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EISEVIER Journal of Financial Economics 39 (1995) 353-378 An analysis of value destruction in AT&T’s acquisition of NCR Thomas Lys*~“, Linda Vincentb “J.L. Kellogg Graduate School of Management, Northwestern University, Evanston, IL 60208, USA “Graduate School of Business, University of Chicago, Chicago, IL 6063 7, USA (Received August 1992; final version received March 1995) Abstract AT&T’s $7.5 billion acquisition of NCR decreased the wealth of AT&T shareholders by between $3.9 billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0 billion. We find that AT&T paid a documented $50 million and possibly as much as $500 million to satisfy pooling accounting, thus boosting EPS by roughly 17% but leaving cash flows unchanged. We conclude that AT&T’s decision to acquire NCR in what the market perceived as a value-destroying transaction was related at least in part to the 1984 consent decree with the Department of Justice that led to the break-up of AT&T. Key words: Mergers; Acquisitions; Purchase; Pooling JEL classijication: G34; M41 1. Introduction After almost six months of hostile maneuvering, NCR agreed to be acquired by AT&T in an all-stock transaction valued at $7.5 billion. This was the largest *Corresponding author. Financial support from Deloitte & Touche, KPMG Peat Marwick, and the Accounting Research Center at the J.L. Kellogg Graduate School of Management, Northwestern University, is gratefully acknowledged. We are indebted to Robert C. Holder, President of AT&T Computer Systems (and previously head of the transition team for the purchase of NCR), for answering numerous questions about this merger in discussions on December 6, 1991. We have benefited from the comments of W. Bruce. Johnson, Steven N. Kaplan, Margaret Neale, Lawrence Revsine, Michael C. Jensen (managing editor), Richard S. Ruback (editor), and William Fruhan and Victor Bernard (referees.) 0304-405X/95/%09.50 0 1995 Elsevier Science S.A. All rights reserved SSDI 0304405X9500831 X
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Page 1: AT&T Acquisition of NCR_Lys&Vincent

EISEVIER Journal of Financial Economics 39 (1995) 353-378

An analysis of value destruction in AT&T’s acquisition of NCR

Thomas Lys*~“, Linda Vincentb

“J.L. Kellogg Graduate School of Management, Northwestern University, Evanston, IL 60208, USA “Graduate School of Business, University of Chicago, Chicago, IL 6063 7, USA

(Received August 1992; final version received March 1995)

Abstract

AT&T’s $7.5 billion acquisition of NCR decreased the wealth of AT&T shareholders by between $3.9 billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0 billion. We find that AT&T paid a documented $50 million and possibly as much as $500 million to satisfy pooling accounting, thus boosting EPS by roughly 17% but leaving cash flows unchanged. We conclude that AT&T’s decision to acquire NCR in what the market perceived as a value-destroying transaction was related at least in part to the 1984 consent decree with the Department of Justice that led to the break-up of AT&T.

Key words: Mergers; Acquisitions; Purchase; Pooling JEL classijication: G34; M41

1. Introduction

After almost six months of hostile maneuvering, NCR agreed to be acquired by AT&T in an all-stock transaction valued at $7.5 billion. This was the largest

*Corresponding author.

Financial support from Deloitte & Touche, KPMG Peat Marwick, and the Accounting Research Center at the J.L. Kellogg Graduate School of Management, Northwestern University, is gratefully acknowledged. We are indebted to Robert C. Holder, President of AT&T Computer Systems (and previously head of the transition team for the purchase of NCR), for answering numerous questions about this merger in discussions on December 6, 1991. We have benefited from the comments of W. Bruce. Johnson, Steven N. Kaplan, Margaret Neale, Lawrence Revsine, Michael C. Jensen (managing editor), Richard S. Ruback (editor), and William Fruhan and Victor Bernard (referees.)

0304-405X/95/%09.50 0 1995 Elsevier Science S.A. All rights reserved SSDI 0304405X9500831 X

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public financial transaction in 1991 as well as the largest computer industry merger to date. AT&T persisted in its pursuit of NCR despite the security market’s initial and consistently negative reactions to the proposed deal. AT&T shareholders lost between $3.9 and $6.5 billion in market value during the negotiations. Upon completion of the transaction, investors assessed AT&T’s overpayment for NCR at between $60 and $101 per share on a final bid price of $111 per share.

We explore the motivation behind AT&T’s strategy to acquire NCR as well as its determination to proceed with what the market perceived to be a value- destroying transaction. We also examine why AT&T was willing to pay as much as $500 million extra for NCR to satisfy requirements to use the pooling-of- interests (pooling) accounting method rather than the purchase method, even though the accounting method had no direct cash flow implications for this deal.

Our analysis suggests that AT&T’s management initiated the acquisition of NCR in order to save face for perceived past management mistakes stemming from the 1984 divestiture of the Bell operating companies. AT&T’s management pursued the acquisition, despite NCR’s resistance and the market’s consistently negative reaction to the deal, because of a combination of hubris, bad judgment, and escalation of commitments. Although this assessment is made with the benefit of hindsight, we document that there were clear indications that AT&T would have difficulty succeeding in this acquisition because of the dismal history of similar mergers and management’s limited experience in a competitive envi- ronment. AT&T preferred the pooling method of accounting to avoid the decrease in future earnings per share (EPS) that would result from the purchase method. We also find that AT&T successfully lobbied the SEC to grant ap- proval for pooling, despite several violations of the requirements for pooling.

The next section describes the background and motivation for AT&T’s acquisition of NCR. Section 3 analyzes investors’ reactions to the acquisition as well as the relative costs and benefits of the acquisition. Section 4 documents the magnitude of the incremental costs of pooling as well as possible reasons for AT&T’s willingness to pay for the opportunity to use pooling. Section 5 dis- cusses explanations for AT&T’s completion of this merger despite repeated and unambiguous indications that investors did not view NCR as a value-enhancing acquisition. Finally, Section 6 provides a summary and our conclusions.

2. AT&T’s motivation for purchasing NCR

AT&T was founded in 1885 and, as a regulated utility, enjoyed a virtual monopoly of long-distance telephone service and equipment manufacture for almost a century. In 1974, the Department of Justice (DOJ) brought a civil antitrust action against AT&T for monopolizing telecommunications services and equipment. This suit sought divestiture of AT&T’s equipment manufacturing

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subsidiary (Western Electric Company, Inc.) and the separation of its long- distance services (AT&T Long Lines Department) from the Bell operating companies which would then provide only local telephone service. After fighting the DOJ for several years, AT&T signed a consent decree in early 1982. The decree required AT&T to divest the Bell operating companies, representing about 75% of AT&T’s total assets, in exchange for the right to enter into previously prohibited (except for internal activities), unregulated, computer- oriented endeavors. The consent decree, effective January 1, 1984, allowed AT&T to sell both computer equipment and ‘enhanced services’ which em- bodied data processing.

AT&T’s management was roundly criticized in the financial press for signing the consent decree. This criticism intensified when the DOJ dropped its concur- rent antitrust suit against IBM several months after AT&T’s capitulation. However, AT&T’s management believed that its future lay in linking telecom- munications with computer operations and considered the divestiture an oppor- tunity to expand into new areas of information services as well as to capitalize commercially on its accumulated expertise in both telecommunications and data processing (e.g., AT&T’s Bell Labs had pioneered significant developments in computer science, including the UNIX operating system). Given the changing nature of the telecommunications industry, as exemplified by not only the antitrust action against AT&T but also the results of the FCC’s Second Com- puter Inquiry (in which the FCC ruled in 1981 that enhanced services and customer premises equipment would be detariffed) and the court’s 1974 ruling that AT&T had to supply access lines to its competitor, long-distance supplier MCI, AT&T’s management believed that it had no choice but to alter its strategy for the future.

