Operating performance and free cash flow of asset buyers

Financial Management (Financial Management Association), Winter, 2003 by Steven Freund, Alexandros P. Prezas, Gopala K. Vasudevan

We examine a sample of 552 firms that announce asset purchases. We find that the announcement period returns are negatively related to the amount of free cash flow for buyers with fewer growth opportunities. Compared to the year prior to the purchase, the mean long-run operating performance of asset buyers worsens in each of the three years following the transaction. Operating performance changes are negatively related to the amount of free cash flow, and the relationship is stronger for buyers with fewer growth opportunities. We also find that buyer firms experience a decline in the return on assets and asset turnover ratios. These findings are consistent with Jensen's (1986) free cash flow theory.

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Asset sales have become increasingly common in recent years. Two recent examples are the Fuji Xerox purchase of Xerox's Chinese operations for $550 million and the Univision Communications purchase of USA's television stations for $l.1 billion. John and Ofek (1995) and Lang, Poulsen, and Stulz (1995) examine stock price reactions to the announcement of changes in the ownership of assets. They find that the announcement period stock returns are positive on average for the seller and positive or zero for the buyer of the asset.

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. We examine the operating performance of the asset buyers during a seven-year period around the asset purchase, measuring performance in terms of pretax operating cash flow scaled by the book value of assets. Two other measures are an industry-adjusted measure, which adjusts raw performance by a matched portfolio based on industry, and a matched-firm-adjusted method, which is based on a portfolio matched by firm size and performance. By all three measures, compared to the year prior to the purchase, operating performance worsens during the three-year period following the asset purchase. We also find that the asset buyers experience a decline in the return on assets and asset turnover ratios during the three years following the purchase.

The cross-sectional regressions show a significant relationship between the changes in operating performance and growth opportunities and free cash flow of the asset buyers. On average, operating performance changes are negatively related to free cash flow for buyers with fewer growth opportunities. Although the coefficient of free cash flow is also negative for high-growth firms, free cash flow has lower economic and statistical significance than in the case of low-growth firms. Changes in focus or the method of payment for the purchased assets have no effect on the long-run performance of the buyers.

Like several other authors, we find the average stock price reaction is positive for the asset buyers. Our univariate results show that announcement period returns are positive and significant for buyers with low free cash flow. The cross-sectional regressions control for other factors affecting announcement period returns (i.e., growth opportunities, method of payment, firm size, and relatedness of purchased asset with assets in place) and extend these results. Stock price reaction is inversely related to free cash flow for low-growth buyers, but not for high-growth buyers. We find no relation between the stock price reaction and either the method of payment for the asset or the relatedness of the asset purchased with those the buyer already has in place.

Overall, our findings suggest that the market anticipates the negative effect of free cash flow on asset buyer shareholder wealth. The market's expectations are subsequently confirmed, given that we find a performance decline following the purchase. The negative effect of free cash flow on performance is of greater economic significance for low-growth firms.

Our study makes several contributions to the literature. We believe this is the first article to examine the operating performance of asset buyers following a purchase. Second, we provide evidence on the free cash flow hypothesis for asset buyers. Third, we also assess the implications of the fit and focus hypotheses for asset buyers. Fourth, we examine a sample that is much larger than most previous studies. (1)

In what follows, Section I reviews related papers. Section II describes the sample and methodology. Section III presents the results. Section IV provides a summary of the findings.

I. Background

The literature provides several explanations for the positive announcement period stock returns of asset sellers. Hite, Owers, and Rogers (1987), Jain (1985), and Alexander, Benson, and Kampmeyer (1984) argue that announcement period returns are positive for the seller, because of an efficient deployment of assets. The assets are worth more to a buyer, and the buyer is hence willing to pay more for them. This is commonly referred to as the fit hypothesis. Consistent with this hypothesis, Maksimovic and Phillips (2001) show that partial-firm asset sales improve the productivity of transferred assets by effectively redeploying assets from firms that have less of an ability to exploit them to firms with more of an ability. (2)