Mergers: The Sign Of Economic Recovery?

By Ryan Barnes | September 30, 2009 AAA
Mergers: The Sign Of Economic Recovery?

In recent weeks, investors have been treated to a flurry of news related to merger & acquisition (M&A) activity. While some deals, like Disney's $4 billion acquisition of Marvel Entertainment, have been friendly and pre-arranged, others have been unsolicited, like Kraft's $17 billion offer for British confectioner Cadbury.

The recent uptick in M&A activity is good news for global stock investors, all the more so when you consider the M&A drought of late – U.S. deal activity in August was the lowest month on record since February of 1994, according to Thomson Reuters. And year-to-date, M&A activity was down 40% from 2008 levels. (For some background, check out our Mergers And Acquisitions Tutorial.)

Labor Day Burst
But with over $60 billion in deals announced in just five days around the U.S. holiday, it appears that companies around the world are finally deciding to make good on their strategic plans. They are deciding to go after the companies they've analyzed and pined over.

Also of note is that the deals aren't just happening in one sector; recent buyout offers have occurred in consumer goods, semiconductors, financials, telecoms and energy. This breadth of activity bodes well for the rest of the year, and serves as a barometer of both the health and resilience of the broad economy.

Why is M&A a Good Thing?
Stock market prices are all about confidence. As investors, we're given a slew of financial figures, and enough ongoing analysis & commentary to choke an elephant. But it's our confidence in those numbers, our faith in companies' ability to execute on their goals in the future, that really propels stock prices higher - and sustains them once they get there.

With the markets rallying so impressively from the March lows, it's obvious that select investors have taken a leap of faith in the broad economy and our ability to get ourselves out of this once-in-a-generation recession. But when a multinational company like Disney or Kraft has enough confidence to spend billions, it reaffirms the faith of those who already have it, and opens the door for investors who have been sitting on the sidelines to enter the fray.

Kraft and Disney are essentially betting that the economy will turn. They are betting that their own balance sheet is strong enough to make the deal, and that their cash flows will be good enough to make the deal accretive to earnings. (Learn more about mergers in The Merger - What To Do When Companies Converge.)

Corporate Buyers: Just Like Investors
Companies that decide to spend billions to snap up a competitor or a peer don't do so lightly. They spend months, if not years, on due diligence. They know that in order to make an offer for a publicly-traded company that will be accepted by the target's shareholders, they will have to pay a premium to the current price of the stock. Quite simply, they have to pay up. Acquirers can do so because they foresee both strategic benefits (like entry to new markets & product lines) and the ability to streamline operations, cut costs and find new synergies.

But at the end of the day, corporate buyers have the same goals as retail investors – make purchases that will produce real returns.

Rising Tide Lifts All Boats
Another reason why M&A is beneficial to all investors is that it raises valuations of companies across the board. When a premium is paid for one company in an industry, it serves as a natural boost to other industry players. For example, the day after the offer for Cadbury was announced, shares of industry competitor Hershey shot up over 6%. A big deal in the industry can serve to re-level the playing field at a higher price/earnings (P/E) multiple, so even if you miss out on owning the target of an acquisition or merger, you can still reap the benefits of increased stock returns. (Do you know why companies merge? In What Makes An M&A Deal Work? we take a look at three successful company acquisitions and why they succeeded.)

Other Big Buyers
Corporations aren't the only players in the M&A field. Private equity managers have been building up large cash reserves ever since the financial crisis began over a year ago, just biding their time until the right combination of stability and opportunity arrived. As confidence builds among all market participants, look for private equity to step in and make offers as well.

Our nation's banks have been feeling the brunt of the recession more than most, so lending has been very slow to pick up steam despite the zooming stock market. When banks do decide to offer lending to companies, it's only when they see stability and safety on the other side of the bargaining table. M&A activity initiated by top-flight companies with strong balance sheets has a much better chance of finding the open hands of lenders available to them. If this trend were to continue, we could finally get some needed liquidity to flow out of U.S. and global banks and into the broad economy.

Parting Thoughts
M&A activity looks to be ending its recent drought, which is another important signpost on the way to economic recovery. It tells us that stock prices are reasonable, and that big investors feel confident about the future. (For further reading, check out The Wacky World Of M&As.)

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