At first I was going to list all the M&A deals announced to date this year and then realized that this would be the longest article I had ever written in my life. The markets are definitely different this year. I can still recall the numerous times throughout 2006 that upon reading about an acquisition I would mutter to myself the words 'nice move'. I have yet to mutter these words this year.
While contemplating how to construct a useful commentary that would catch the essence of what is going on in the markets, I recognized that this is not just a US market phenomenon. It is global. Hence, one scenario below covers none US companies.
Such being the case I put forward three hypotheses that attempt to explain the current situation.
I doubt very much that there is an analyst alive that would categorize the Microsoft (NASDAQ:MSFT) $6 billion acquisition of AQuantive (AQNT) anything other than insane. There have been numerous articles written about this including various attempts to explain Microsoft's rationale behind the acquisition price. None resonate the truth nor quell the uneasiness that swirl in our hearts and minds.
A macro global analysis that explains this particular M&A move and sheds light on the broader picture encompassing dozens of deals globally may help put things into perspective.
What Microsoft is signaling is that cash is overvalued. What appears to be a dollar today is really 25 cents in a few years from now. Google (NASDAQ:GOOG) apparently is more bullish about the future and estimates that a dollar today is worth about 50 cents just around the corner.
In order not to confuse the issue, both Microsoft and Google are signaling that ALL currencies are overvalued, not just the US dollar. It is the flight from paper currencies and demand for hard assets that is fueling the M&A activity. Some currencies may devalue faster than others but all will devalue never-the-less. The fundamentals behind this are; accumulated deficits and monetary policy. Everyone is running a deficit, not just the United States. After years of accumulating debt, coupled with no other means to continue the show without the printing presses, something has to give and that something is paper currencies.
The question is, how much?
According to bullish Google, the true rationale for buying DoubleClick for $3.1 billion is that in reality it paid only $1.55 billion when taking into account the value of currency in a few years time. When putting this into perspective, this is still a bold play as DoubleClick had only $150 million in revenue (yes - revenue, not profits) last year. Due to the constant slide in currencies, time is of the essence. The longer a company sits on cash, the higher the risk that more notice the intrinsic value. Google did not flinch at the fact that it had depleted its entire cash reserves. On the contrary, this is exactly what they intended on doing; getting rid of the cash.
The more bearish Microsoft sees things differently. One of the theories floated was that Microsoft wanted to stun the world and prove that it would not be bullied by Google. Therefore, as the theory goes, they intentionally overpaid for AQuantive. Nonsense!
There are cheaper ways to pull off a PR stunt and one should give Microsoft a little credit. The rationale behind the $6B price tag is that they are paying only $1.5B in relative terms. In a few years time, $6B today will be $24B in nominal terms. Getting rid of the overvalued cash in a way that can generate future positive cash flows in larger nominal numbers is of the essence.
According to this hypothesis, only companies that have the potential to generate substantial cash flows are up for acquisition. Companies that need extensive cash outlays are not going to be acquired, at least not at this stage of the game. The objective is to get hold of as much cash as quickly as possible and promptly spend it. Acquiring assets that generate hefty cash flows further enable additional acquisitions of new cash producing hard assets.
Likewise, companies that continuously issue new stock to finance their operation are not good acquisition candidates. In addition, companies that report top line revenue growth that are dependant on high payrolls, resulting in little bottom line improvement are not good acquisition candidates. Excess cash generation is the key.
This also explains Berkshire's foray into the railroads. True to his nature, Buffett is acquiring hard assets realizing that these cash generating assets are not going to be replaced with new technology anytime soon. No matter what the price is today, in a few years from now, the cash value will be higher as it will take more suitcases of cash to acquire the same asset.
This would explain why so many companies are buying back their shares. Getting rid of the cash through a share buyback is actually better for investors than declaring a dividend. In the long term, unless investors are going to reinvest the dividends, the nominal share price will increase in tandem with the devaluation of currency, keeping pace with the underlying value behind the stock certificate.
