Monday, June 15, 2015

Mergers and Acquisitions: The Elusive Search for Growth

Firms have largely recovered from their near death 2008 Great Recession experience with margins and stock prices exceeding pre crisis highs. Revenue growth, however, remains disappointing. A low growth, low interest rate environment is partly responsible. Consequently, many firms have focused on cost cutting efficiency improvement and curtailed organic growth related CAPEX and working capital investments. Thus, free cash flow (EBIT [1-t) +DA-[CAPEX+WCI]) has grown resulting in excess cash. Firms have responded with massive dividend and share repurchases which could exceed $1T this year.

This development appears to have run its course. Repurchases are becoming difficult to justify at current price levels. Thus, investors are now seeking firms who grow their operations, not just increase shareholder near term distributions. Of course, not all firms can achieve such growth. 
Organic growth still remains tough. Therefore, firms are increasingly turning to acquisitions to achieve growth objectives. This is reflected in near record M&A volumes. As previously mentioned this comes with increased risk. The Q ratio, a quasi -market to book ratio indicates stock prices are fully priced. The “q” is at its highest levels since the 2000 tech boom peak and well above its historical mean. Adding the usual 30-40% M&A premium means you need to improve the targets’ contribution by 60-80% to cover the premium and yield a “home run”-sounds tough because it is.

 Making acquisitions in such a market becomes tricky unless managers can clearly distinguish between good and bad growth. Good growth occurs when returns on assets (ROA) exceed their cost of capital (WACC). Acquisitions earning more than cost yield such growth and increase shareholder value. The levers management can pull to achieve such results is to control how much they pay and make sure they execute to achieve the required synergies to earn out the purchase price premium. The higher the premium the more difficult this becomes. Failure to achieve ROA>WACC results in bad growth. Revenues may increase, but shareholder value suffers. This is usually a time lag before this result becomes clear, and by then the damage is done.

A checklist I use to help me sort thru these issues is:

I hope managers are not acquiring out of desperation over what to do with their excess cash. It is always better to return the cash to shareholders than making poorly advised acquisitions.

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