We're rapidly approaching the thirteenth anniversary of an important market event, and it's the sort of event that could repeat itself.
If any of you have guessed what this anniversary refers to, you get an "A" with multiple pluses after it. Indeed, we are talking about what is probably the largest corporate takeover in the history of America: the one in which the then largest corporate company, Exxon, took over and merged with another company that was probably in the top ten in terms of capitalization - namely, Mobil Oil. Today Exxon is no longer just 'Exxon,' but Exxon Mobil (XOM).
What prompted us to look at this anniversary, which will officially take place in the fourth quarter of this year, were a couple of factors. One, as our chart shows, is that free cash flow yield for as far back as the statistics go on big-cap stocks (in this case the Russell 1000) is currently close to record levels - nearly 8 percent.
Not only in nominal terms is this an extraordinary number, but in relative terms it's a blowout. Now, let's consider exactly what free cash flow yield is. One way of interpreting it involves the dividends a company could pay without in any way impinging upon its growth.
Note that free cash flow is a number that comes after all capital expenditures and after all research and development expenditures. So when you're looking at 8 percent free cash flow yield, you really are saying that a company with this level of free cash flow could, if it wanted to, raise its dividend yield to 8 percent without harming its operations or growth.
Or, it could use that free cash to buy other companies.
Keep in mind that interest rates are now at record lows not only on a government level, but also amongst top corporate companies. So to do just a little thought experiment: if you borrow money at 3 percent to buy out a company whose free cash flow yield is 8 percent, you're making out like a bandit.
Moreover, keep in mind that the money you borrow is pre-tax, whereas the free cash flow yield is of course after-tax. So if you borrowed all the money needed to buy out a company whose free cash flow yield was 8 percent, you're starting out earning 6.5 percent (8 percent less one-half of 3 percent) plus all the growth that the acquired company might have. In other words, that 6.5 percent is a freebie in additional cash that you'd be earning. This is like getting a yield of 6.5 percent on top of any growth the purchased company would add to your business.
All of this leads us to a question: Could there be some mega-takeovers in the works now?
Clearly one reason that companies have hesitated in buying out other companies, even though there's this huge built-in profit that we've described due to the unprecedented differential between free cash flow yields and bond yields, is the big question about future economic growth.
But if either (a) companies become more convinced that the world economy can recover and sustain growth, or (b) these companies simply become convinced that any particular company they're looking at as a potential acquisition will continue to grow despite these very turbulent times, you could indeed have the makings of some mega-takeovers.
After all, though there were obvious synergies between Exxon and Mobil in 1999 as well as between other major companies involved in the big takeovers of that era, there was nothing like the current differential between free cash flow and bond yields. The current situation is utterly unprecedented.
From this perspective, betting on the prospect of mega-takeovers has never been as strong a bet as it is today.
We're not going to leave you hanging at this point, so here are two candidates for what may be such mega-takeovers:
Let's start by going back to Exxon Mobil. But instead of buying another oil company (which would be likely to have the same kinds of problems Exxon is having these days, e.g., finding reserves) why not go for something that would involve vertical rather than horizontal integration? That is, something in a related industry that would complement Exxon's business, but isn't the same one.
A major takeover in this vein would be Schlumberger Ltd. (SLB).
This nearly $100 billion corporation is clearly the king of oil service companies and a company that Exxon uses in many ways on virtually every project it participates in. It's a company with a free cash flow yield of over 5 percent, which is likely to rise. So this is a situation in which Exxon could borrow all the money needed to acquire Schlumberger, say something north of $100 billion, and let Schlumberger's business operations more than fund the interest costs and reduce the debt on the loan. Does Exxon have the money and the credibility to bring this off? Yes, clearly it does. It is one of the few AAA companies still around.
In case you're wondering about possible anti-trust implications, of course, Exxon would agree to have Schlumberger continue to service other companies. After all, that's where Schlumberger's free cash flow would continue to come from. So none of these other companies would be disadvantaged, though Exxon would obviously have an advantage in owning its own oil services provider.
To be sure, we can't be 100 percent certain that no anti-trust issues would be raised to such an acquisition. But if there were no objections to an Exxon-Mobil merger, why should there be any to an Exxon-Schlumberger merger?
Now let's shift gears and speculate about another possible mega takeover. What's the most profitable and successful company in the history of technology/consumer products?
Probably no one has to guess: it's Apple (AAPL).
This company right now has about $110 billion in cash and generates around $50 billion a year. Its borrowing capacity is huge - you probably couldn't name a number large enough, given its nearly 10 percent free cash flow yield, its incredible cash horde and its total dominance in many critical markets. The only reason the company doesn't have a AAA rating is because it doesn't have a drop of long-term debt.
Apple's big problem, which it's had for some time (and what a problem to have!) is how in the world can it deploy all that cash and all that cash flow-generating ability?
Well, here's a suggestion: how about if it were to buy Intel (INTC)?
If any company can rival Apple in terms of overall stability, longevity and position in its market, it's going to be Intel. By a wide margin, this long-term favorite is the leading producer of microprocessors. Free cash flow yield amounts to about 5 percent - not great, but not bad.
But what's intriguing about Intel is that really for the first time since the whole microprocessor era began, the company has gained some pricing control.
Even more intriguing from the perspective of Apple is that Intel is now making rapid inroads into chips other than microprocessors. These new chips compete, and then some, with those that are used in those very same devices that Apple has ridden to fame and fortune on - namely iPhones and iPads.
While there's no guarantee that Intel will be hugely successful here, there is a near guarantee that in terms of raw specifications, i.e., the size and power of these chips, it will by far out-do all other competitors.
Some have said that Intel's lead in manufacturing is as much as four years, and that it is the only company that can deliver the kinds of supplies of chips that will be needed if this industry does continue to grow. It is clearly one of a kind.
An Apple takeover of Intel would obviously be massive and certainly top not just Exxon-Mobil, not just Exxon-Schlumberger, but also, for those of you who have good memories, the mega-merger of Time Warner (TWX) and AOL (AOL).
No doubt such a takeover would require Intel to continue to service its other customers - which I think both Intel and Apple would be happy to do - and there might very well be other obstacles to overcome. But ultimately, it should be doable.
* * * * *
Just to be clear, we are not predicting that the two mega-takeovers described above are about to happen (or will ever happen). Rather, what we are saying is that market metrics, in terms of valuations, have probably never been as extreme as they are today. And therefore, it might take only a very small spark (or no spark at all) generated by companies like the four we've mentioned to set off extreme events.
This is, after all, a world of extremes. And any extreme event might serve the purpose of waking up the market in a very big way.
But even if no such extreme events come to pass, make no mistake: Apple, Intel and Schlumberger, whether they target another company for acquisition (in the case of Apple) or become the targets of another company (Schlumberger and Intel) remain very strong buys.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.