ofek (1995), John and Ofek (1995) and Comme

nt and Jarrell (1995).

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Literature Review and Hypothesis Development (2/4) The positive announcement period

stock returns of asset sellers.

3. Management discretion Hypothesis: It is based on the assumption that managers value firm

size and control. This suggests that the proceeds from asset sales retained by the firm represent free cash flow that managers can use to pursue their objectives. Hence, the announcement of asset sales would be good news to the market when the proceeds are paid out rather than reinvested within the company.

Lang et al. (1995) find that asset sales follow poor operating performance and the associated stock price reaction is positive only when the asset sales proceeds are paid out.

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Literature Review and Hypothesis Development (3/4) The announcement period returns of ass

et buyers.

1. Main Hypothesis: The buyers could be purchasing the assets because of ma

nagerial incentives to add to their private benefits. Jensen (1986) argues that firms with large amounts of free cash flow can purchase an asset for a price above its true economic value.

Lang, Stulz, and Walking (1991) document that bidders with high free cash flow and poor investment opportunities have negative returns when they announce acquisitions.

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Literature Review and Hypothesis Development (4/4) The announcement period returns of ass

et buyers.

2. Competing Hypothesis: Emery and Switzer (1999) hypothesize that managers acti

ng in the best interests of shareholders choose the acquisition method that maximizes the announcement period returns.

Sicherman and Pettway (1992) examine the wealth effects of divestitures for both sellers and buyers. They find that announcement period returns are positive for both sellers and buyers.

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Sample and Methodology (1/4) Data : There are 552 asset purchases in our sample for

the period 1984 through 1996. They are chosen to meet criteria as follows:

1. The buyer is an industrial firm, and information on the asset purchase is variable in the database maintained by the Securities Data Company (SDC).

2. Only the first transaction is included per firm per year.3. The asset purchased has a value of at least $100 million.4. The buyer and the seller are publicly traded firms.5. Accounting data on operating performance variables are

available in the Compustat annual database.6. Stock price data are available in the Center for Research

in Security Prices (CRSP) database.

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Sample and Methodology (2/4) Methodology : We examine the stock price reaction to the announcement

of asset purchases using the standard event study methodology.

We then examine the relationship between the stock price reaction and firm variables using cross-sectional regressions.

• Cumulative abnormal returns are regressed against: 1) method of payment; 2) degree of similarity between the buyer's existing assets and the new asset; 3) buyer's operating free cash flow; and 4) firm size in the year prior to purchase.

The method of payment variable is a dummy variable that equals 1 if the buyer used cash to purchase the asset, and zero otherwise.

• Travlos (1987) and Loughran and Vijh (1997) find that firms that pay for merger with stock have significantly poor returns, while firms that make purchases with cash have positive excess returns.

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Sample and Methodology (3/4) Methodology : The industry-relatedness variable is a dummy variable

that equals 1 if the asset purchased has the same SIC code as one of the buyer's three main lines of business.

• The focus hypothesis predicts that firms with fewer lines of business are valued more highly than conglomerates (Berger and Ofek, 1995). It is presumably easier for buyers to manage a new asset if they have knowledge of the business. This hypothesis implies that firms that purchase related assets should perform better than firms that purchase unrelated assets.

The free cash flow defined as Lang and Litzenberger (1989)

• The free cash flow theory predicts a negative relationship between the free cash flow of the firm during the purchase year and the announcement period returns to the buyers. The market perceives that buyers with high free cash flow may be wasting shareholder wealth by engaging in asset purchases.

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Sample and Methodology (4/4) Methodology : The size variable is the natural log of the book valu

e of assets of the buyer. Others have found stock price reaction to be related to firm size (e.g., John and Ofek (1995)).

The growth opportunities is the ratio of the market value of equity plus the book value of debt, to the book value of assets. This is a proxy for Tobin's q and has been used by Jung, Kim, and Stulz (1996) and Lang et al. (1991), among others.

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Table 1. Distribution of Asset Purchases by Calendar Year

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Table 2. Summary Statistics for Asset Buyers

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Table 3. Announcement Period Returns for Asset Buyers (1/2)

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Table 3. Announcement Period Returns for Asset Buyers (2/2)

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Table 4. Regression

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Table 5. Operating Performance

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Table 6. Change in Operating Performance

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Table 7. Regression of Change in Operating Performance on Asset Buyer Characteristics

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Table 8. Change in Other Efficiency Ratios

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Conclusions (1/2) Announcement period returns are positive and

significant for asset buyers with low free cash flow. There is a negative relationship between the stock

price reaction and buyers' free cash flow. This suggests that the market perceives low growth firms with high free cash flow as wasting shareholder wealth by overpaying for the assets they buy.

The sample firms experience better operating performance than the industry median performance during the entire period of our analysis.

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Conclusions (2/2) We also find free cash flow to be negatively

related to operating performance changes for the high-growth firms, although the changes are of lower economic and statistical significance than for the low-growth firms.

Our findings suggest that firms with fewer growth opportunities and large amounts of free cash flow may potentially be wasting shareholder wealth by engaging in these asset purchases.