This does not explain Google's purchase of YouTube unless there is a way to turn YouTube into a cash cow.
A slightly different hypothesis is along the lines that inflation is higher than reported yet we are not in the throws of a major currency crunch. According to this school of thought, all stocks are undervalued as they have not kept up with true inflation.
The recently announced Alltel (NYSE:AT) acquisition for $71.50 cash per share ($27.5B) demonstrates this theory. Goldman Sachs Group is a banker, not tech geeks. The rationale behind the purchase is to flip the company once industry consolidation sets in. A quick check reveals that no less than three competitors use the same technological infrastructure as Alltel. China's Unicom (NYSE:CHU) may not be in a position to enter the US marketplace today but there is no telling what the situation will be in a few years from now. With the newly found 'bigger is better' atmosphere, AT&T (NYSE:T) wouldn't face much opposition should it desire to devour Alltel. Sprint (NYSE:S) is also in the running.
On the surface, Alltel has only 12.1 million customers yet boasts the largest geographical footprint in central and south-west US. Until consolidation is on the table, Goldman Sachs can use Alltel to make further acquisitions. Alltel has a very strong balance sheet with little debt. More enticing is the strong cash flow. Loading up the balance sheet with debt and then flipping the company including the debt is probably the long term plan.
Taking DoubleClick as a precedent for return on investment percentages, Goldman Sachs expects to flip this company within three years at a 90% nominal premium including the assumption of (moderate) debt. With little intentions of actually investing in this business and with every intention of milking the business for what it's financially worth, it is relatively transparent that Goldman values the demise of paper currencies (in this case the US dollar) to be in the vicinity of 60 to 70 cents to the dollar today.
This reflects a 4% to 6% compounded discrepancy between the reported inflation and actual inflation from 2002 to 2007 (EOY). If incorrect and inflation is as reported, the current value would be $20.2B, not $27.5B.
With all the merger mania being reported in the media, it was not surprising to see the headlines regarding the purchase of Israeli pharmaceutical company, Taro (TAROF.PK). As expected, the media concentrated on the 27% premium ($7.75 cash) being paid by Indian Sun Pharmaceutical Industries Ltd (BSE: 524715) for the company.
What was omitted was the fact that Taro was trading at $10.60 just last January. More to the point is the omission that Taro was thrown off the NASDAQ due to insider trading allegations. The same people behind the insider trading scandal are behind the sale to Sun. Franklin Advisers, Inc. and Templeton Asset Management Ltd. (9% shareholders with no voting power) attempted to thwart the deal as they felt that minority shareholders were getting shafted. After their first taste of the Israeli judicial system, the two may think twice before making any new substantial investments in hard assets in Israel.
What is more intriguing is that once Taro is sold to Sun, the company can tell the SEC to kiss them where the sun doesn't shine. Sun is listed in India.
More to the point is that even companies that are up to their necks in foul play seem to be able to get acquired based on globalization. In this case, technological know-how is needed by Sun. In the US, Taro would have a much lower acquisition value as US companies would value Taro for its pharmaceutical portfolio and place no value on its manufacturing know-how and knowledge of the inner workings of the FDA.
According to this hypothesis, US equities need to be valued based on foreign valuations. If standard average P/E ratios are double the US average, eventually US equities will either match overseas valuations or be acquired by overseas companies. Globalization dictates that eventually it all evens out. Of course there is the possibility that Indian, Japanese and Chinese valuations can come down to current US standards, but I wouldn't bet on it just yet.
Take Your Pick
Whether you are 'insane' and anticipate 200% over the next two years or 'bad' and settle for 90% and a money back upfront loan or just plain 'ugly' for a 100% gain, the bottom line is - the market is heading up. Call it technical, call it insane, call it inflation, call it what you like, just pick any dozen stocks and ride the wave.
Disclaimer: Personally I think the market is getting over extended but I won't fight the ticker. No current conflicts, except with myself.