They say what's past is prologue.
So when history starts repeating itself like this, it’s wise to take notice.
Mergers and acquisitions are picking up after a drought in activity for much of the past year. On Monday, Dell (Nasdaq: DELL) said it would buy computer-services provider Perot Systems (NYSE: PER) for $3.9 billion, or $30 a share, a +67.5% premium from the previous day’s close.
This deal is one of several Wall Street has been talking about. Four drug makers are set to merge into two as Pfizer (NYSE: PFE) buys Wyeth (NYSE: WYE) and Merck (NYSE: MRK) takes over Schering Plough (NYSE: SGP). Disney (NYSE: DIS) recently snapped up comic-book powerhouse Marvel (NYSE: MVL), and Kraft (NYSE: KFT) is trying to buy Cadbury (NYSE: CBY).
This is a beginning.
The likelihood is Corporate America is headed for an unprecedented period of deal making, which is excellent news for shareholders.
Mergers and acquisitions in the U.S. are on their slowest pace since 2003, according to Bloomberg data. The number of deals crept to a standstill when credit markets were frozen, as most deals are financed one way or another. Now that credit isn’t locked up so tight, the number of deals is likely to rise.
Not only is credit easing, but so is Corporate America’s stranglehold on its cash hoard. Companies went into survival mode to conserve precious cash during the downturn by cutting costs. As the economy emerges from this deep recession, U.S. companies have $1.5 trillion in cash flow. That’s expected to climb to record levels.
Now for a brief history lesson.
The last time cash flow was this high was in 2005. Stock valuations were cheap. With plenty of cash on hand, companies made a record number of deals in the next two years. All told, takeovers soared +32% in 2006 and +13% in 2007. The deals added up to $3.7 trillion.
Valuations aren’t as cheap now as they once were, but a two-year decline in earnings for S&P companies is projected to reverse and climb +25% in the next year. That could mean that executives think some companies are still cheap, even with the S&P trading at a high overall valuation. With earnings on the rise, investors can expect companies to put their extra cash to work and hunt for deals that can fuel even more growth.
This could be a huge development for investors who own the right companies, as the average takeover premium is about +24%. These heady gains happen overnight. (Even so, investors have to be mindful not to sell too soon. It’s not at all uncommon for another bidder to emerge and offer a higher price.)
Picking acquisition targets isn't an exact science, but here are a few things to keep an eye out for:
-- Market leaders typically acquire smaller rivals. This was the case with the Disney-Marvel deal. Disney was looking to expand its stable of characters and were more than happy to pay a +29% premium for Marvel shares to do it. A large company like Disney may decide it's cheaper to buy a company that owns existing products rather than to develop new products on its own.
-- Sectors tend to get hot. Some companies will pursue a deal just to keep up with its competitors. This is what happened with drug companies earlier this year: Pfizer agreed to merge with Wyeth, and Merck subsequently acquired Schering-Plough. Wyeth shareholders received a +15% premium; Schering-Plough’s shares jumped +34%. The drug sector is a good current example, but petroleum, technology and consumer discretionary sectors have all had their fair share of M&A activity over the years.
-- Low-debt. If you buy a house with a lien, it has to be satisfied before you can have the deed. And so it goes with companies: Acquiring companies must assume their target’s debt. Companies that don’t have much debt are cheaper to buy. The reverse is also true: High debt at an acquiring company can hinder its ability to make a deal. Kraft is experiencing this problem with its Cadbury proposal. The company is reluctant to raise its offer out of worry that the increased debt burden would threaten the company's investment-grade rating.
If you missed the +65% gain Perot Systems shareholders had Monday, don't worry. The next year is likely to be one of the biggest deal making seasons on record. The trick is to identify strong candidates with robust cash flow in sectors that are ripe for activity. There are no guarantees, but the rewards for smart investors can be great.