AT&T’s management stressed the net benefits to be obtained from signing the consent decree in its external communications. For example, the 1984 Annual Report (p. 9) stated that ‘one of the most significant events of 1984 was our entry into the general purpose computer business. . . Computer hardware and soft- ware systems play a major part in our strategy to provide integrated commun- ications based office automation systems’. AT&T’s Chairman of the Board and CEO reconfirmed this commitment to the computer business in the 1985, 1986, and 1987 Annual Reports, stating (1986 Annual Report, p. 2) that ‘. . . computers are an intrinsic part of our business. We will continue to sell them on a stand- alone basis, but in a larger context we view computers as a vital element in the development and implementation of information networks. Our vision is to link computers and other customer premises equipment with public and private network facilities . ..’ None of this was possible under the pre-consent decree regime.

The current CEO, Robert Allen, took office in 1988 and part of his stated strategic vision was to make AT&T a significant player in the computer business. Allen wanted the company to be technology-driven and to provide an

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outlet for the technological advances generated by Bell Labs (Verity and Cory. 1992). Thus, all three post-divestiture CEOs made major public commitments to the computer industry as part of the justification for and strategy after signing the consent decree.

AT&T experienced difficulty in achieving the benefits foreseen from the divesti- ture. Results for its computer operations are not disclosed separately, but the financial press estimated that AT&T’s computer operations lost at least $2 billion between 1984 and 1990, with losses of between $100 million and $300 million on sales of $1.5 billion for 1990 alone (Keller and Wilke, 1990; Davis, 1991). AT&T’s management did not deny the unprofitable nature of its computer operations, and their unsuccessful attempts to bolster computer operations included joint ventures and investments in several high technology companies (Keller and Wilke, 1990). AT&T had also considered several large candidates for acquisition.

In 1990, AT&T’s management concluded that continuing computer losses dictated either a significant increase in its investment or divestiture of the com- puter operations (Keller, 1990). Management elected to increase its commitment to the business. Analysts speculated that AT&T chose to expand its investment in order to save face for signing the consent decree as well as for its subsequent public confirmations of the divestiture-related strategy and its significant investment in computer technology (Noll, 1991; Sloan, 1991a). Having tried other approaches, AT&T decided to make a major acquisition. This decision was made despite the consistently dismal history of computer mergers (e.g., Burroughs with Sperry Corp. (UNISYS), Honeywell with Bull, Hewlett-Packard with Apollo Computer, and IBM’s 1984 purchase of Rolm) by a management with limited competitive experience entering a highly competitive, rapidly changing industry. In addition, AT&T’s acquisition candidate, NCR, had experienced recent setbacks, with operating income before taxes declining in both 1989 and 1990 and revenues increasing an average of only 2% in each of those years. NCR’s stock price was at a three-year low just prior to the bid and NCR had just introduced a new line of computers in an attempt to improve its lackluster performance.

AT&T first approached NCR as an acquisition candidate in July 1988. At that time, NCR stated its preference to remain independent but told AT&T that if it were ever under attack from another company, AT&T would be its favored ‘white knight’.’ AT&T approached NCR again seeking a merger agreement in June 1989 and was again rebuffed (Davis, 1991). AT&T considered NCR an appropriate acquisition target for several reasons:

a) NCR and AT&T had compatible product lines and a similar philosophy about open computer systems using the UNIX operating system. NCR was also stronger than AT&T in networking.

‘This is according to our December 1991 conversation with Robert C. Holder.

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b) NCR had a corporate culture compatible with AT&T’s, especially as com- pared to some of the Silicon Valley firms which AT&T had considered as merger candidates.

c) NCR had an international computer marketing presence and customer base which AT&T lacked.

d) NCR was a possible and practical acquisition whereas some other candidates such as Hewlett-Packard had impediments to acquisition (e.g., family trusts).

Perhaps concerned about its poor reputation in the computer business, AT&T announced early in the negotiations with NCR that it planned to combine AT&T’s and NCR’s computer businesses under NCR’s senior management team, retaining NCR’s name.

In summary, the decision to acquire NCR reflected AT&T’s continued efforts to transform itself from a regulated monopoly to a successful market competi- tor. Unable to demonstrate profitability in its own computer operations, AT&T went outside to obtain critical mass and management talent. The next section examines whether investors agreed with AT&T’s strategy to acquire NCR and whether the merger resulted in synergies as reflected by an increase in the combined market values of AT&T and NCR as a result of the announced merger.

3. Shareholder value implications

3.1. Total wealth implications

In order to assess the wealth effect of the proposed merger, we compute abnormal returns for AT&T and NCR using the market model (Fama, 1976) and continuously compounded daily returns for AT&T, NCR, and the S&P 500 Composite Index. Because the negotiations extended over a six-month period, encompassing many nonmerger events, we focus on the major, merger-related events and calculate abnormal returns in two-day windows consisting of the trading day prior to and the day on which each major merger-related event is reported in the Wall Street Journal (WSJ). Table 1 summarizes the key events and associated abnormal returns. Because of the short windows, we are reason- ably sure that no other events were announced concurrently, allowing attribution of any unexpected share price changes to the merger-related announcements.

AT&T investors reacted unfavorably to the initial news of the proposed merger and the market responses to subsequent events were generally negative for AT&T whenever the events implied an increase in the probability of successful completion of the transaction. Moreover, as indicated in Table 1, this

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Table 1 Chronology of major events in the acquisition of NCR by AT&T

The ‘report date’ refers to the publication date of the Wall Street Journal in which the event was first reported The abnormal return is calculated for the two-day window consisting of the trading date just before the repor date and the report date. The t-statistic is calculated by dividing the abnormal return by its standard error fron the estimation period, adjusted for out-of-sample predictions. For multiple event days. the t-statistic i computed as the sum of the t-statistics for each individual day divided by the square root of the number of days

Report date

AT&T NCR abnormal abnormal return return (t-statistic) (t-statistic) Event description

I l/8/90 - 2.43 % + 12.53% ( - 1.39) ( + 6.61)

- 3.96% + 3.97% ( - 2.27) ( + 2.11)

12/3/90

12/3/90

12/06/90

12/06/90

02/20/9 1

02/21/91

03/10/91

03/19/91

03/27/9 1

- 7.41% + 44.46% ( - 4.25) ( + 23.37)

- 1.75% ( - 1.01)

+ 10.52% ( + 5.47)

- 1.46% + 3.62% ( - 0.82) ( + 1.91)

- 1.96% + 2.04% (- 1.12) ( + 1.08)

+ 3.72% - 1.86% ( + 3.00) (-1.40)

+ 1.80% + 5.78% ( + 1.07) ( + 3.03)

+ 1.51% + 2.23% ( + 0.88) ( + 1.18)

Unconfirmed report that AT&T and NCR were discuss ing a combination of their computer businesses.

AT&T proposed to acquire NCR in a tax-free merger (i stock for stock exchange) worth $85 per share to NCR a premium of 80% over the pre-rumor trading price o NCR stock of $47.25 per share. NCR shareholders woulc also receive a 140% increase in the dividend. AT&l indicated that it would complete a cash transaction i NCR preferred.

NCR’s board unanimously rejected the AT&T offer AT&T increased its bid to $90.

