M&A Boom Spells Trouble for the U.S. Economy

by: Martin Hutchinson
With its $39 billion hostile bid for Canada's Potash Corp. (NYSE: POT), mining giant BHP Billiton Ltd. (NYSE: BHP) capped an active August in the mergers-and-acquisitions market.

With the moribund growth prospects of the U.S. economy, there would seem to be no great urgency for companies to go on an M&A spree, yet the total value of announced buyout deals for August alone has topped $175 billion.

Cynics are reaching only one conclusion: With interest rates so low and corporations so cash-rich, it seems that company management teams would rather do anything with that cash than to give it back to shareholders via stock buybacks or boosted dividends. And those deals signal additional trouble ahead for the U.S. economy.

Corporate America: The New Cash Cow

There's certainly plenty of cash available to keep fueling this deal boom. According to Moody's Investors Service, U.S. non-financial corporations are currently sitting on $1.84 trillion in cash. When measured as a percentage of total corporate assets, that's Corporate America's biggest cash hoard in 50 years.

And that cache of cash doesn"t end there: Hedge funds hold an additional $450 billion in cash, which can also be brought to bear in M&A deals. With bond-market conditions also currently favorable and interest rates at 50-year lows, it's thus not surprising that top Corporate America execs are indulging their wildest empire-building fantasies.

U.S. CEOs could, of course, be paying that money out to shareholders as dividends. As of Aug. 25, the dividend yield on the Standard and Poor's 500 Index was 2.09% -representing a 40% dividend-payout ratio on an S&P index that was trading at 19.38-times earnings.

While that's above the average of 32% payout ratio of the 2000s it's well below historical levels - the payout ratio in the Great Depression was greater than 90% and averaged more than 55% through the 1950s and 1960s. Given the huge amounts of cash that so many companies currently possess - as well as the relatively favorable tax treatment of dividends (individuals currently pay only 15% on dividend income) that's right now in place - U.S. public companies could easily pay out much more of their income in dividends than they presently are.

As shareholders, we should demand higher dividend payouts. Historically, dividends have represented about half the return on the S&P 500 Index. Dividends alone provided U.S. shareholders with a total uncompounded return of 61% in the 1980s and 43% in the 1990s.

The 2000s, by comparison, were pathetic: Dividends provided a total return of only 16%, not enough to make the overall return positive. Given that companies have accumulated record levels of cash (as well as making innumerable fatuous takeovers), we investors should feel shortchanged.

The Dealmaking Payoff

A number of factors have caused this change in management behavior.

First and foremost, monetary policy has been very loose since 1995. So there's always been lots of liquidity sloshing around the global financial system, making mergers easy to finance.

Modern financial theory has held that a company should concern itself mostly with the tax consequences of its balance sheet. This meant that earlier concepts of balance-sheet 'soundness" were irrelevant and that cash dividends should be of less interest to investors than the fluctuations in the company's stock price. Top managers have increasingly been rewarded with stock options, and as a result have come to view dividends as unattractive, since those payouts take cash out of the company - reducing the value of the shares (besides, option-holders themselves don"t reap the benefit of dividends).

These have all been factors. However, the most important factors leading to merger activity have arisen from the shift in the shareholder power base that we"ve seen. It was once true that large individual shareholders exercised direct control over a company's management.

But that's now a relatively rare situation: The top shareholders are now largely institutional in nature. And rather than waste time sparring with a corporate management team whose policies or strategies it doesn"t like or agree with, an institutional investor will be all too willing to simply "dump" its shares.

All of these changes have induced corporate leaders to treat companies as their own private piggy banks, paying themselves ever-larger salaries and bonuses and being relatively unconcerned about shareholder value - except as something to which they pay lip service.

Most important, managers get rewarded based on the size of their empires. This elevates the importance of the M&A deal: Acquisitions, which increase the size of the empire being managed, become all the more alluring to a CEO who is looking to increase the span of the company he controls.

Merger-and-acquisition deals have the additional advantage of allowing frequent restatements of earnings and other financial accounts, meaning it's easier for managers to hide losses or other financial problems without having to actually run them all the way through the income statement.

Some of these same issues make M&A deals attractive to the target ("acquiree") company. For instance, with the "golden-parachute" payouts and other payoffs that management teams receive as compensation when their firm is taken over, it's not surprising that the leaders of a firm that becomes a buyout candidate don"t fight too hard to preserve their company's independence. When Potash CEO Bill Doyle is due to receive a $445 million payoff when his company is sold, he will be less than ferocious in opposing the sale.

Thus, it is not surprising that corporate cash is useful to management primarily for acquisitions. If the shareholders are particularly quiescent, as in the Kraft Foods Inc. (NYSE:KFT) takeover of Cadbury PLC (OTC:CDSCY), the buying chief executive can be paid off with a $27 million premium for undergoing the nervous stress of arranging the deal, without waiting to see whether it actually provided any benefit to Kraft.

In that case even Warren Buffett, owning 9% of Kraft stock, was unable to prevent the acquisition, as Kraft's financially counterproductive aggression and its oodles of cheap money wiped out a 200-year-old British company.

Management behavior will only change when its incentives change, and that won't happen until interest rates are much higher than they are today. In the meantime, the damage that foolish acquisitions will inflict on U.S. industry is immeasurable: Corporate America will slash employment, hold back on capital investment and - worst of all for the future - dial down research-and-development activities.

Action to Take: Concentrate your investment dollars on companies that pay high dividends, and on foreign companies in countries such as Germany and Japan where management remuneration is lower and does not contain many stock options.

At shareholder meetings, vote against all acquisitions that are not obviously beneficial, and blatantly ask management if it is putting acquisitions before dividends - which is another way of asking why the company is embracing a ruinous short-term viewpoint and shortchanging

Cross-examine the Remuneration (Compensation) Committee of the board of directors of the companies you invest in about top-management pay. Your objective: To ascertain - or, better still, to ensure - that top-executive compensation is both lower and contains fewer incentives to play merger-and-acquisition (M&A) games with your money.

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