The New Logic of M&A by Joseph G. Paul, AllianceBernstein
May 9, 2014
There seems to be a new calculus at work in the recent rash of takeovers, as investors set aside their usual wariness of deals and dealmakers for the promise of growth these combinations may bring. We think it’s a good reason to stick with stocks.
Announced global deals have already hit US$1 trillion this year, one of the highest quarterly levels since 1998 and almost double the level announced for the same period a year ago. The action is reaching across industries and continents, which recent announcements including US drugmaker Pfizer Inc. (NYSE:PFE)’s US$100 billion (and climbing) bid for UK drugmaker AstraZeneca plc (ADR) (NYSE:AZN), cable giant Comcast Corporation (NASDAQ:CMCSA)’s proposed acquisition of Time Warner Cable Inc (NYSE:TWC) and Apple Inc. (NASDAQ:AAPL)’s newly revealed talks to buy headphone maker Beat Electronics.
This recent wave of M&A mania is hardly shocking. It’s been expected for some time. The market’s response, however, has been a surprise. More often than not, the stocks of both acquirer and acquired have rallied on the news of a combination, friendly or otherwise. But this isn’t the normal reaction. From the early 1990s until the past couple of years, the top quintile of the most acquisitive US companies has trailed the market by about nine percentage points annualized. History is rife with acquisitions gone wrong. Managements overpay or overestimate potential deal synergies.
Over the past couple of years, however, the most acquisitive quintile of companies has outperformed the market by almost 15 percentage points annualized. Why the big reversal? Are dealmaking managements suddenly geniuses and careful stewards of capital? Or is something else going on?
By our reading, much of this atypical behavior is a reaction to the atypically favorable conditions for accretive deals. For one thing, the bar for evaluating acquisitions has never been lower. The balance sheets of both acquirers and their targets are flush with cash, while the opportunity cost of capital—as measured by the return that companies get on cash—is next to nothing. Likewise, the after-tax cost of debt is very low, owing to historically low interest rates and tight corporate credit spreads.
Moreover, the prospective targets of this cheap capital are of unusually high quality. The current yield on Baa-rated US corporate bonds is about 5%, while return on equity for large-cap US stocks is nearly 17%. That translates to a spread of more than 11 percentage points, nearly double the average spread of the past six decades (Display 1). That’s a powerful tailwind for acquirers.
For cash-rich US multinationals, tax savings is another major enticement. Instead of repatriating its huge overseas cash hoard, subjecting it to higher US taxes, Pfizer is proposing to use that cash to finance its takeover of AstraZeneca and reincorporate the new, combined company in the UK. Britain’s lower tax rate and other potential breaks could save Pfizer US$1 billion or more annually. Since 2008, about two dozen American companies have used this strategy to shift their legal residence abroad via acquisition.
The main concern of the stock market is growth. By our calculations, stocks are pricing in far less earnings growth than the 6% long-term average, while the share of market valuation accounted for by future growth remains well below average (Display 2).
In our view, this is precisely why M&A activity is being so rewarded today. It reduces the uncertainty as to how surplus capital will get put to work and, with the cost of capital so low, raises the odds that acquisitions can boost future earnings growth.
It all works because the spread between the cost of debt and the return for investing in equity is so wide. Company managements will find ways to close that gap if the market does not do it for them. And with the equity risk premium (the extra compensation earned for investing in stocks relative to bonds) still well above the long-term average, we think stocks—particularly undervalued stocks—remain the best bet for investors.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Joseph G. Paul is Chief Investment Officer of US Value Equities at AllianceBernstein (NYSE:AB).
