M&A as a Source for Growth

When one company announces its intent to acquire another, it is fairly common to see the acquirer’s stock price fall on the news.  This is generally true whether the acquirer uses stock or cash to make the purchase.  If stock is used, a sizable acquisition can dilute existing shareholders, giving them a smaller share of total company profits.  If cash is used, the acquirer will often raise the cash by taking on more debt.  More debt causes higher interest costs at a minimum and financial distress in extreme scenarios.  And then there’s the issue of whether or not acquisitions actually create shareholder value.  Some of the largest and highest profile mergers in recent times (think Bank of America’s acquisition of Countrywide or AOL’s acquisition of Time Warner’s) have resulted in disastrous consequences for legacy shareholders in those companies.  So given the dubious track record of M&A in general, some of the knee-jerk, negative response to acquisition announcements could simply be investors expressing their dissatisfaction with investment decisions that carry highly uncertain payoffs.

Obviously, the price paid to acquire another companies is very important to the success of a deal.  In an ideal scenario, a prospective acquirer might find itself the lone savior of a company in financial distress.  On March 16, 2008, Bear Stearns reluctantly agreed to be acquired by JP Morgan Chase “in a stock swap worth $2 a share, or less than 7 percent of Bear Stearns’ market value just two days before.” (Wikipedia)  This deal was fraught with risk at the time, but in hindsight I’d bet Jamie Dimon would gladly do it over again.  It’s rarely so cheap to eliminate a major competitor.  So there are times when sellers are so desperate that they are willing to take almost any price.  But these situations are pretty rare.  A much higher percentage of acquisitions are doomed from the start due to excessive price, bad rationale, or poor execution.  Unless, of course, you are an investment bank generating fees from these deals.  No acquisition looks bad to investment bankers.

 

There are a select few companies that earn their mettle through the acquisition process.  These companies, which would include Berkshire Hathaway and Danaher, have perfected the process of identifying and acquiring other companies.  In fact, they many times use acquisition spending as a substitute for capital spending.  In Danaher’s case, acquisition targets are underperforming manufacturing companies that are made more efficient through the “Danaher Business System.”  DBS is a set of processes based on the principles of lean manufacturing and continuous improvement (or “kaizen”, as it’s known in Japan).  These processes have enabled Danaher to successfully identify and consolidate hundreds of acquisitions over the company’s history.  Berkshire, for its part, employs a different model whereby acquisition targets are highly performing companies with very strong management teams who are left relatively autonomous after consolidation.  Both models have worked, but there are very few companies that have been as successful as Danaher and Berkshire.

In recent years, acquisition announcements, generally speaking, have been greeted more warmly by investors.  There are several reasons why acquisitions in the post-financial crisis world might make more sense than they have historically:
  • A slow-growing global economy has left many industries with few opportunities for organic top-line growth; acquisitions can improve growth prospects;
  • High stock prices have enabled many companies to use an inflated currency (their stock) to pay attractive prices for acquisition targets; all else equal, using high-priced stock limits dilution;
  • Ultra-low interest rates have enabled many companies to fund acquisitions through very low-cost debt; using low-cost debt can increase earnings accretion;
  • Many companies are carrying tons of cash on their books right now as a result of limited investment opportunities; these high cash balances dilute returns on invested capital, and they can sometimes affect management compensation; moreover, the deployment of cash, which is earning next to nothing, into acquisitions can be highly accretive to earnings;
  • Some companies have made acquisitions in recent years to take advantage of “tax inversions”; tax inversions allow acquiring US companies to assume the target’s tax jurisdiction, thereby avoiding relatively high US corporate tax rates;
  • Many companies, most notably large US multinationals, have tons of cash sitting overseas that cannot be repatriated without significant tax repercussions; cash held overseas also cannot be used to pay dividends or buy back stock;
  • Some companies, faced with slowing growth in their core markets, have been opting to diversify into higher-growth end markets through acquisition.

This brings me to the case of Qualcomm (QCOM) and its pending acquisition of NXP Semiconductors (NXPI) – a deal that has been received very positively by investors since rumors began circulating in late September.  This deal meets many of the motivating factors in the bullet points above.  QCOM’s largest end market, mobile devices, is maturing and therefore company growth prospects have come down.  NXPI gives the company immediate scale in faster-growing end markets like automobiles.  QCOM plans to utilize most of its $30 billion in cash, most of which is held outside the US and therefore cannot be brought back without penalty, to fund some of the $47 billion acquisition price (includes $8.5 billion in assumed debt).  The company also plans to issue about $11 billion in new low-cost debt to fund the balance of the acquisition.  Going forward, QCOM can use the cash it generates overseas to pay down that debt.  So, in essence, QCOM is buying an entity with far superior top-line growth prospects using both low-cost debt and encumbered cash which is earning next to nothing and diluting returns on capital.  Because of the terms, the deal is expected to be highly accretive to current QCOM shareholders.  This seems like a winning game plan, and investors are reading it as such.  But this deal was made possible by a very accommodating set of factors that are not normally in place.

One last thought:  M&A activity is generally perceived as a sign of an aging bull market.  Why?  Because companies tend to pursue acquisitions when their stock prices are high and there is a dearth of other investment opportunities.  But not all M&A is created equal.  We believe that by taking advantage of today’s unique backdrop we are likely to continue to get positive receptions regardless of the investment cycle.