The recent surge in U.S. mergers & acquisitions (M&A) activity in 2011 is a result of companies having strong earnings, a significant cash balance as well as more available financing.
In the first quarter of 2011, M&A activity in the United States was up over 100 percent compared to last year with deal values reaching $451 billion.
There is also pressure on management to put their “money to work” as shareholders are not happy that billions of dollars are being held in cash. Another reason why U.S. multi-nationals are taking over foreign companies is because they hold tens of billions of U.S. dollars overseas in order to reduce their tax liabilities. By taking over companies overseas, U.S. global firms are saving on the ridiculously high corporation taxes but aren't creating jobs at home.
Some of the bigger deals which have grabbed headlines are: Microsoft’s expensive acquisition of Skype, LVMH’s takeover of Bulgari, and VF Corp.’s (owner of many well known fashion brands) acquisition of Timberland.
While the media tends to cover the mega-deals (over $10 billion) there have only been a handful of such transactions this year in the United States with the most famous one being AT&T/ T-Mobile ($40 billion) and Duke Energy/Progress Energy ($26 billion). The latest mega deal was the recent acquisition of ING Direct USA for $9 billion in cash and stock by Capital One Financial.
The middle market deals (under $1 billion), which are less well known, contribute to over 90 percent of deal volume and over 25 percent of deal value.
In the first six months of 2011, over 1000 middle market M&A deals have been carried out in the US. It is not only corporate that drive this M&A activity but also private equity who have substantial amounts of cash.
In both cases, management is frequently overpaying in takeovers because top management salaries might be linked to increase in revenue and growth but not necessarily to an increase in shareholder value.
Some activist funds are pressuring managers of listed companies to return capital to shareholders by buying back shares or increasing dividends rather than overpaying in takeovers.
Many recent takeovers have been at a high PE valuation and unless one is expecting a highly inflationary environment in many situations this will not increase shareholder value.
Another reason why some M&A takeovers have been at a high PE valuation is that U.S. companies have too much cash parked overseas (due to high corporate taxes in the United States).
With such a tax policy, it makes sense for companies like Microsoft to overpay for Skype rather than bring it back home, paying around 35 percent tax (or more) and taking over a local company. Spending $8.5 billion for Skype, which although has 107 million users and $1 billion in revenues, does not make sense as it has no profits. The only explanation to shareholders is that it would have to pay a lot of taxes if it repatriated the money home to pay a dividend.
Many companies are waiting for a tax holiday to repatriate their funds but with the current government in office it is off the table. A tax holiday by the Obama government would have the potential to increase the number of U.S. middle market company takeovers rather than U.S. multinationals competing with each other and ending up overpaying for foreign ones.
What can the average investor do in order to profit from this surge in M&A activity?
Investors should try to search for mid-cap companies which are undervalued or which seem likely targets for a takeover. Can one forecast which sector is likely to have enhanced M&A activity?
If one looks at recent activity, then technology, energy, retail, industrial and healthcare are all sectors with increased M&A activity.
The financial sector might also have increased M&A activity as regulatory changes will result in smaller to mid size banks having no choice but to merge in order to have a large enough scale. A depressed valuation with a good cash flow and strong balance sheets are characteristics of many apparel retailers which make them attractive to private equity firms. For example, in 2011 one can see the takeover of BJ’s Wholesale, Timberland, Volcom, J.Crew, Gymboree and Jo-Ann Stores. Companies with similar valuations and financials can also be potential takeover targets.
Another strategy is to invest part of your portfolio in an index fund which mimics the Russell 2000 (for example IWM) as most M&A in the U.S. will be a takeover of small to midsize companies. The median market value of the Russell 2000 stocks was $528 million rising 25 percent in 2010 beating the S&P 500 by 13 percentage points. It should also be pointed out that although profits in small companies have been growing much faster than larger ones, they are much more expensive on a price-earnings (PE) basis.
The S&P 500 trades for 16 times reported income while the Russell 2000’s multiple is 34. Historically, the Russell 2000 has traded at a much higher valuation than the large cap indices. Some analysts believe that the valuation of small companies is too high. Still, if large companies want to expand at a faster rate than simply by organic growth they may have no choice but to takeover smaller companies.
At the same time, one should think of who benefits from these deals?
Although, Goldman Sachs is no longer at the top ranking of M&A advisers, it might be one of the few US financial institutions that are more a pure play on Mergers and Acquisitions. Thus by owning a Russell 2000 like the iShares Russell 2000 (IWM) and Goldman Sachs (GS) one might participate in the M&A activity in the U.S.
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