Mergers and acquisitions are often seen as risky, since mature businesses with cash on hand may be looking for growth without considering whether M&A activity actually produces returns above the cost of capital.
Consolidation reduces competition, improves stickiness
“There is a natural pull toward consolidation among mature or maturing industries. An oligopolistic market structure can turn a cut-throat commodity industry into a highly profitable one,” writes Goldman Sachs analyst Robert D. Boroujerdi. “A smaller set of relevant peers faces lower competitive intensity, greater stickiness and pricing power with customers due to reduced choice, scale cost benefits including stronger leverage over suppliers, and higher barriers to new entrants all at once.”
Looking at the US airlines, global beer, US containerboards, hard disk drives, DRAM, and US wireless sectors Boroujerdi concludes that if M&A activity pushes consolidation to a high enough level (above 2000 on Goldman’s Herfindahl-Hirschman Index), then it usually results in outperformance for the sector as a whole.
American/US Air merge drove sector gains
The US airline sector provides a good case in point, because a number of large mergers had no clear impact on the industry because of unfavorable market conditions. The Delta Air Lines, Inc. (NYSE:DAL)/Northwest merger took place just before the financial crisis hit, so any effect it might have had was washed out, and the United Airline/Continental merger faced rising oil prices, again damping any benefit it might have had on the industry.
The $13 billion American Airlines Group Inc (NASDAQ:AAL)/US Airways Group Inc (NYSE:LCC) deal was the biggest in the industry’s history, nearly twice as large as either of the two previous big mergers, and it launched a period of clear outperformance.
“Stocks had generally tracked the market coming out of the financial crisis, followed by a period of underperformance as oil prices jumped,” writes Boroujerdi. “Amid a backdrop of more stable oil prices, the group embarked on a significant period of stock outperformance beginning in late 2012 when reports began to emerge that American and US Air were in discussions.”
Since then Delta Air Lines, Inc. (NYSE:DAL), Southwest Airlines Co (NYSE:LUV), and United Airlines have averaged 135% growth compared to a 33% rise in the S&P 500, and American has grown even more.
For investors looking for the next M&A bump, Boroujerdi recommends looking at sectors with low growth and lots of cash including cable, cement, generic pharma (which just had a big M&A deal come out), and hospitals.