Merger Activity - A Record Year?

Tuesday's Wall Street Journal contains a very interesting article on this year's merger activity. (See Merger Activity is on Pace for Record, by Dana Mattioli and Dan Strumpf).  Citing Deal Logic as a source, the authors note that if the current pace of deals continue, it will outpace 2007 - the last record year.  Illustrative of this is Berkshire Hathaway's $32 billion deal to acquire Precision CastParts Corp.  the largest deal in Berkshire's history.

What interests me most about the article are the reasons cited for the large number of deals.  We've covered most all of these in these posts - and also urged caution.  Some of the main issues are noted below:

• Low interest rates - and the fear future rates will rise
• Executive confidence
• Fear of being left behind
• The desire to boost growth through acquisitions (as growth from other sources becomes limited)
• The "economy isn't in free-fall"
• Accumulated cash on acquirer balance sheets

I firmly believe these concepts are on the minds of today's executives and I don't doubt they are driving deal activity.  What concerns me is that with the possible exception of confidence none of the reasons are valid by themselves for doing deals.

Sure, low interest rates are better than high rates, but if a deal doesn't make strategic sense, low rates are not a sound motive for doing deals.  (See Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price).  The same is true of fear of being left behind.  On the face of it, it implies a 'keeping up with the Jones' mentality. It could also imply an 'eat or be eaten' mentality.  While shifting landscapes are certainly catalysts for deals, it is important to understand the economics behind these shifts.  Again, deals that fit the strategic plan of the company are best and sometimes the best deals are those you don't attempt.  In some situations, selling the company is actually the best move for shareholders.

Joe has talked extensively about the attempt to boost growth through acquisitions.  If the benefits don't exceed the costs, the deal is bad, even if it produces a short term boost to earnings.  Unfortunately, it can be easy to get caught up in deal fever and overestimate benefits and understate the difficulty in integration.  (See A Man Hears What He Wants to Hear).

The economy not being in free fall is a good thing, but hardly enthusiastic support for doing deals.  Finally, accumulated cash is absolutely no justification for doing deals.   Each company must ask - can I earn a superior return on this cash for my shareholders.  If not,  it should  be returned to its owners - the shareholders.

So this brings us back to executive confidence.  Confidence can be driven by many desirable qualities - knowledge and experience come to mind.  Confidence can also be driven by emotion and influenced by every one of the other factors in the list.  Bottom line - only attempt deals that make strategic sense and that are justified based on a hard look at the costs and benefits.  Without this step, none of the other items matter.

All the best,

Ralph

Merger Activity and the Stock Market

In spite of this week's dip in the market, the recent trend has been quite positive.  So too is the increase in deal activity (and IB profits!  see Goldman Sachs Profits Jump).  In fact, mergers are strongly correlated with the stock market and it is instructive to consider  some of the possible reasons.

• Hot markets are often associated with catalysts providing opportunities.  At the beginning of an upturn, mergers provide opportunities for rapid expansion and additional synergies from expanded sales.  As the business cycle matures and product markets become more competitive, mergers provide opportunities for the synergistic reduction in costs.  
• Deals are easier to finance in market expansions.  Credit becomes more widely available and the acquiring firm's stock is higher priced.  Indeed, the use of stock financing as a form of payment is correlated with market levels.  
• Related to this, it is sometimes conjectured that acquiring firms can snap up bargains by using their 'inflated' stock.  Not so fast - it is likely that many targets have also experienced run-ups in price.  The resulting 'bargains' may exist, but are not mechanically generated by rising markets.
• However, there is a theory that firms with overvalued stock can 'lock in' that valuation by buying hard physical assets with that inflated currency.  The ability to implement this tactic requires sellers to be naive about the bidder's inflated price and assumes the hard assets are not also overpriced.  Indeed, bidders using stock tend to underperform those using cash at the announcement of a deal.  More broadly, firms issuing stock tend to drop 1-3% in value upon the announcement.  Issuing stock seems to act as a signal - why issue stock if it isn't at least fairly valued and probably overvalued?
• Confidence - buyers tend to have increased confidence when their stock price is high.
• Among the most intriguing reasons given for increased activity in hot markets is the 'pool of exhausted managements' theory.  According to this theory, many owners hang on to their firms in downturns waiting to sell when prices again rise.  The idea makes intuitive sense and corresponds with some known psychological findings:  we often anchor our price expectations on a historically high price.  Nevertheless, it doesn't explain why bidders are more willing to buy at this time - unless one factors in one of the reasons in the above list.

In any event, here is hoping for a renewed market rise and more deal activity.

All the best,

Ralph

Excess Cash, Leftover Wine, and Acquisitions

Quiz:

When a company has excess cash, what is the optimal thing to do?

a) return the cash to shareholders via dividends or repurchases

b) make acquisitions

c) return cash to shareholders only when they have a better use of the funds than the company

d) retire debt

e) save the cash, rainy days are ahead

(f) increased CAPEX.