AT&T made a public bid for NCR at $90 per share o a total of $6.04 billion. NCR stock price increased $24.7: to $81.50 in response. AT&T’s stock fell $2 per share tc $30.125.

The board of directors of NCR rejected the AT&T bit. but approved the strategy to enter into negotiations witl AT&T if AT&T offered not less than $125 per share NCR’s shares closed at $86.625 per share.

AT&T commenced a tender offer to purchase all out standing shares of NCR common stock for $90 per sharl in cash.

NCR established the SavingsPLUS Plan, a qualifiec ESOP.

NCR announced a $1 per share special dividend am $0.02 per share regular dividend increase.

AT&T announced that it was prepared to raise its offe to $100 per share if NCR would negotiate a merge agreement. NCR rejected this offer.

Federal Court invalidated NCR’s ESOP.

NCR reduced its asking price to $110 per share fron $125 per share.

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Table 1 (continued)

Report date

AT&T abnormal return

(r-statistic)

NCR abnormal return (r-statistic) Event description

04/19/91

04/20/9 I

05/06/9 1

08/13/91

09/13/91

09/19/91

- 1.32% + 5.81% ( - 0.74) ( + 3.09)

- 2.25% + 0.77% ( - 1.29) ( + 0.41)

- 2.29% - 0.37% ( - 1.31) ( - 0.19)

- 1.11% - 1.00% ( - 0.63) ( - 0.53)

- 1.63% - 1.73% (*) ( - 1.34) (- 1.33) (*)

Total for the 20 event days

through 05/07/9 I

- 13.33% ( - 2.47)

Total for the 24 event days through 09/l 619 1

- 16.26% ( - 2.82)

+ 120.29% ( + 14.70)

+ 117.29% ( + 13.96)

AT&T increased its offer for NCR to $110 per share with no collar or adjustment. The merger would be tax free and, subject to SEC approval, accounted for as a pooling of interests.

NCR responded that it preferred a cash and stock deal but would negotiate an all-stock transaction if AT&T insisted.

AT&T agreed to buy NCR for $110 per share, a total of $7.48 billion. This agreement was for an ah-stock merger unless AT&T could not satisfy itself that an all-stock merger could be accounted for as a pooling of interests, in which case the merger would be converted to a cash election merger with 40% of NCR’s shares exchanged for $110 cash per share and the remaining 60% exchanged for $110 in AT&T stock. High and low collars were added to the stock deal so that NCR shareholders would be protected in case of a decline in AT&T’s share price prior to the actual merger date.

AT&T filed NCR’s proxy statement with the SEC for the shareholders’ meeting to approve the proposed merger. This indicated that AT&T had received tacit approval from the SEC to structure the acquisition of NCR as a pooling of interests. However, the proxy states that if AT&T is not able to satisfy the conditions necessary for treatment as a pooling of interests, then it will revert to the 40% cash and 60% stock purchase.

NCR shareholders voted to merge with AT&T.

Merger between AT&T and NCR completed. AT&T issued 184.5 million shares for the merger. NCR no longer traded on the NYSE. [(*) = oneday return for NCR]

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Table 1 (continued)

Report date

AT&T abnormal return (t-statistic)

NCR abnormal return (t-statistic) Event description

Total for the 25 event days through 09/19/91

- 17.62% + 113.53% ( - 3.03) ( + 12.68)

10116/89 10/16/90 1111190 05/7/91 9/l 9/91

t-

Negotietion Period

. . . .

Estimation period

I Acquisition Period

Fig. 1. Estimation, negotiation, and acquisition periods.

The estimation period, 10/16/89 to 10/15/90, is used to estimate the market model parameters used to compute abnormal returns. The negotiation period of 1 l/1/90 to 5/7/91 commences just prior to the first bid by AT&T for NCR and extends through the announcement of the signing of the merger agreement. The acquisition period is defined as the negotiation period plus the period from the merger agreement announcement date to the actual completion of the merger on 9/19/91 when NCR stopped trading.

negative reaction was consistent across the different structures that AT&T proposed for the deal (e.g., the initial merger offer followed by a hostile tender offer), offer prices (ranging from $85 to $110 per NCR share), and modes of payments (cash or exchange of stock). These returns imply that (for the proposed terms) investors viewed AT&T’s acquisition of NCR as a negative net present value investment. The sums of the two-day cumulative abnormal returns (CARS) over the negotiation period (see Fig. 1) of November 1, 1990 (just prior to the initial rumors of merger talks between AT&T and NCR) to May 7, 1991 (the date on which the signing of the merger agreement was announced) total - 13.33% (t = - 2.47) for AT&T and + 120.29% (t = + 14.70) for NCR.

These abnormal returns translate to a total wealth loss by AT&T shareholders of $4.9 billion for the 20 event days comprising the major events during the negotiation period, computed by multiplying AT&T’s abnormal return of 13.33% by its pre-announcement (October 31,199O) stock price of $34 and the 1.092 billion shares outstanding as of the end of the year. In contrast, NCR shareholders’ wealth increased by $3.7 billion, computed by multiplying NCR’s abnormal return of 120.29% by the pre-announcement (October 31,199O) stock

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price of $47.25 and the 64.5 million NCR shares outstanding as of December 31, 1990. The details of all calculations are shown in Table 2. Our abnormal returns analysis concentrates on the six-month negotiation period rather than the entire ten-month acquisition period (Fig. 1) because the negotiation period captures the majority (88.6%) of the resolution of uncertainty associated with the merger (Larcker and Lys, 1987).’

While mitigating the influence of nonmerger-related events, the two-day windows capture only the change in the probability of the merger directly attributable to the announcements, thus underestimating the aggregate market impact of the announcements (Lewellen and Ferri, 1983). Therefore, we also expand the analysis to include all trading days within the negotiation period, resulting in CARS of + 103.27% (t = + 15.30) for NCR and - 14.32% (t = - 1.00) for AT&zT.~ NCR’s CAR of + 103.27% translates to an overall wealth gain of $3.1 billion for NCR’s shareholders. AT&T shareholders, on the other hand, experienced a decrease in wealth of approximately $5.3 billion, or roughly $4.87 per share, over the same period.

AT&T’s market price decline implies that investors assessed the value of NCR to AT&T at between $28 and $35 per share, computed as the price paid by AT&T of $110.74 per share less the per (NCR) share decrease in AT&T’s market value. For example, AT&T’s total market value decline of $4.9 billion for the major events of the negotiation period translates to $76 per acquired NCR share ($4.9 billiom64.5 million shares). Therefore, the implied value to AT&T of each NCR share was $110.74 less $76, or $34.74, substantially less than NCR’s pre- merger price of $47. Consistent with these computations, the synergies for the negotiation period, computed as the sum of the changes in shareholder wealth of the target and the bidder (Bradley, Desai, and Kim, 1988) are estimated at between - $1.3 billion and - $2.2 billion. Extending the analysis to the entire acquisition period (1 l/1/90 to 9/19/91) results in negative synergies of $3.0 billion for the merger-related events as AT&T shareholders’ wealth declined by $6.5 billion and NCR shareholders’ wealth increased by $3.5 billion. This translates to a per share value of NCR to AT&T of $10.

Investors’ negative response to AT&T’s acquisition of NCR was consistent with AT&T’s poor performance in the computer business; that is, investors may

*The market-implied probability of completion is computed as (P - P&P, - I’,.,,), where P is the closing price of NCR stock on May 7, 1991, PNS is the closing price of NCR stock on October 31, 1990, and Ps is the final offer price [($103.50 - 47.25)/($110.74 - 47.25) = 0.8861.

