Three M&A Catalysts

Event-driven investors look for potential mispricings in the market before or after corporate events. One example is M&A activity. Within this strategy the most common objective is to identify companies that would be attractive as takeover targets. The reason being that a takeover bid is generally substantially greater than the current market price. So as an investor you would be interested in the forces driving M&A activity and the characteristics of a business most attractive to potential acquirers.

The most recent Barron’s cover story details 10 “promising candidates,” and did an excellent job prefacing the story with some of the market factors driving M&A activity.

An Abundance of Cash:

First, companies sit on plenty of financial firepower. In the U.S., nonfinancial companies in the Standard & Poor’s 500 index hold a record $1.4 trillion in cash. Meanwhile, borrowing is cheap. Among S&P 500 companies, 88% of those with credit ratings are investment-grade, and bond yields of 2% to 4% are common.

Limited Growth Prospects:

Second, growth has gotten scarce. During the first quarter, S&P 500 companies increased their revenue by just 2.7%… Second-quarter guidance has been mostly weak. That makes now a tempting time for companies to pursue outside avenues for growth, including acquisitions.

Lack of Alternative Options for Yield:

Third, alternative uses of cash are looking less attractive. Debt repayment adds limited value with yields so low. Companies have rightly poured more cash into dividends; payments for S&P 500 companies have increased nearly 50% over three years. There’s room for continued dividend growth, because companies are paying out less than one-third of their profits as dividends.

I also appreciated that the article then provided an example of an alternative use of cash (share repurchases), and the reason that it would not presently (in this market) be more attractive:

Studies on repurchases show, unsurprisingly, that they add the most value for shareholders when share prices are low relative to fundamental measures of value. Over the past two years, the forward price-to-earnings ratio of the S&P 500 has climbed from below 12 to over 15, which could make repurchases less attractive from here.

That leaves M&A, which shareholders now seem to embrace. Companies that made acquisitions last year enjoyed an average full-year stock gain of 48% … according to Bank of America Merrill Lynch. Meanwhile, companies that spend heavily on share repurchases have underperformed.

Deal volume and the premium paid for an acquisition (the reason event-driven investors seek to identify these targets), were also mentioned as metrics investors should monitor for erratic behavior. The implication being that these metrics can be used in evaluating the potential for a market correction. I also like that it provides quantitative context for the premiums paid in takeovers.

It’s no coincidence that two top years for deals — 2000 and 2007 — preceded steep market declines.

Recent trends are mostly benign, however. Last year the average premium paid for an acquisition was 18%, the lowest since 2008. The 20-year average is 24%. Also, the M&A peaks in 2000 and 2007 started with surging deals in 1998 and 2005, respectively. S&P 500 returns in 1998 and 1999 averaged 25%. In 2005 and 2006 they averaged 10%.

Most of the information detailing what makes the individual companies attractive as takeover targets is specific to the company so I did not find it as relevant for this post. But one passage did a great job defining a valuation metric and giving some insight into how scale is taken into consideration.

ONE WAY TO SCREEN for companies that are priced for acquisitions is to compare “enterprise value” — stock market value plus net debt — to earnings before interest, taxes, depreciation, and amortization. Lower EV/Ebitda ratios are better. Solid free cash flow adds appeal, as does growth potential. Of course, some companies are just too big for deals. Apple (AAPL) screens pretty well on takeover metrics, and makes a fine long-term holding, but barring a joint bid from God and Warren Buffett, an offer seems unlikely.

While I had not considered it previously, having read this article I have concluded that if I ever build a successful company, I would most like to receive an offer for purchase of the company from God and Warren Buffett.

For a list of the companies that Barron’s believes would make great takeover targets and the reasoning behind their picks please visit the LINK.