By James T. Tierney, Jr.
Equity markets got off to a rough start in 2014, but a resurgence of corporate dealmaking has given investors reason to cheer. With executives’ confidence increasing, and companies sitting on a mountain of cash, we think that the stage has been set for a sustained recovery of US takeover activity.
January was a great month for M&A. US companies announced deals worth $84.1 billion, marking the second-highest month of activity in more than six years (Display 1). And the reawakening of M&A has continued in February with Actavis (NYSE:ACT) announcing today that it agreed to buy Forest Laboratories for $25 billion, after last week’s $45 billion deal between Comcast (NASDAQ:CMCSA) and Time Warner Cable (NYSE:TWC). While it’s too soon to say that a new trend has begun, several signs point to a better environment for M&A this year.
Upbeat Executives Pay in Cash
Most recent deals are being funded with cash rather than with stock. When a company levers its balance sheet for a take-over, management is providing an implicit vote of confidence in the underlying economy. And optimism on the economy combined with historically low interest rates creates fertile ground for deals.
CEOs of US companies also have plenty of cash to spend. At the end of the third quarter, US nonfinancial companies had record cash holdings of $1.9 trillion, according to Federal Reserve data. What’s more, M&A involving private firms might be more attractive for some companies than share buybacks, particularly after last year’s stock market rally resulted in inflated share prices.
Beware of Megadeals
Corporate earnings should support this trend. We expect US corporate profits to grow by about 6% to 7% annually over the next five years, and selective acquisitions can help bolster revenue and earnings growth. Of course, there are many challenges to successful integration after a deal is done. That’s why we prefer smaller deals that augment a company’s current business over mega-takeovers that are difficult to integrate.
Take Amphenol (NYSE:APH), a US technology company that announced its purchase of GE’s (NYSE:GE) Advanced Sensors business for $318 million in November. The deal provides a nice incremental revenue boost and gives the company a foothold in the growing sensor market. In our view, this is a good example of a manageable acquisition with a solid strategic rationale.
Takeovers Support Profit Margins
M&A can also help dispel some concerns about US earnings. Bears argue that record high profit margins are unsustainable. We disagree. Increased takeover activity allows companies to unlock labor synergies to cut costs and sustain margins (Display 2). So, an accelerated pace of M&A should enhance the ability of companies to maintain profitability, in our view. While this might not be good news for employment, it’s likely to buoy corporate earnings, which should be supportive of equity prices.
Investing in M&A
Is there a way to invest for acquisitions? In reality, it’s not so simple. Many takeover candidates are difficult to pinpoint and tend to be underperforming businesses that aren’t very attractive unless they’re acquired.
What about the buyers? Acquirers usually face investor skepticism, which often hurts their stock. But in recent months, shares of buyers have actually risen after deals have been announced. Earlier this month, shares of Entegris (NASDAQ:ENTG) jumped 11% on the day that the company announced its acquisition of ATMI for $1.15 billion in a deal combining two semiconductor suppliers. In December, shares of Sysco (NYSE:SYY) jumped nearly 10% on the day it announced its takeover of US Foods for $3.5 billion.
This suggests that investors are beginning to see the logic of intelligent takeovers by companies flush with cash. So, investing in companies with robust organic growth that are capable of making selective acquisitions could be a rewarding strategy in a new M&A boom.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.