3Because the negotiation period contains numerous nonmerger-related events and because AT&T is roughly six times larger than NCR, it is not surprising that AT&T’s CAR within that period is statistically insignificant at conventional levels. Indeed, AT&T’s CAR for the six-month period would have to be roughly - 28% or - $10 billion in total market value in order to be significant at the 5% level, an unlikely outcome in a $7.5 billion acquisition.

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have believed that AT&T would dissipate its investment in NCR just as it had previous computer investments. An alternative explanation for the negative market reaction is that the market was responding to the effective announce- ment that AT&T was not going to exit the computer business. For two reasons, however, we believe that the negative response was due to the announced acquisition of NCR. First, AT&T had previously pursued several potential merger partners and had initiated joint ventures with companies including Sun Microsystems and Olivetti, implying that the prior probability that AT&T intended to exit the computing business was low. Second, if the negative market responses were due to the announcement that AT&T was remaining in the

Table 2 Cumulative abnormal (i.e., market- and risk-adjusted) returns (CARS), continuously compounded (neither market-nor risk-adjusted) returns, and shareholder wealth effects, for AT&T and NCR during the negotiation and acquisition periods.

The continuously compounded returns are provided for comparison purposes so it is clear that the use of the market model is not the sole source of the results. The wealth effects for the merger-related events are computed using the sum of the abnormal returns for the events days given in Table I. The wealth effects for the entire period are computed using the cumulative abnormal returns for all trading days within the period, thereby including the effects of nonmerger-related events. The net shareholder wealth effect (the sum of the change in wealth of AT&T and NCR) measures the (negative) synergies for the merger. The (imputed) value to AT&T of each NCR share is calculated as the price per share of NCR that AT&T could have paid without decreasing its own price per share.

Negotiation period November 1, 1990 to May 7, 1991

Acquisition period November 1, 1990 to September 19, 1991

Cumulative abnormal returns (merger-related events only)

AT&T (t-stat.) - 13.33% ( - 2.47) NCR (t-stat.) 120.29% ( + 14.70)

- 17.62% ( - 3.03) 113.53% ( + 12.68)

Cumulative abnormal returns (all trading days)

AT&T (t-stat.) - 14.32% ( - 1.00) NCR (t-stat.) 103.27% ( + 15.30)

- 10.49% ( - 0.51) 111.35% ( + 4.24)

Continuously compounded (nonmarket-adjusted)

AT&T 10.34% NCR 124.11% S&P 500 25.03%

16.81% 129.50% 30.47%

Merger-related events only

AT&T wealth loss NCR wealth gain Negative synergies’ Value to AT&T of NCR share

- $4.949 billion” + $3.664 billionb - $1.285 billion

$35 per shared

- $6.542 billione’ + $3.459 billion’ - $3.083 billion

$10 per shares

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Table 2 (continued)

Negotiation period November 1, 1990 to May 7, 1991

Acquisition period November 1, 1990 to September 19, 1991

Entire period (a/l trading days)

AT&T wealth loss NCR wealth gain Negative synergies’ Value to AT&T of NCR share

- $5.3 17 billion” + $3.146 billion’ - $2.171 billion

$28 per share’

- $3.895 billion” + $3.392 billion’ - $0.503 billion

$50 per share”

a - 13.33%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of 1013 l/90. b120.29%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of 10/31/90. ‘Wealth loss of AT&T plus wealth gain of NCR. d$l 10.74 - ($4.949 billion + 64.48 million shares of NCR). e - 17.62%CAR x 1,092 million shares outstanding as of 12/31/90 x $34.00 per share price as of 10/31/90. ‘113.53%CARx64.48 million shares outstanding as of 12/31/90x$47.25 per share price as of 10/31/90. YS110.74 - ($6.542 billion + 64.48 million shares of NCR). h- 14.32%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of 10/31/90. ‘103.27%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of 10/3 l/90. $110.74 - ($5.317 billion + 64.48 million shares of NCR). k- 10.49%CAR x 1,092 million shares outstanding as of 12/31/90x $34.00 per share price as of 10/31/90. ‘111.35%CAR x 64.48 million shares outstanding as of 12/31/90x $47.25 per share price as of 1 o/3 I /90. “$110.74 - ($3.895 billion t 64.48 million shares of NCR).

computer business, then we would expect the market reaction to be immediately negative and not spread out over additional events in the acquisition period that offered no additional information about a change in strategy.

3.2. Was the market’s assessment correct?

Although results for AT&T’s computer business are not broken out separ- ately in its financial statements, AT&T discloses them in its quarterly earnings announcements. Because of the consolidation of NCR and AT&T’s previous computer operations, post-merger results are not directly comparable to NCR’s pre-merger results; however, the post-merger results should be greater because they incorporate more than just NCR’s assets. NCR’s last full year financials for 1990 reported $6.3 billion in sales and $369 million in net income. NCR’s 1991

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results were ‘materially below’ projections made to AT&T of $6.62 billion in sales and $386 million in operating income, with actual sales of $6.3 billion and operating income of $103 million, including a $182 million charge due to merger expenses (Keller, 1991b). AT&T reported 1992 computer results of $7.1 billion in sales and $288 million in operating income. The 1993 results indicated $7.3 billion in sales and a net operating loss of $99 million, including $190 million of restructuring charges. The first quarter 1994 operating loss of $61 million included restructuring charges of $120 million. Thus far, operating results have not been impressive compared to NCR’s historical performance, especially when considered relative to a $7.5 billion investment.

In addition, in late 1993 NCR announced plans to reduce its work force by 15% or 7,500 employees during 1994. In early 1994, AT&T changed the name from NCR to AT&T Global Information Solutions (GIS). NCR CEO Exley, with 36 years of experience in the computing business, had departed, as prom- ised, when the merger was completed and former NCR President Williamson left AT&T during 1993. AT&T has thus not maintained its announced strategy to retain NCR’s name, reputation, and management following the merger. Finally, in June 1994 the AT&T executive vice president and chief of its multimedia products and services group who had launched all three of AT&T’s attempts to acquire NCR left AT&T for another position (Rundle and Keller, 1994). In summary, while one may argue that sufficient time has not passed for the final assessment to be made of AT&T’s acquisition of NCR, the evidence to date is not encouraging.

This assessment of the market’s prescience with respect to the acquisition of NCR is conducted with the benefit of hindsight. The market has not always been correct in its evaluation of acquisition proposals. However, indications that this acquisition would be difficult at best were provided by AT&T’s lack of experience in a competitive environment, its lack of success with its own computer operations, and the history of unsuccessful computer mergers. These conditions do not imply that ex ante AT&T’s overall strategy for merging telecommunications with computers was incorrect, AT&T’s strategy was consistent with trends in the industry to integrate voice and data processing capabilities. However, based on performance to date, inves- tors correctly perceived AT&T’s implementation of the strategy as value- destroying.

4. The costs and benefits of pooling

AT&T made pooling-of-interests accounting one of the central issues of the merger with NCR. In this section, we estimate the incremental costs and discuss the potential benefits from AT&T’s obtaining permission to account for this transaction using pooling-of-interests accounting.

