Why Isn’t M&A Activity Picking Up?
If valuation levels are so inexpensive, doesn’t it stand to reason merger activity and buyouts would be sprouting?
After all, ten year AA’s are yielding 4.1%, or an approximate after-tax cost of just 2.9% for the 30% cash payer.
While the cost of equity capital is substantially higher-9.2% for the median S&P Industrial, a weighted average cost of capital, assuming a 20% cash, 60% debt 20% equity deal, is approximately 3.2%, given today’s cash yield.
If free cash flow is as high as has been reported during the past earnings season, not to mention the expected growth by security analysts, one would logically assume buyouts to be flourishing. After all, if one believes the free cash flow numbers being reported as accurate, the gap between that number and the cost of capital would add significant value to shareholders. After all, wouldn’t you invest in firms with a free cash flow yield of 8% if you could borrow at 3.2%?
The reason we are not seeing more M&A activity is simple. The free cash flow, as is being defined by analysts is incorrect, that of operating cash flow minus capital expenditures. They are not making the important adjustments to cash flow from operating activities to divine the real free cash flow number, which is lower than being reported.
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Acquisitions are typically value-destroying undertakings for shareholders, and are considered a negative signal for shareholders and creditors. Many companies look upon acquisitions as a growth strategy without a clear plan for synergies and the creation of additional free cash flow. Most acquirers overpay. While financially flexible firms often have the capacity for acquisitions during economic downturns, when prices would be lower, they most often wait for economic expansion. The most successful business combinations are those which build upon established core competencies.
Underperforming entities which attempt to improve their performance by buying well-regarded competitors normally run into trouble, as a “best practices” approach typically succeeds when both parties to an acquisition are already successful.
There are many notable examples of large companies failing in a business combination: AT&T’s purchase of NCR, Time Warner’s purchase of AOL, Applied Material’s acquisition of Etec and Damler’s acquisition of Chrysler. In each of these cases, the entity being acquired had a cost of capital in excess of its ROIC.
When final demand in a particular industry shows signs of slowing, or firms have excess cash on their balance sheet, it is not unusual to see merger activity pick up. At this stage, most failed mergers take place.
But not all mergers are value-destroying. Acquisitions grounded on cash flow, as opposed to “filling in gaps” or shortfalls in revenues or product, have a greater probability of success. And, if the acquirer can easily reduce the cost structure, free cash flow can increase significantly, lowering cost of capital. Exxon’s purchase of Mobil resulted in points deducted from its cost of capital.
Some of the more easily cut costs are duplicative departments and cost savings in key expense areas, such as finance and treasury, advertising, technology, insurance and employee benefits. Manufacturing, including the supply chain and transportation can also results in significant savings. If the acquired entity has been mismanaged, new management can quickly turn the cash flows is a positive direction.
Successful business combinations are marked by experienced managers who have shown a history of success with such integration. When this is the case, the merged entities combine various departments and put additional pressure on vendors for cost savings. Difficulties are more easily overcome as experienced teams work together toward a common goal, pulling in employees who can solve unique problems. Vendors often feel obligated to cut their selling prices under the fear of losing the relationship. Landlords are also under pressure to hold back increases as leases come up for renewal as good, strong tenants are often difficult to replace, and also act as a draw to the property. It is thus important the analyst weigh the effect of a business combination on tertiary parties. If a supplier is weakened resulting from a business combination, the price for an important input could rise.
