M&A activity is on a tear this year, with $775.8 billion in US deals announced thus far. Some have called this evidence of growing confidence in Corporate America. Others have called it euphoria, saying execs are paying too much for overvalued companies. One contrarian viewpoint emerged Tuesday, courtesy of The New York Times, which warned mergers might be masking weakening fundamentals, and investors might be misinterpreting them as a sign of confidence. On the one hand, this raises a fair point: M&A activity isn’t a great sentiment barometer, and it is always important to look under the hood and see what is driving consolidation. However, there isn’t much evidence today’s mergers are a cheap Band-Aid over mounting troubles.
It is easy to see why the myth of M&A as a confidence signal persists. Deal-making rose gradually as the last bull market progressed, reaching an apex in 2007, and its recent ascent coincides with the maturing of this bull market. But growing confidence doesn’t always drive mergers. Sometimes trouble does, too. Industries often consolidate during times of stress, when pessimism reigns. A ton of bank mergers happened during the Savings & Loan crisis. Ditto 2008. Remember Bank of America and Merrill Lynch? BofA and Countrywide? JPMorgan and WaMu? JP Morgan and Bear Stearns? Wells Fargo and Wachovia? Morgan Stanley and Smith Barney? PNC and National City? I could continue, but you get the drift. In the next several months, it wouldn’t be surprising to see a flurry of M&A in Energy as the giants snap up smaller, less nimble producers. Getting bought out is a way to salvage an otherwise doomed venture. This wouldn’t be a sign of euphoria in Energy—if anything, it would probably be one indication the industry was hitting bottom.
So is this year’s M&A surge the happy kind of deal-making or the merge-your-way-out-of-trouble kind? The article states:
In contrast to previous merger booms, this recent spate of deals shouldn’t necessarily be considered a barometer of a healthy economy. If anything, it might be an indicator of the troubles that lie beneath an overheated stock market.
In many cases, companies are pursuing takeovers not because they are excited about a growing economy, but because their own growth prospects have waned.
The numbers tell the story: Revenue growth at United States companies has declined every year for the last five years, to about 5 percent now from 11.2 percent in 2010, according to a report by Citigroup. The bank put the problem bluntly: “Many companies will therefore require a source of inorganic growth to meet analyst revenue projections.”
If you can’t build it, then maybe you can buy it.
This evidence seems a tad thin. Revenues ended 2014 at all-time highs and, excluding the Energy sector’s widely known issues, are still rising. Slower-growing revenues are still growing—a sign firms are healthy, able to grow earnings through more than mere cost-cutting. That is the very definition of organic growth. Slower growth rates are normal as bull markets progress, the early cycle rebound effect fades, and the year-over-year comparisons become tougher to top. Then again, S&P 500 revenue growth last year (which appears to differ from the Citigroup metric quoted above) was the fastest since 2011:
Exhibit 1: Earnings and Revenue Growth, 2010 – 2014
Source: FactSet, as of 6/10/2015.
The other bit of evidence offered is a forecast for slower growth in capital expenditures, or capex, over the next year. That might happen, but there too, slower growth is still growth. US business investment tumbled in Q1, but that was tied mostly to Energy producers cutting back as prices fell. Outside Energy, firms are expanding apace, investing in new plants, offices, people, projects and the much-maligned research & development. Notably, R&D spending grew in Q1 even as overall business investment fell, notching another new high. Overall, there is little evidence firms are actually retrenching to the degree hypothesized.
So what is driving the M&A boom? Partly confidence, maybe, but also math. Investment-grade corporate bond yields, though up in recent weeks, remain near historic lows. Despite all the chatter over “overvalued stocks,” P/E ratios are just modestly above-average, fairly normal as bull markets progress—we haven’t yet seen the P/E multiple expansion typifying a bull’s final days. Moreover, the P/E’s inverse, the earnings yield, remains comfortably above borrowing costs, making the environment ripe for arbitrage—firms can borrow cheap, snap up higher-yielding assets, and enjoy a handy profit. Sometimes, those higher-yielding assets are the firm’s own shares—stock buybacks. Other times, those higher-yielding assets are other companies—M&A. Either way, as long as the return exceeds borrowing costs, the transaction isn’t “too expensive.” What we’re seeing today is quite healthy and normal, and it reduces stock supply to boot!
Usually, M&A booms go bad when more deals are funded with stock, not cash. That increases stock supply, and it’s also usually a sign investment banks are trying to cash in on cheery sentiment—the M&A equivalent of pushing sloppy IPOs. When we get to that point, it might be one indication the bull market’s end is approaching. But we aren’t there yet.