With some explanation, the only correct answer is (a).

First, let's look at (e) and (c) and (f) which could be the best answers if we hadn't specified  the phrase 'exess cash'.  By definition, 'excess cash' occurs after consideration of the safety and usage reasons for holding cash.  The term 'excess' also implies that management has already taken all positive NPV projects which would seem to rule out any reason for management to keep cash for safety reasons (e) or as in (b) make acquisitions.  If there were good acquisitions to make, the cash would not be 'excess'. The same is true of increased CAPEX. 

Retiring debt (d) might make sense if a firm was over-leveraged and/or interest rates were high, but in general only makes sense if the cost of debt is less than the return shareholders can earn on their funds at risks typical to those of this firm. Typically, this is the cost of equity for the firm which exceeds the cost of debt and especially the after tax cost of debt.  Rule out (d).  

Now lets give greater credence to (b).  Sometimes it is argued that when a firm's stock price is inflated, it makes sense to use that over-priced currency to acquire hard assets.  When the firm's stock price adjusts to reality, the firm will still have acquired the hard assets at inexpensive prices.  This argument may explain why the number and dollar volume of mergers is strongly correlated with the stock market.   When stock prices are high, more deals get done.  The problem with this argument is that the target's stock price is also  likely to be high so the acquiring firm could be purchasing overpriced assets.  

Thus, when a firm truly has 'excess cash' the only correct answer is (a). Nevertheless, when faced with a decision to relinquish cash or build the empire, many managements choose the later. 

And it is well known that deals increase with stock prices.  

Currently stock prices are at or near record highs.  

So are the number of deals being completed.  This graph from Jesse Solomon in  CNN Money reveals that the number of deals completed in the first half of this year outpaces the total number of recent years and is on pace to surpass the all time highs of 2007.  

Why?  Certainly some deals make sense - and the conditions in many industries are demanding consolidation, but for many firms, one can suspect that excess cash, like excess wine is just not that apparent when it is in your hand.  

All the best,

Ralph

European Mergers in 2013

Joe and I have recently been commenting about merger activity or lack thereof.   In his most recent post (viewed here) Joe notes, "Overall Volume is a Tale of Two Continents: U.S. volume is up over 11% over 2012 to over $1T-a post crisis high.  Europe, however, continues to lag, reflecting its structural problems." In the post before that (viewed here) I discussed deals of the year for 2013.  Combining these two streams, today's post deals with European Mergers in 2013, drawing on the note, Cross Market Commentary: European Merger Activity Falls in 2013.  

While aggregate deal activity was down in Europe in 2013, an analysis of quarterly activity reveals interesting and juxtaposed trends: the dollar volume of activity increased each quarter while the number of deals decreased each quarter.  Obviously, the average deal size was increasing by quarter as well.  The largest European Merger deal of the year was the 19 million dollar deal by Brazilian telecommunications firm Oi SA to acquire Portugal Teleccom SGPS S.A.  

Some of the Trends noted in the European Report are also borne out by Thompson Reuters.  Here we find that US merger activity accounted for the largest percentage of world activity since 2001 while European Activity hit a ten year low.  This reflects Joe's comment about the tale of two continents.

Regardless of the trends it is certain that mergers will continue to be important in the US, in Europe and in the World.  Why?  Because The forces that drive mergers will continue to be dominant in all of these markets, specifically changes in: technology, consumer tastes, regulation, competition, and factors of production.  The size and volume of activity will ebb and flow, but the fundamental factors driving deals are ever present.  More detail is contained in our post on Catalysts for Merger.

All the best,

Ralph

Experience Matters: The Impact of the Financial Crisis on M&A

I have been stumped by the continued low level of M&A activity. Despite improving fundamentals, strong stock market performance and the need for many industries to consolidate, M&A remains stuck in low gear. I understand macro headwinds and political uncertainty still exist. Nonetheless, something else seems to be dogging managerial animal spirits. My concern is the 2008 Financial Crisis may have a long term damping effect on management risk appetite.

The Financial Crisis represented a near death experience for many firms. Stock prices fell by 50%.  Although they have largely recovered over the past 5 years the cumulative return over that period remains flat. The collective memory of this experience may take years to dissipate.   Experiences matter - sometimes even more than fundamentals. Risk tolerance is time varying. Thus, the financial crisis is likely to have a long term negative impact on managers’ willingness to engage in M&A.  See a book chapter I authored on this subject chapter_24_post_crisis_investor_behavior_-_rizzi_-_final_-_05-18-13.pdf.

J

Bank M&A: A Wake Up Call-Finally?

