One defining characteristic of 2014 has been an increase in merger and acquisition (“M&A”) activity around the world. According to figures from Deloitte, the second quarter of 2014 saw the highest level of M&A activity since the global financial crisis1. Most commentators regard M&A activity as positive for investors because it indicates rising confidence amongst corporates, suggesting a willingness to pay higher prices for deals, and thereby justifying higher share prices. But is M&A really such a good thing? How should investors go about assessing whether a particular deal is a good idea?
As usual my starting point with a question such as this is to see what the data says. One comprehensive study, undertaken by McKinsey, analysed the acquisition track records of the world’s 1000 largest companies over the previous decade2. It concluded that large deals – defined as an acquisition greater than 30% of the acquirer’s market capitalisation – on average destroy value for the acquiring company. However, smaller more selective types of deals were more successful. The results also varied considerably by sector. This suggests to me that investors would be best to consider the individual merits of any deal on its own terms, rather than relying too much on historic data driven conclusions. Below are some important factors I always consider when one company buys another:
“Price is what you pay, value is what you get”. Mr Buffett’s timeless quote is as relevant for M&A as it is for investing itself. Overpaying for an asset today is the easiest way to achieve poor returns tomorrow. With M&A this is complicated by the fact that the value of company A to company B may be considerably higher than the stock market value of company A. For example, company B may see the potential to increase the profits of company A through cost-reductions that would not be possible on a stand-alone basis. In my view, investors should prioritise absolute over relative value when it comes to assessing M&A. The most value destructive M&A has tended to occur when overvalued companies buy other companies at inflated valuations, which are then justified by reference to their own high valuations. The most obvious recent example of this was in the technology, media and telecoms sector in the late 1990s, with the AOL-TimeWarner deal being the poster child.
Smaller is better. The abovementioned McKinsey study showed that companies that made lots of small acquisitions tended to perform better than those that did one or two large deals. It’s easy to see why this might be the case. Smaller deals require less financial resources, are easier to execute and take up less management time. Often they form part of a broader growth strategy, where the M&A is almost like capital expenditure in adding small incremental capabilities or geographies. An excellent example of this in practice is Bunzl3, a business-to-business distributor of non-food consumable products (= coffee cups, toilet rolls, employee uniforms, hard-hats etc.). It sounds boring and it is, but the business model works because Bunzl has huge scale advantages embedded in its vast logistics network, allowing the company to service its customers quickly and efficiently. In most years Bunzl makes between 5 and 10 small “bolt-on” acquisitions to supplement its relatively low organic growth. This acquisition strategy has created a lot of value for Bunzl because the company has gained additional product and geographic reach and has not had to pay high prices for this.
Quality matters. My colleague Jeremy Thomas recently wrote an interesting piece discussing what makes a business or industry high quality. I believe this is very important when assessing the merits of M&A. Companies often justify paying a premium to acquire another company due to the cost savings (“synergies”) that are available. This is fine in theory, but it relies on the critical assumption that the company will be able to hold onto the cost synergies. Practical experience has shown that companies operating in highly competitive industries have ended up giving back most or all of the cost savings to their customers in the form of lower prices. Perhaps the best example of this is the telecoms industry in Europe where, over the past decade, profit margins have been on an inexorable downward trend, despite much M&A activity designed to increase scale and reduce costs. In contrast, higher quality industries with pricing power such as branded consumer goods have been able to drive their profit margins up over the long term helped, in part, by accretive M&A strategies.
Pay attention to management behaviour. Because company executive teams will always present M&A deals in the best possible light, it is wise to consider other factors – beyond the headline financial projections – that may be indicative of management motivations. Is the deal consistent with management’s previous strategy? If not, this may indicate a problem with the core business, with the acquisition being an attempt to paper over the cracks. It could be argued that many of the recent US “tax inversion” deals fall into this category. If a deal only makes sense because the tax rate can be reduced by a few percentage points then it is unlikely to be hugely compelling strategically. Management remuneration is also important. As I argued in “Earnings accretion is not value creation” it is easy to manufacture earnings per share growth by embarking on big M&A deals, even though this may not create shareholder value. Investors should be cautious of big M&A deals where management are heavily incentivised on earnings per share growth.
3. This is no recommendation to buy or sell any particular security.