Merger activity is picking up once again, although the transactions are quite different from most of the deals done in 2005 and 2006. Many of the deals that preceded the recession were done by private equity firms using a lot of debt to finance the buyouts. As purely financial deals, they needed a healthy economy to perform well, so many are struggling now under a mountain of debt at a time of weak sales.
In contrast, the deals being announced now are strategic, initiated by companies within the same industry seeking complimentary businesses or overlapping activity, as cost cutting can significantly increase competitiveness. The other implicit, important message behind these deals is that stocks are cheap and firms have enough confidence in their outlook to go forward with acquisitions.
M&A activity is dominated these days by strategic deals, not financial deals. At this very moment, Merck (NYSE:MRK) is buying Millipore (MIL) (beating out Thermo Fisher (NYSE:TMO)), Pepsi (NASDAQ:PEP) and Coke (NYSE:KO) are buying their bottling companies, AIG (NYSE:AIG) is selling off an insurance division to Prudential (NYSE:PRU), Yara (OTCPK:YARIY) is buying Terra (TRA), and Astellas (OTCPK:ALPMF) is going hostile to buy OSI Pharmaceutical (OSIP).
These deals are to gain scale, broaden product lines, gain access to raw materials, or more generally, to increase competitiveness and the surge started in 2009. Many mergers do not work out well for acquiring shareholders, but these types of deals are far more likely to be successful because acquiring management knows their own industry.
Merger activity tends to increase only when conditions are favorable, which requires the buyer to think they are able to get the acquisition done at a good price. Mostly, this means making payment with a currency thought to be expensive to acquire stock that is thought to be cheap.
Sometimes the “currency” that’s overvalued is debt, sometimes cash, and sometimes securities of one sort or another. When stock prices are high, it is unattractive to use cash or debt as the acquisition currency, so stock is used.
However, the acquiring company must sport a higher price earnings multiple than the acquired. These days, stock values are low, so many deals are being financed with cash or debt.
The implicit message of the pickup in merger activity is that both cash and debt are expensive or overvalued and worth using to pay for cheap stock. How else can we explain premiums of 25% to 40% being paid for acquisitions?
Clearly, the acquirer thinks the deal is worthwhile and, since they are mostly in the very same industry as the acquired, they should have a very good sense of the business prospects of the companies being bought. We agree and think stocks are attractive.
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