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4.1. Requirements for pooling

Generally accepted accounting principles (GAAP) provide two methods for recording business combinations: purchase and pooling-of-interests. The re- quired method is dictated by the structure of the transaction and the history of the two companies. The pooling method uses the book value of net assets of the target. The purchase method uses the market value of the consideration paid, with the difference between the market value paid and the book value of the acquired net assets, or $5.69 billion in this case, to be amortized over the life of the acquired assets. As a result, accounting net income in this case would be lower under purchase accounting, although cash flows would be identical.4

GAAP prohibits any change in equity interests of the voting common stock of either combining entity within two years of a combination accounted for as a pooling. Because AT&T had made clear its strong preference for pooling early in the negotiations, NCR used this requirement as part of its defense against AT&T during the takeover battle. In February 1991, NCR established a quali- fied ESOP with control of approximately 8% of NCR’s voting shares and declared a special cash dividend of $1 per share at the same time. Both of these actions qualified as changes in equity interest, thus precluding the use of pooling for the business combination. (To the best of our knowledge, NCR’s use of accounting issues in its acquisition defense is unique.)

Two additional impediments to pooling, NCR’s share repurchases in 1989 and 1990 and the cash-out provision of NCR’s stock option plan, preceded the merger negotiations, but AT&T believed there were precedents for reversing them. In summary, the four impediments to AT&T’s obtaining SEC permission to use pooling-of-interests accounting were:

1) NCR’s share repurchases in 1989 and 1990, 2) the establishment of NCR’s ESOP, 3) payment of the $1 special dividend by NCR, and 4) the cash-out provision in the NCR stock option plan.

Items l-3 violated the prohibition against any changes in equity interests. Item 4 violated another pooling requirement prohibiting the selective payment of cash to some NCR shareholders but not to others.

AT&T’s accounting firm, Coopers & Lybrand (C&L), requested the SEC’s concurrence on November 29,199O with the reissuance of treasury stock to cure the taint of repurchased shares so that the proposed business combination could

Vash flows could differ due to differential tax treatment. However, with the exception of the all-cash offer made on December 6,1990, all offers made by AT&T were structured as tax-free acquisitions of stock (IRC Sec. 368), regardless of whether the SEC allowed pooling.

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be accounted for using pooling, stating that ‘the pooling issue is fundamental to the proposed transaction’. The Chief Accountant of the SEC responded on December 6, 1990 that the SEC staff would not object to pooling under the proposed circumstances. However, the SEC required the shares to be reissued prior to the merger, and such reissuance would be impossible without the co operation of NCR, an unlikely outcome in a hostile takeover. Had this transac- tion not used the pooling method, there would have been no reason to reissue these shares and incur the associated costs of a securities offering.

The SEC staff orally advised C&L on February 26 that if the court declared the ESOP invalid, as a result of AT&T’s lawsuit, then the ability of AT&T and NCR to account for the transaction as a pooling would not be impaired by the attempted establishment of the ESOP. The Court’s invalidation of the ESOP on March 19, 1991 eliminated that impediment to pooling.

On February 25, 1991, C&L wrote to the SEC regarding the potential effect on pooling of NCR’s $1 special dividend (approved February 20). This item was discussed in a meeting of representatives from both AT&T and NCR with SEC staff on May 14. According to a July 5, 1991 internal SEC memorandum:

. . . the SEC staff determined the dividend would be considered to be in contemplation of the business combination and a violation of the pooling rules. The staff did not accept the argument that the $65 million dividend was immaterial. However, the staff has previously allowed registrants who have had an alteration of an equity interest to ‘cure’ it by unwinding the transaction within a short period of time after it occurs, resulting in the transaction putting the entity in the same position it would have been prior to the alteration.

Therefore, the SEC staff, while acknowledging that NCR deliberately violated the requirements for pooling during the takeover activities, agreed to permit pooling if NCR would cure the special dividend by forgoing the normal second- and third-quarter dividends. Again, NCR’s cooperation was necessary to ac- complish the SEC’s requirements. To gain this cooperation, AT&T increased the price of the deal from $110 to $110.74 so that NCR shareholders were not hurt by the cancellation of the two normal quarterly dividends of $0.37 (a total of $48 million).

Finally, NCR’s stock option plan provided that during a change in control, all outstanding executive stock options would immediately vest and the holders would be entitled to receive the difference between the fair market value of the stock and the price of the option in cash. There were approximately one milhon such options outstanding with an aggregate value of $63.4 million; 336,000 additional shares were subject to the cash-out provision. A July 5, 1991 internal SEC memorandum stated that both the SEC and the Financial Accounting Standards Board concluded that the cash-out provision violated pooling provi-

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sions. SEC staff informed AT&T and NCR that the option provisions would have to be amended so that NCR option holders would receive equivalent AT&T options or exchange their options for AT&T shares. Thus, NCR’s cooperation was also necessary to accomplish this requirement for pooling, illustrating the bargaining power afforded NCR by AT&T’s determination to achieve pooling treatment.

The above discussion also indicates that a literal interpretation of SEC requirements precluded AT&T from using the pooling-of-interests accounting method. As Robert Willens, an accounting and tax expert with Lehman Brothers, noted (Sloan, 1991b): ‘If the [$l special] dividend is paid, it would be very unlikely that AT&T could get pooling treatment’. Similarly (Cowan, 1991): ‘All along, AT&T has indicated that it would prefer to account for the proposed acquisition [of NCR] under the so-called pooling method, rather than the purchase method. But NCR took steps (i.e., the ESOP and the special dividend) that would make it hard for AT&T to use the pooling method. However, this merger demonstrates that it is possible for a cooperating target retroactively to reverse its own (hostile) actions in order to qualify a transaction for pooling. NCR agreed to reissue 6.3 million NCR shares prior to the completion of the merger, to withhold further dividend payments in 1991 so that the combination of the regular February dividend payment of $0.37 per share and the special $1 dividend would represent the total ‘normal’ dividend for the year, and to amend the cash-out provision of the stock option plan.

4.2. The incremental costs of pooling

On August 9, 1991, the SEC released NCR’s proxy statement for shareholder approval of the merger with AT&T, indicating the SEC’s tacit approval of the terms outlined in the proxy. On that same day, AT&T filed a registration for the shares it would issue in the stock swap to acquire NCR and NCR filed a registration statement for the 6.3 million shares to be reissued prior to the acquisition to satisfy one of the conditions for pooling. The NCR offering was structured to sell the shares on the eve of the merger, after approval by NCR shareholders at a meeting scheduled for September 13, and to convert automati- cally from NCR to AT&T stock under the terms of the merger agreement. Although three investment banks were named to comanage the issue, AT&T arranged on August 29 for NCR to place the 6.3 million shares with Capital Group, Inc., a California money manager, for $102.75 per share. This private placement was at a 5% discount to the then market price of NCR shares and permitted Capital Group to withdraw from the purchase if the merger was not approved by NCR shareholders. Upon approval of the merger by NCR share- holders, the 6.3 million shares of NCR stock would be exchanged for $110.74 worth of AT&T stock, an immediate profit to Capital Group of $50.3 million and an offsetting cost to AT&T. (Our investigation of the placement of the 6.3

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million NCR shares did not reveal the existence of any compensating transac- tions between Capital Group and either NCR or AT&T.)

The indirect costs of gaining SEC approval for pooling were even higher. As mentioned above, AT&T needed the cooperation of its hostile target to reverse actions NCR had taken which would prevent pooling. NCR had rejected AT&T’s offer of $100 which was contingent on negotiating a friendly deal, but finally agreed to be acquired for $110 and to work with AT&T in seeking approval for pooling. At least part of this increase in price was offered to obtain the cooperation of NCR’s management. Indeed, at one point during the negoti- ations, the financial press reported that AT&T offered to pay NCR an addi- tional $55$7 per share ($325-$450 million in total, given the 65 million shares outstanding) if NCR would cooperate in obtaining the SEC’s approval for pooling:

‘AT&T has indicated it is prepared to pay as much as $102 a share in cash to gain a friendly merger agreement, plus another $5 a share if AT&T pays in stock and can treat the acquisition as a pooling of interests, avoiding certain accounting charges.’ (Smith, 1991).