Bank M&A, like M&A in general, has been depressed since the 2007 financial crisis. Deal volume for 1H13 was below 2012 anemic levels with just 76 deals. The deals done were primarily small fill-in transactions involving motivated (i.e. troubled) sellers. Low pricing multiples reflected the buyers’ market nature of the environment. A variety of factors were responsible for the depressed volume. These include:

1)     Post crisis malaise: confidence fell following the crisis. Banks were focused on surviving and resolving asset quality issues than growth. Investors also supported a cautious view regarding acquisitions-buyer share prices would fall for the few deals that were announced.

2)     Weak stock prices: buyers were reluctant to incur significant dilution by funding acquisitions with under valued stock. Sellers were unlikely to sell at depressed prices unless forced to do so by regulators.

3)     Regulatory uncertainty: regulators were likely to encourage banks to solve their own capital problems before approving significant acquisitions.

4)     Purchase accounting: the adoption of purchase accounting in June 2001 had a larger than anticipated negative impact on bank M&A. Any goodwill created reduced a key regulatory ratio concerning tangible book value (TBV) to assets. This pressured acquirers to consider larger equity issues to offset TBV reductions. Combined with depressed stock prices this would produce larger levels of earnings dilution. Dilution is dismissed as an accounting measure. Nonetheless, it serves as a useful buyer pricing constraint.

Despite the above, the case for M&A has been growing for years ( see M&A May be Best Path Available to Profit Growth). Stock prices for both buyers and sellers have risen substantially this year. Buyer confidence has returned as operating performance has recovered. Investors have signaled greater openness towards acquisitions that make strategic sense and are appropriately priced. Added to this is the growing frustration of many banks regarding weak loan demand (reflected in low loan to deposit ratios) and rising cost levels as a percentage of revenues.

In July, two large transactions were announced. The first was a July 15 $680MM deal involving MB Financial’s ($9.B assets-MB) acquisition of Cole Taylor Bank ($5.9B assets-TAYL) in suburban Chicago MB Taylor. The price was relatively full at 1.8X TBV (to book value) -sufficient enough to entice the seller to accept. The following week PacWest ($5.3B assets-PACW) announced the largest banking deal of year with a $2.3B deal PACW CSE to acquire Capital Source ($9.2B assets-CSE) an industrial loan company. The CSE price was 1.66X TBV. The market response to the less well covered Taylor transaction was muted with MB’s price falling 3% on announcement. Some investors have expressed concern regarding the price given Taylor’s mortgage reliance in a rising rate market. PACW’s price jumped 7% on its planned acquisition. This reflects the tighter pricing relative to expected synergies.

The transactions share some common features as follow:

1)    The driving force was strategic: the buyers had substantial low cost deposit bases and depressed loan to deposit ratios highlighting their difficulty in making loans. The sellers were 'demand deposit constrained' but had national asset origination capabilities in asset based finance, equipment leasing and mortgages reflected in high loan to deposit ratios. The buyers hoped to utilize the sellers’ national origination platforms to distribute credit products funded by their excess low cost deposits.

2)    Substantial identified cost savings.

3)    Tax free transaction involving use of the buyers’ appreciated stock limited TBV and EPS dilution. MB was trading near its 52 week high of $29 p/s as was PACW compared to its 52 week high of 33. Thus, fewer new shares needed to be issued.

4)    Relatively large transformational acquisitions involving significant integration risk. This  is offset by the experienced teams at MB and PACW. The business profile and risk of both acquirers will be altered by the transactions. How this impacts their pricing multiples is yet to be determined.

The transactions offer insight into possible future deals. First, buyers are unlikely to be big banks ($250B+ assets) due to regulatory concerns regarding too- big- to- fail. Rather, buyers will likely be in the $5-10B asset size institutions looking to achieve scale and national lending platforms. Banks with assets exceeding $10B appear to have economies of scale reflected in higher ROEs compared to smaller institutions. Targets will likely either be lower priced smaller (less than $1B assets) deals, or larger fully priced $5B+ assets institutions. There are a limited number of the larger targets which offer scale. Hence, a scarcity value for these banks may exist.  The thousands of banks below $1B assets are likely facing a more difficult selling process. Non bank finance companies may also become more popular bank targets.

These two transactions could serve as a wake-up call to other banks which have been reluctant to consider acquisitions. This will be driven by investors growing frustration with low bank ROEs due rising costs and weak loan demand. My guess is we will see the formation of more regional ($10-20B assets) and super regional ($20-50B assets) combinations. Keep in mind that of the 7000+ domestic banks there are only 100+ with assets above $10B. Going forward,  small banks will need to get bigger, while the too-big-to-fail will need to shrink. The keys to implementing this strategy will be the patience to wait for the right target, discipline to avoid over paying and the ability to execute.

J

p.s. disclosure-I am a PACW shareholder.