Low Rates Could Spur M&A Surge

-Over past five years low interest rates have spurred buybacks; M&A could be next

-Rising M&A consistent with mid-cycle view

-Lowly-valued stocks with high operating costs could attract interest  

The stock market’s worry du jour is the $15 trillion or so in bonds around the world that offer negative rates. There have been plenty of headlines about it, and rightly so. In other words, instead of getting interest  you are paying the borrowers, such as the Swiss and German governments, to hold your money for you. It’s like a safety deposit box, only this is terra nova for government bonds. It’s not how they are supposed to work.

I don’t dismiss that concern. It’s unprecedented in financial markets. But today’s missive isn’t about negative rates. We’ll save that  for another day. 

Mergers and acquisition (M&A) activity is something few are talking about because, as the bears insist, this is supposedly the end of the cycle. I don’t ascribe to that.

What piques my interest is what the incredibly low interest rates means for stocks  in general, and for the M&A market in particular.  It’s true that the low rates of recent years have led to a stock buyback boom, as companies have borrowed cheaply and used the cash to repurchase their shares and boost EPS.

But now that we are in the world of low, low, low rates, investors shouldn’t be surprised if M&A activity heats up.  Lower rates means the cost of debt is cheaper and the bar for acqusitions is lower as well.

As my colleague Tom Lee has maintained all year, we are mid-cycle not late cycle, as the bears claim. If you think about (i) how low rates are now; (ii) how relatively inexpensive many sectors in the market are now; (iii) that value sectors in particular have underperformed big time over the past decade, and (iv) that we are indeed mid-cycle, then a big jump in M&A is consistent with that. 

Low Rates Could Spur M&A Surge

My guess is this extended period of M&A activity has been fuelled not only by low interest rates but also by the dearth of global growth  outside the U.S.  CEOs want to keep their jobs and are worried about where they can get growth. Some of them are concerned about a potential recession and see acquisitions as a way to shore up their defenses and improve competitivity ahead of it.

According to Morningstar’s Pitchbook, for example, (see chart above) North American M&A activity was solid in the 1H19, helped along by a strong stock market, up 17%, and a recovery in lending markets.

And while  the 1H19 M&A numbers are more “tepid” than the year ago pace, the recent numerous and large deal announcements suggest a healthy 2H19. North American M&A activity saw 4,754 deals worth aout $850 billion closing in the first half. Pitchbook notes that the second half deal book is full, with, for example, the 10 largest deals announced having a combined value of $487 billion, nearly equivalent to the total in 1Q19. If the deals close, Pitchbook says it should mark the fifth consecutive year total deal value tops $2 trillion.   

Low Rates Could Spur M&A Surge

Here’s another sign of an active M&A market.  Median deal size continues to rise, with the median EV/Ebitda multiple currently around 10.2 times, a new high.  (See chart below.) That’s partly been driven by good performance in the private markets, with so called “unicorns” getting high valuations.

This suggests there is a lot of money chasing M&A deals, particularly with private equity funds fully loaded with cash. One of the areas that PE money is chasing is software as a service sector, whose high valuations I wrote about here back on July 3.  According to Pitchbook, PE funds sit on a war chest of about $1 trillion. Wow.  Pitchbook expects M&A trends to continue and so do I.

The tech space has seen lots of deals, but other big deals include the $121 billion purchase of Raytheon (RTN) by United Technologies (UTX). In the energy field, there was a battle over Anadarko Petroleum (APC) between Chevron (CVX) and Occidental Pete (OXY), with the latter winning out.

I’ve put together a short list of companies from the Russell 3000 universe with a rudimentary screen of low valuations compared to peers (0.5 times or less EV/EBITDA of peers)  and high costs (1.5 times or more of operating expense to sales), as a kind of laundry list of stocks that might be attractive to other companies or the PE world. (The market caps are above $1 billion and below $25 billion.)  This isn’t a “Buy List,” but just a group of stocks that roughly exhibit the most basic of characteristics that could attract M&A attention.

Low Rates Could Spur M&A Surge

Interest rates are likely to drop even further, so M&A should accelerate.

Where could I be wrong?  If inflation increases and rates rise, that would raise the cost of money. And if a recession comes too soon it could dent animal spirits temporarily, though longer term it would make target companies cheaper and spur deals.  

Bottom Line: Cheap cost of debt capital often drives M&A. This time should be no different.

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