AT&T’s Robert C. Holder confirmed this willingness to pay for pooling in our discussions on December 6, 1991. Furthermore, this amount was paid even though AT&T had achieved effective control of NCR when shareholders ten- dered 70% of their shares in response to AT&T’s $90 per share offer in February 1991. AT&T then captured 78% of the votes cast at a March 28 special shareholders’ meeting, sufficient to replace immediately four of the twelve directors, including both the CEO and the President. However, the deal, under these conditions, would not have been friendly and would not have qualified for pooling.

In summary, AT&T paid a confirmed $50 million for the reissuance of NCR’s treasury stock and was willing to pay another estimated $450 million to gain NCR’s cooperation in order to account for the transaction as a pooling rather than a purchase. All of this was in the face of uncertainty as to whether the SEC would permit pooling. Although NCR’s share repur- chases and the ESOP had been eliminated as impediments to pooling, the SEC had not indicated its position on either the snecial dividend or the cash-out provision of the stock option plan at the time the merger agreement was signed. Because of the remaining uncertainty, AT&T indicated in the May merger agreement and the final proxy statement that if pooling were not allowed, it would shift to a 60% stock and 40% cash deal for the purchase; i.e., AT&T signed the merger agreement and indicated that it would consummate the transaction, even if the SEC disallowed pooling. Nonetheless, AT&T’s preference for pooling was strong, as demonstrated by the costs incurred to qualify for pooling.

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4.3. Why was AT&T intent on achieving pooling treatment?

Although the choice between pooling and purchase accounting has no direct cash flow implications, the effects on the combined financial statements are significant. The following quote is representative of the concern expressed in the financial press over the negative impact on AT&T’s EPS of the merger with NCR if the purchase method of accounting were used:

’ ‘If AT&T does not get permission from the SEC to use the pooling accounting treatment, the resulting good will could hurt annual earnings to the tune of 5% a year,’ said Joel Gross, an analyst at Donaldson, Lufkin & Jenrette Securities Corp. ‘The street has AT&T earning $2.90 this year (i.e., 1991), but pooling could boost that to between $3 and $3.50 or cut it to $2.75 if pooling isn’t allowed.’ (Keller, 1991a)

Table 3 illustrates the effect on AT&T’s 1990 EPS of the accounting alternatives for the acquisition of NCR. AT&T’s preferred pooling-of-interests method results in an EPS of $2.42. An all-equity purchase transaction would result in an EPS of $1.97. The SO.45 per share difference between an all-equity pooling and an all-equity purchase is due to the amortization of goodwill. Because of the nature of NCR’s business and its rapidly changing technology, it is probable that the goodwill would have been amortized over a maximum of ten years, resulting in a $569 million annual decrease in earnings.5 We next discuss three nonmutually-exclusive explanations for AT&T’s willingness to pay such a pre- mium for pooling.

4.3.1. Shareholder communications AT&T, with more than 75% of its stock held by individual investors, was

concerned about its shareholders’ reactions to two aspects of the financial reporting results under purchase accounting. First, AT&T expressed concern that shareholders would misinterpret the decreased earnings under purchase accounting as decreased cash flow, resulting in a lower share price. Second, AT&T was concerned about explaining a potential deficit in retained earnings under purchase accounting.

As illustrated in table 3, purchase accounting would decrease AT&T’s EPS by more than 20%. AT&T’s assistant general counsel stated to us in a telephone

‘The SEC Staff Training Manual states that for high technology industries, amortization of purchased goodwill over less than ten years is typically appropriate. AT&T amortized goodwill over periods ranging from lo-15 years (AT&T’s 1990 Annual Report, p. 28). Also, see comments by Robert Willens of Lehman Brothers in which he estimates that a ten-year amortization period would be required (Sloan, 1991b).

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Table 3 Scenarios depicting possible values of AT&T’s EPS for the year of the acquisition assuming that the acquisition took place on January 1, 1990

This simplifying assumption is necessary because once the merger was consummated on September 19, 1991, the results of AT&T and NCR were combined, making it impossible to construct separate pro forma financials for 1991. Other assumptions are that the cash portion of any scenario is financed with debt at an interest rate of 6%, goodwill is amortized over ten years, and net income is reduced for the after-tax cost ofdebt using the federal statutory tax rate of 34% which approximates AT&T’s actual 1990 rate. The stock-for-stock exchange ratio used is the actual one of 2.839 shares of AT&T for each share of NCR.

Net income

_____.. --.-

Number of shares EPS

AT&T EPS for 1990 (without NCR) Pooling-of-interests with 100% stock Purchase with 40% cash and 60% stock Purchase with 100% stocka Purchase with 100% cashb

$2,735,000,000 1,089,000,000 $2.51 $3,104,000,000 1,285,ooo,000 52.42 %2,416,200,000 1,207,000,000 $2.00 $2,535,000,000 1,285,OOQOOO $1.97 $2,238,792,000 l,O89,OOO,OOG $2.06

“This scenario resulted in the lowest EPS due to the greater dilution caused by the new shares. This scenario could have been replicated with any of the partial cash scenarios if AT&T issued new shares to retire the debt. ‘This transaction would not have been tax-exempt to either shareholders or the corporation and therefore was not a likely alternative. It is included for purposes of comparison only.

interview that AT&T believes investors mechanically capitalize its accounting earnings. Using AT&T’s P/E ratio of 15, the additional $5-$7 per share repor- tedly offered by AT&T in exchange for pooling roughly corresponds to the earnings increase of $0.45 per share achievable with pooling (for a description of similar executive behavior, see Wilson, 1991).

In addition to concern over individual shareholders’ reactions to the de- creased EPS, AT&T believed that in subsequent years even financial analysts would forget the composition of earnings and penalize AT&T’s stock price for the lower earnings. These concerns were expressed to us in telephone interviews with spokesmen for AT&T. The financial press echoed this preoccupation with EPS as illustrated in the following quote, suggesting that AT&T was justified in paying a premium for pooling:

‘AT&T could save hundreds of millions of dollars in reported profits with the flick of a pen by changing its hostile $6.12 billion cash offer for NCR Corp. into a friendly stock swap, accountants say. The potential savings would come from avoiding a tricky accounting item called good will, which AT&T could dodge if it transformed the battle into a friendly deal. The maneuver also could allow AT&T to pay a slightly higher price, according to accountants. ‘The marriage would be a lot happier and so would Wall Street, if AT&T shifts to a pooling from a cash offer,’ says Janet Pegg,

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a certified public accountant who is an analyst and vice president at Bear Stearns & Co. ‘AT&T could boost its offer - and NCR shareholders wouldn’t be hit by taxes - under a pooling’.’ (Cowan, 1991)

Further evidence of AT&T’s concern occurs in a May 17,199l memorandum to the SEC staff indicating that if purchase accounting were required, then AT&T management would be ‘compelled’ to mitigate the double impact on EPS of the increase in number of shares for a pure equity transaction and the decrease in earnings due to goodwill amortization. AT&T maintained to the SEC staff that the decrease in earnings caused by purchase accounting could affect its access to equity and debt capital in the future because of investors’ and creditors’ perceptions. Thus, AT&T indicated it would change the structure of the acquisition to 40% cash and 60% stock, increasing the amount of debt outstanding even though AT&T did not want to compromise its flexibility for making additional investments by taking on more debt.

