Merger Mania Reflects Growth Conundrum For Investors

by: AllianceBernstein (AB)

By James T. Tierney, Jr.

While the world obsessed over every twist and turn in the US presidential election, corporations seemed to see the political noise as a call to action and went on a buying spree. So why the sudden surge in M&A?

During October, US companies announced more than US$200 billion of mergers and acquisitions (Display) across a broad range of industries. Prominent deals included AT&T's (NYSE:T) move to buy Time Warner (NYSE:TWX), Qualcomm's (NASDAQ:QCOM) acquisition of NXP Semiconductors (NASDAQ:NXPI), Level 3 Communications' (NASDAQ:LVLT) takeover of CenturyLink (NYSE:CTL) and GE's (NYSE:GE) merger of its oil and gas business with Baker Hughes (NYSE:BHI). It was the strongest month of M&A activity in 2016 and one of the biggest bursts in history - after what had previously been a relatively quiet year globally.

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The Impetus To Acquire

Several trends are driving the increased activity. For many companies, growth challenges and industry consolidation have created an impetus to acquire. The potential end of the low interest rate era, as well as an uncertain regulatory and political environment, have also created an incentive for action.

The lack of growth opportunities is an important factor. Over the past seven years, the modest US economic recovery has led to anemic revenue growth for corporate America. As a result, many companies have turned to acquisitions to augment revenue streams. Since we don't think there is a magic wand that will drive growth over the next few years, the focus on deals makes sense and can be expected to continue - at least in the short term.

Chain Reaction

Growth-driven activity often sets off a chain reaction in sectors. For instance, the agriculture sector, under tremendous pressure given low crop prices, has seen significant consolidation announced over the past year. It started with Dow Chemical (NYSE:DOW) and DuPont (NYSE:DD) agreeing to merge late last year. Then, ChemChina announced a deal with Syngenta (NYSE:SYT) in February, followed by Bayer (OTCPK:BAYRY) finally reaching an agreement with Monsanto (NYSE:MON) in September.

In each case, we think there was sensible economic rationale for the deal. Yet we also think that one merger by an industry giant compels rivals to follow suit, as companies fear a competitive disadvantage of being left behind in a sector of giants. With this perspective, it's worth considering whether a similar chain reaction has just started in the media sector by AT&T's deal for Time Warner.

In this type of deal environment, funding costs matter. With 10-year US government bond yields rising by almost 100 basis points since June, many executives are anxious to lock in low rates as quickly as possible. And with deal prices steadily climbing over the past five years, acquisition economics will be even more difficult if there is a sustained increase in interest rates.

Regulators On The Lookout

Regulators are keeping a close watch on these trends. With so many catalysts for deal-making, regulatory bodies and politicians have become more skeptical about approving deals. Ironically, this seems to have created a race to get a deal done before the spigot is turned off entirely. Consolidation in the agriculture sector, for example, will be an interesting test. While no single deal in isolation seems problematic, the three deals together would reshape the competitive landscape significantly.

So our takeaway is twofold: Deal announcements will continue at a rapid pace, but approval will increasingly get more difficult. Through October, this year already ranks as one of the 10 largest in history, coming on the heels of 2015, which was a record year in terms of deal value. Yet as far as deal approval is concerned, the market remains wary of big deals like Bayer/Monsanto and AT&T/Time Warner. Indeed, shares of Monsanto and Time Warner are trading at about 20% below their deal prices, a record arbitrage spread for US takeovers.

M&A Matters For Investors

The M&A environment matters for investors. We believe that the increased regulatory approval hurdle will place a premium on companies that have strong embedded secular growth - and don't need M&A to grow. Companies that we forecast to post organic revenue growth of at least 10% over the next five years - like Google (NASDAQ:GOOG) (NASDAQ:GOOGL), priceline.com (NASDAQ:PCLN), MasterCard (NYSE:MA), Celgene (NASDAQ:CELG) and Starbucks (NASDAQ:SBUX) - should be rewarded, in our view.

Other companies might find it harder to sell out as an exit strategy if interest rates rise and deal valuations become prohibitive (Display). And companies that historically relied on buying growth could also be challenged if the regulatory hurdles to acquisitions increase.

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So while M&A will probably stay in the spotlight for a while, questions about deal pricing, higher interest rates and regulatory scrutiny could cool the trend. That's why we think a focus on companies with strong organic growth seems preferable to hunting for companies that depend on acquisitions for growth. Today, companies with strong secular growth potential are surprisingly trading at only a modest valuation premium to the market. This means that even though growth is tough to find today, investors don't have to pay a huge premium to capture the return power of companies with true growth potential.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.