The headlines this week contain more and more news about possible acquisitions in the works. "Pfizer Plans to Pursue AstraZeneca" and then there is the effort by General Electric Co. (NYSE:GE) pursuing the French industrial company Alstom SA (OTCPK:ALSMY).
This on top of news about 2014 having the highest level of M&A activity in its first four months of the year since 2007. This information is from an article by Ed Hammond in the Financial Times.
The big question mark about this behavior, to me, has to do with the confidence now being felt in the ranks of corporate CEOs. I have written about this issue for at least four years because this would be, I felt, one of the leading indicators of how corporate managements felt about the economic recovery.
Usually when the economy recovers it tends to be a good time for corporations that escaped the previous recession with a strong balance sheet went looking for other companies with weaker balance sheets that fit into their growth plans and could be acquired at a very good prices.
At the beginning of this recovery there was lots of talk about fiscal stimulus and about a monetary policy that was very aggressive intending to keep interest down for a substantial amount of time. Seemed, initially, like a perfect time for well-positioned corporations to build for the future.
Many corporations took advantage of the very low interest rates and issued large amounts of debt that only added to the substantial cash balances that had already been accumulated.
Microsoft (NASDAQ:MSFT), for example, went to the market twice with debt issues, even though it had a lot of cash on hand anyway, to take advantage of the low interest rates. Microsoft had never issued long-term debt before.
Thus, everything seemed right for an M&A boom.
But, the boom never really materialized.
Seems as though corporate CEOs sensed a great deal of uncertainty about what was actually going on in terms of the government's fiscal policy and how this uncertainty would play into the behavior of the economy.
The weakest economic recovery in the post-World War II era resulted and this did not contribute to the confidence of these corporate executives.
And, we saw substantial increases in cash balances during this time. I have written several posts over the years on this subject. It should be noted, however, that not all of this build up was in the United States, of course, as the foreign buildup in cash had a lot to do with the tax laws.
So, pressure increased on the corporations to use this cash. So, as the recovery dragged up we saw dividend payouts increase and stock buy backs also increased. This was the only real outlet for corporations to give some indication that they were using their cash and retained earnings well.
Now, there are hopes that the M&A movement is picking up steam and that 2014 will be a stellar year.
The economy seems to be showing a little more life. I have argued that the growth in real GDP this year will be around 3.0 percent, not the greatest in the world but the largest growth rate in the past three years. Furthermore, the biggest battles in Washington, D. C. over fiscal policy seem to be over. (I hope that this is not just wishful thinking.) President Obama is a lame duck and given that there is a very good chance that the Republicans will take over both houses in Congress, it seems as if we might be in for two and one half years of the government doing relatively nothing…which will reduce uncertainty.
The Federal Reserve is expected to continue to taper its security purchases until QE2 becomes history. But, there is plenty liquidity around and the banking system seems to be in relatively stable condition. Although it unclear exactly how the Fed will play this situation out, they will tend, in my mind, to continue to err on the side of ease as the economy continues to sputter along.
Ed Hammond in the Financial Times article lists several things about the pickup in M&A activity that is quite encouraging.
First of all, the deals that are being announced at not "new" deals that people are rushing to get through. They are deals that have been on the books for some time with the managements just waiting for the right time to move ahead.
As a consequence, the response of investors to these deals have been positive as Hammond reports that "In 2014, the share prices of acquiring companies have gained 4.4 percent within a day of a deal being announced, the highest post-announcement increase since Dealogic began tracking the data in 1995."
Furthermore the deals are being financed differently than they were in the period leading up to 2007. In 2007, for example, Mr. Hammond writes that "Deals where only cash was used accounted for 76 percent of the total market during the first four months. This year, all-cash deals account for 47 percent of the market, the lowest level since 2011. In contrast, deals purely paid for with stock have accounted for 19 percent of M&A this year compared with 8 percent in 2007."
There are other encouraging signs as well.
To me, this is all very good news. We have to have the corporate sector confident in the future if we are going to continue to see the economy grow. We are going to have to see CEOs stretching for more commitment to risky transactions like these if the recovery is to progress.
There are two comments, however, that I would like to make. First, in order to continue to have confidence in a stellar year of M&A activity, we need to continue to watch the deals closely. So far, stock prices have tended to rise after transactions have been announced. Investors have judged that the acquisitions seem to be economically sound. They represent a good use of the acquiring firm's retained earnings.
This is a major point to me and one that I have been stressing in the case of Microsoft. (See, for example, "Microsoft at $40.") One of the arguments for the fact that the price of Microsoft stock flat-lined the tenure of Steve Ballmer is that he did not use Microsoft's retained earnings well. As M&A activity continues to pick up, we need to watch how CEOs are using their cash. Irrational exuberance seems to overtake prudence in this game. So, keep watching.
Second, even though the M&A business pickup may be a very positive sign of an increase in executive confidence, it doesn't mean that the activity will contribute much to economic growth. Acquisitions, if they are to work, require re-structuring and re-alignment of companies, many times resulting in large layoffs of employees. The rationalizing of industry is all about making economic sense and not about increasing productive output.
A substantial pickup of M&A activity at this point, however, is good for the long-term, because the deal-making is based on confidence and the new, stronger, more efficient companies will help to drive future growth.
Disclosure: I am long MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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