AT&T’s concerns about the balance of retained earnings may have also affected its accounting decision. AT&T had paid $8.52 per share in dividends and earned $8.01 per share since 1984, thus depleting its retained earnings by the difference and leaving a balance of $4.2 billion in retained earnings as of 12/31/90. Under pooling, this balance would be increased by NCR’s retained earnings of $1.5 billion, while avoiding the annual goodwill amortization ex- pense of $569 million. Thus, compared to pooling, purchase accounting would result in a lower, and possibly negative, balance of retained earnings. AT&T is a New York corporation and while New York’s Business Corporation Law does not prohibit payment of dividends that exceed retained earnings, it does require special written notice to shareholders when such excessive payment is made (McKinney’s, 1986). Dividend payments in excess of accumulated earnings and profits (computed for tax purposes) are not taxable to the recipient at the time of distribution but reduce the basis of the stock [IRC Sections 301(c) and 316(a)] and would be a benefit to the tax-paying shareholders of AT&T. However, AT&T intended to do a tax-deferred (IRC Sec. 368) reorganization even if purchase accounting were used, so these benefits would not be available to shareholders. In any case, AT&T may have worried that dividend payments out of reported contributed capital would alarm its ‘unsophisticated individual investors.

On the surface, concerns with retained earnings as an explanation for pooling appear inconsistent with AT&T’s announcement in November 1991 that it would take a one-time charge of between $5.5 and $7.5 billion in the first quarter of 1993 to recognize other post-employment benefits rather than spreading this charge over the allowable maximum of 20 years [Statement of Financial Accounting Standard (SFAS) # 1061. This one-time write-off in combination with the amortization of purchased goodwill from the NCR acquisition would likely result in negative retained earnings for AT&T by the end of 1993.

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However, when making that decision, AT&T was already assured that the SEC would allow pooling. AT&T’s adoption of SFAS 106 in one step, however, avoids annual charges against earnings that would have occurred under the alternative method. Thus, the write-off of the post-employment benefits and the avoidance of purchase accounting are consistent with AT&T’s concerns about the importance of EPS and its belief that neither investors nor financial and credit analysts remember the composition of earn- ings from year to year, leaving AT&T with a preference for avoiding carrying over deductions.

4.3.2. Bond covenants Typically, bond covenants use financial accounting numbers (e.g., net income,

total assets, or working capital) to define restrictions (Smith and Warner, 1979; Holthausen and Leftwich, 1986; Watts and Zimmerman, 1986). Consequently, management may select accounting procedures to avoid potentially binding covenants and thus influence both firm value and the distribution of that value between bondholders and shareholders. We examined 1990 AT&T indentures with Bank of New York and Chemical Bank, neither of which had any restric- tive covenants that would have been affected by the pooling/purchase decision. Likewise, both Moody’s Industrial Manual and Standard & Poor’s Corporation Bond Guide indicated no restrictive debt covenants for any of AT&T’s other outstanding issues. Therefore, debt covenants cannot provide an explanation for AT&T’s preference for pooling and financial structure.

4.3.3. Incentive compensation (bonus) plans Another possible explanation for AT&T’s preference for pooling is evidence

that accounting-based bonus plans influence management decisions (Healy, 1985; Dechow and Sloan, 1991). Unfortunately, no specifics of the relation between compensation and accounting numbers such as earnings or EPS, or any other plan details, are provided in public documents for the three incentive compensation plans in effect at the time of the acquisition. Therefore, we estimate the association between executive compensation and AT&T’s earnings to assess the potential magnitude of the accounting choice on total cash compensation by regressing contemporaneous total cash compensation for both the CEO and the top officers as a group on AT&T’s EPS for the years 1984-1990 (Healy, Kang, and Palepu, 1987). The slope coefficients are statist- ically significant at the 10% level for the CEO and at the 5% level for the executive officers as a group. Assuming that the Board does not adjust cash bonuses for the effect of goodwill amortization, our estimates imply that the $0.45 reduction in EPS resulting from the amortization of goodwill in 1991 would have reduced the CEO’s cash compensation by $63,212 or 3.1% (using the CEO’s 1990 cash compensation of $2,021,000), and by $508,140 or 3.8% for officers as a group (based on their 1990 total cash compensation of

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$1 3,530,000).6 The decrease would persist for the ten-year amortization period. Assuming a 10% discount rate, the present value of such decreases in compensa- tion would total $427,245 (i.e., the present value of $63,212 per year for ten years discounted at 10%) for the CEO (age 55 in April 1991) and $3,434,530 for all officers as a group.

To evaluate the wealth implications of the accounting method choice, we compare the present value of the cash compensation effect to the reduction in value of the stock and options held by the CEO and the corporate officers caused by the estimated maximum $500 million incremental payment for pool- ing. This computation is based on the assumption of no direct stock price benefits from pooling.

AT&T’s proxy statement indicates that of the 1,092 million common shares outstanding as of December 31, 1990, 1.8 million (including 1.2 million stock options) or 0.162% were beneficially owned by directors and officers. The largest individual shareholder was Robert E. Allen, Chairman and CEO, with 65,902 shares and 239,414 options. Assuming a corporate marginal tax rate of 34%, the after-tax present value of the incremental compensation paid of $2.267 million ($3,434,530x (1.0 - 0.34)) along with our estimated cost of obtaining NCR cooperation for pooling of $500 million, translates into a decrease of AT&T’s stock price by about $0.46 per share ($500 million + 1,092 million shares), which, in turn, translates to a value loss of $140,445 for Allen ($0.46 x 305,316 shares) and $811,468 ($0.46 x 1,764,063 shares) for all officers as a group. Consequently, the (pre-tax) net wealth effect of the accounting choice is the difference between the present value of the increase in cash compensation and the offsetting decrease in stock price. These net effects are $286,800 ($427,245 - $140,445) for Allen and $2,623,062 ($3,434,530 - $811,468) for all officers, an average of $13 1,153 per person in favor of pooling. If the costs of pooling were less than $500 million, the estimated benefits to the CEO and all officers would be even greater (i.e., at a cost of $50 million, the net benefits would be $413,200 to the CEO and $167,667 on average to all officers).

Although we cannot conclude whether the magnitude of these net benefits of pooling to individual officers and directors is sufficiently large to justify expend- ing between $50 and $500 million of corporate assets, the magnitude of these net benefits relative to total cash compensation and the wealth of these individuals appears, albeit subjectively, to be small.

In summary, while there is evidence that there may have been some compen- sation-related incentives to manage EPS, the more convincing reason for AT&T management’s preference for pooling is their belief that they can manage investors’ and analysts’ perceptions via reported EPS, i.e., by avoiding a decline

% a private discussion, a compensation consultant indicated to us that AT&T’s short-term bonus plan is based on earnings before extraordinary items (thus including the amortization of goodwill).

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in EPS due to purchase accounting. The issue then becomes whether an expenditure of $500 million (less than $0.50 per share) or even $50 million (less than $0.05 per share) can be justified on the grounds of improving communica- tions with some shareholders since there are no direct cash flow benefits. Justification would imply that the benefits from improving communications with some shareholders in the form of higher EPS outweighed the costs to these as well as to all other shareholders. One can also argue whether, in a transaction of $7.5 billion, a $50 million additional payment is material. However, AT&T has not considered even $10 million an immaterial amount in other contexts. For example, in 1992, AT&T refinanced more than $2 billion in debt in order to save $10 million in annual interest (or roughly $50 million on a pre-tax net present value basis). Some benchmark, such as the shareholders’ relations budget, would be helpful to assess whether the expected benefits in the form of shareholder understanding outweigh the costs; unfortunately, no such bench- mark is publicly available.

