Thursday, June 4, 2015

Merger Waves: Health Care, Autos, and Semiconductors

Weve written several times before about merger waves.  They cluster in the aggregate economy, generally correlating with the stock market.  And – they cluster by industry.  The reason for the latter is generally that some catalyst has forced a change in the industry and consolidation is in order.

Consider what makes acquiring another firm attractive.  Simply put, a firm becomes an attractive target when the benefits exceed the costs.   There are three general components to this calculation – the cash flows, the discount rate and the costs.

First, consider the costs.  If something happens that decreases the cost and the benefits stay the same, the firm becomes an attractive target.  Costs could decline because the general value of the industry has declined or because a specific firm is not maximizing value.  Costs could also decline if a firm wanted an immediate sale (sacrificing price for liquidity).

Second, lets consider the discount rate: Picture the present value equation – a string of (generally) yearly projected cash flows in the numerator and an appropriate discount rate in the denominator. The present value or benefit of any asset is equal to the cash flows of the project discounted at an appropriate discount rate.  Appropriate means adjusting for risk and recognizing current market interest rates.  So if risk or current rates decrease, the value of a firm increases.  Some firms that were unattractive before become attractive now. 

Third, consider the cash flows. A similar thing occurs with the numerator.  If something happens that makes the cash flows larger, the value increases and the firm becomes more attractive.  If the cost has remained the same, some additional firms are likely to come into play.

How does this relate to merger waves in an industry?  As we have noted, industry merger waves generally occur because some catalyst has changed one of the three inputs above.  These catalysts include shifts in regulation, interest rates, consumer tastes, technology or other factors of production.    When these shifts occur, the net present value equation (i.e. present value minus the costs) is altered; firms in the industry become attractive and there is a jockeying to acquire them.  In today’s news we have several good examples:

  • ·      Humana is reported up for sale – changes in federal health care laws (Obamacare) have altered the economics of the industry
  • ·      Fiat –urges bigger rivals to recognize the need for consolidation in the industry because of overcapacity in the industry
  • ·      Intel taking over Altera – to boost revenue following consolidation in the semiconductor industry

There are plenty of other examples.  Just look for the catalyst and then look for the opportunity. 

Happy Prospecting,


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