Rob Cox: The worry now is a brewing M&A bubble
By Rob Cox
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
Stop worrying about the tech bubble – there may be an even bigger one inflating beyond the confines of Silicon Valley. The corporate urge to merge has gone into global hyper-drive this year. Deal activity has surged as investors egg companies on and bid up the shares of acquirers well beyond mathematical explication, or prudence. As new metrics from interested parties are trotted out to justify the irrational, it’s time to exercise caution.
So far this year companies have announced some $1.3 trillion worth of transactions around the world, according to Thomson Reuters data. That’s nearly double the level of activity a year ago. European corporations have fueled even greater increases. Much of this is pent-up demand and a delayed response to the past year’s remarkable runup in stock market values.
But after years of relatively restrained M&A movement, giddy shareholders appear to be over-titillating the animal spirits of executives and directors into taking on ever riskier transactions.
Consider the huge regulatory hurdles that Pfizer is attempting to jump in its efforts to seal a $100 billion-plus merger with AstraZeneca and shift its tax domicile to the UK, or the French political sensitivities that General Electric is taking on with its $13.5 billion bid for Alstom’s power assets. Equally, Comcast’s $45 billion takeover of Time Warner Cable raises severe antitrust questions. These may be overcome by divesting assets. The fear that Comcast may succeed, though, is compelling rival AT&T to mull a stab at DirecTV despite having been recently thwarted in trying to acquire T-Mobile US.
The frenzy isn’t just a result of over-incentivized, empire-building CEOs. In a sense, executives are rationally responding to market signals, even if these aren’t themselves entirely rational. In two-thirds of the 46 deals worth more than $1 billion announced in the United States this year, shares of the buyer have risen. Historically the response has been more mixed. The ebullience is often warranted, as companies in complementary businesses with similar customer bases remove redundant costs. In many cases, though, the share price reactions are excessive.
Take the case of Zimmer’s $13.4 billion purchase of rival orthopedics-maker Biomet from a gaggle of private equity firms. Since the deal was announced on April 24, Zimmer’s market value has increased by $1.6 billion. That’s hard to reconcile with the finances of the transaction. Based on comparable companies, Biomet is worth around $11.5 billion. That implies Zimmer is paying a takeover premium of about $1.8 billion.
Happily for Zimmer’s owners, its management expects to excise costs of around $270 million annually. What are these worth to shareholders today? First, you have to lop off the share of these that will go to the tax man – in Zimmer’s case, that’s 23 percent, leaving investors with $208 million of synergies. Since these will take three years to achieve, they need discounting to reflect the time value of money. At five percent, that reduces them down to $180 million. Capitalized at 10 times, that would suggest a net present value of $1.8 billion – or roughly equivalent to the premium being paid.
By rights, that’s just enough to justify Zimmer’s stock not getting whacked. But it cannot explain the $1.6 billion bump in Zimmer’s market cap. It’s not the S&P 500 Index, which has barely budged since the deal was unveiled. Could it be the deal got investors to suddenly pay attention to Zimmer and realize it was undervalued? That, too, seems implausible for a company followed by 22 major Wall Street brokers.
Maybe investors think Zimmer got Biomet for a steal. Umm, nope: Blackstone, KKR, TPG and Goldman Sachs are hardly known for selling assets on the cheap. The explanation has to be that investors are baking in so-called revenue synergies: the miraculous promise that by combining, the two companies will somehow instantly sell more stuff.
It’s not just a medical devices thing, either. Signet Jewelers got an even bigger dose of undeserved bling for proposing to buy rival Zale. By the numbers, it’s a good deal – so good it sparked 9.5 percent Zale owner TIG Advisors last week to say it’s going to vote against the sale. TIG argues that too few of the benefits of the deal will accrue to the seller’s shareholders.
That’s true. At Signet’s tax rate of 35 percent, the cost-savings from the deal create, at least in a spreadsheet, some $560 million of value, or twice the premium on offer. But here’s the head-scratcher: Since announcing the transaction in February, Signet’s stock has risen by $1.7 billion. It’s hard to explain this as anything more than bubble thinking.
As with any market exuberance, financiers who benefit from corporate derring-do are happy to reverse-engineer arguments to justify the excess. Marc Andreessen, the Silicon Valley venture capitalist, for instance, has argued that larger company acquirers can “attach” the products of smaller ones and thereby dramatically expand the overall revenue pie. “When it works, and it often does, it’s magical & worth doing,” he wrote in a recent tweet.
Sadly, this would not be the first time investors have banked on magic to generate returns.