AT&T’s argument that professional securities and credit analysts as well as investors are unable to decompose earnings under purchase accounting or to see through the window-dressing effects of pooling accounting conflicts with the notion of market efficiency. This view is consistent with mounting evidence on market inefficiency (e.g., De Bondt and Thaler, 1985). However, research directly investigating the consequences of purchase accounting on stock prices finds no evidence of inefficiencies (Hong, Kaplan, and Mandelker, 1978). More recently, Vincent (1995) investigates whether investors value mergers similarly regardless of the accounting treatment and reports results consistent with the efficient markets hypothesis. Absent evidence to the contrary, AT&T’s strong preference for pooling, combined with its intention to complete the deal regardless of the accounting method used, makes the additional amount paid for window dress- ing even more curious.

5. Why did AT&T pursue this acquisition, ignoring the market’s assessment?

In Section 3, we document that AT&T pursued this acquisition despite the market’s consistently negative assessment of the investment, resulting in a wealth loss of $6.5 billion to AT&T shareholders. Section 4 documents that AT&T’s insistence on the pooling-of-interests treatment may have contributed $500 million to this wealth loss. In this section, we discuss three possible reasons for AT&T’s persistence in acquiring NCR.

First, AT&T’s pre-merger performance was consistent with Merck, Shleifer, and Vishny’s (1990, p. 33) assessment that ‘bad managers might make bad mergers just because they are bad managers’. Such bad mergers result from managerial objectives that are not generally consistent with maximizing share- holder wealth. In the Merck, Shleifer, and Vishny study, bidders with a three-

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year income growth rate below their industry average are defined as badly managed and experience an average stock market reaction of - 5.02% in the four days ( - 2 to + 1) around the announcement of the initial bid, calculated as the change in the bidder’s equity in the four-day window ( - 2 to + 1) around the initial bid announcement in the WSJ divided by the final

acquisition price of the target’s equity. AT&T’s change in equity value, using this calculation and December 3, 1990 as the date of the initial bid, was - 19.24% ( - $1.365 billion/$7.093 billion), or well below Merck, Shleifer, and Vishny’s result.

Second, AT&T management’s disregard of the market’s response is consistent with management overconfidence (or hubris; see Roll, 1986). Part of the justifica- tion for AT&T’s confidence was its belief that it had been given significant private information by NCR early in the negotiations under a nondisclosure agreement. AT&T’s Holder maintained that AT&T could have justified paying even more than $110 per share based on this information. Furthermore, the market has not been infallible in its assessment of acquisitions, justifying ignoring its response.

A third explanation for AT&T management’s persistence in acquiring NCR is provided by the results of behavioral research into escalation of commitments7 In essence, the argument is that once a decision maker takes action, there are powerful psychological, environmental, and structural pressures to continue the course, regardless of subsequent information to the contrary. Salancik (1977) and Keisler (1971) argue that individuals are more likely to become bound to their prior actions when: (i) the action taken is explicit and unambiguous; (ii) the action is not easily reversed; (iii) the action was taken freely; (iv) the action has important ramifications for the individual initiating the action; and (v) the action is public. CEO Allen’s decision to acquire NCR satisfied most of these conditions. In addition, Allen’s public airing of his strategic vision to make AT&T a significant player in the computer business may have intensified this commitment to proceed. The environmental and historical pressures were also significant because of the signing of the consent decree by which AT&T gave up its regulated monopoly status in exchange for the opportunity to pursue the computer business. The criticism by the financial press and DOJ’s abandoning the IBM suit increased the pressure to justify this tradeoff. AT&T felt compelled to make its investment in computers pay off, and exiting the business was not possible under these conditions.

Furthermore, structural factors encouraged commitment to the chosen course. Research has shown that persistence is likely to occur in projects when persistence is seen as costly but less catastrophic than withdrawing (Ross and

‘We thank Margaret Neale for helpful discussions on this topic.

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Staw, 1989). In explaining this escalation of commitment, Northcraft and Wolf (1984, p. 226) suggest:

‘The decision maker may, in the face of negative feedback, feel the need to reaffirm the wisdom of the time and money already sunk in the project. Further commitment of resources somehow ‘justifies’ the initial decision (Staw, 1976), or at least provides further opportunities for it to be proven correct. The decision maker may also treat the negative feedback as simply a learning experience - a cue to redirect efforts within a project, rather than abandon it (Connelly, 1978). Or perhaps, the decision maker will rationalize away the negative feedback as a whim of the environment - a storm to be weathered, rather than a message to be heeded.’

AT&T’s failure in the computer business and its decision to increase its commit- ment rather than exit the business are consistent with this explanation.

Finally, from an organizational perspective, research suggests that the endowment effect can exist for property rights acquired by a variety of means, even by court decree as in this case (Thaler, 1980). Having attained the right to enter the unregulated computer business, implementing this right was integral and compelling, further explaining AT&T’s persistence. [See Kahneman, Knetsch, and Thaler (1990) for a discussion of the endowment effect on organizations.]

Thus, AT&T may have felt pressured by the consent decree, its own numerous public statements touting its computer strategy after the divestiture, and the mounting losses of its computer operations to initiate and complete the NCR acquisition. Because of these factors, AT&T disregarded the negative signals from the market and relied on its internal valuations.

6. Summary and conclusions

AT&T persisted in acquiring NCR despite the market’s consistently negative reaction to major events during the negotiations. Our analysis indicates a result- ing decrease in AT&T shareholders’ wealth of as much as $6.5 billion and negative synergies from the merger of as much as $3.0 billion. The reasons for AT&T’s persistence can only be conjectured, whether they be hubris, bad management, or escalation of commitments. The patterns in this acquisition are consistent with, but stronger than, those of large-sample studies: managers of poorly performing corporations make bad mergers. Based on history, it appears that AT&T wanted to redeem itself for the 1982 decision to divest its operating companies, as well as to confirm its many public statements of commitment to the computer business and to justify its significant investment in computers. However, AT&T could have continued to pursue its strategy of combining

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T. Lys. L. Vincent/Journal of Financial Economics 39 (1995) 353-378 371

telecommunications and computer technology without remaining in the com- puter manufacturing business.

We conclude that AT&T’s willingness to pay a premium for the pooling-of- interests method of accounting was to avoid a sustained decrease in EPS because of the importance of investors’ perceptions. AT&T’s management believed that the reduction in EPS under purchase accounting by roughly $0.45 per share in each of the next ten years would be detrimental to its share price as well as to its ability to raise capital. This concern with EPS was further illustrated by AT&T’s plan to change to a 40% cash and 60% stock deal to mitigate the EPS dilution if the purchase method was required. We cannot dismiss the possibility that the preference was due to executive compensation but we find no evidence that the choice was due to bond covenants. Pooling is associated with a ‘friendly’ acquisition and AT&T also desired to have the market perceive this business combination as friendly, consistent with its long- standing reputation as a benevolent monopoly (‘Ma Bell’).

The question becomes whether the ‘window dressing’ afforded by the accounting choice was worth the price paid, be it $50 million or $500 million. From an efficient markets perspective, this preoccupation with EPS, to the extent of paying a higher price to obtain a pure accounting benefit, is difficult to justify. However, if AT&T’s concerns about investor and analyst misinterpretation of the reported EPS under purchase accounting were justified, then the additional amount paid to improve shareholder communications could be directly related to higher share prices. Clearly, this issue warrants further analysis, contradicting as it does the results of a significant body of research on this question.

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