Operating Performance and Free Cash Flow of Asset Buyers

Abstract

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. 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 $1.1 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 highgrowth 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