How to Play M&A
Mergers are at near-record levels, and all signs point to more coming. Our top acquisition candidates include AMC Networks, Xerox, and Fluor.
A surge in mergers and acquisitions this year is cause for cautious optimism. While extreme deal frenzies can signal market peaks, the current pace points more to a rebound from the depressed levels of recent years. As long as deal prices remain sensible, investors can expect another leg up for an aging bull market, and companies with takeover potential could fare especially well.
A Barron's search for promising candidates turned up 10 names, including AMC Networks (ticker: AMCX), Xerox (XRX), Alaska Air Group (ALK), and Kohl's (KSS).
So far this year companies have announced deals worth $1.52 trillion that are either completed or pending, according to Dealogic. That's up 56% from last year and marks the largest dollar amount for deals since the $2.06 trillion recorded during the same period in 2007. Jumbo deals in particular are making a comeback.
The worldwide number of transactions of all sizes, including tiny tuck-ins, stands at 13,913. That's down 5% from last year. But there have been 19 transactions announced that are worth $10 billion or more, more than double the count over the same period last year, and another 215 valued at between $1 billion and $10 billion, versus 160 a year ago.
These figures include Pfizer's $118 billion offer for AstraZeneca (AZN), which the London-based drug maker has rejected. U.K. rules give Pfizer (PFE) until May 26 to reach an agreement -- widely viewed as unlikely -- or withdraw its offer. Even without the transaction, this year's M&A remains robust.
Other top transactions by value include Comcast's (CMCSA) purchase of Time Warner Cable (TWC) for $69.8 billion including debt and AT&T's (T) recently announced $67.1 billion buyout of satellite television operator DirecTV (DTV), both of which are pending regulatory approval; and a $47.5 billion bid by Valeant Pharmaceuticals International (VRX) for Allergan (AGN), which Allergan has rejected and which Valeant says it will soon sweeten.
THE RISE IN M&A is likely to continue, for several reasons. First, companies sit on plenty of financial firepower. In the U.S., nonfinancial companies in the Standard & Poor's 500 index hold a record $1.4 trillion in cash. Meanwhile, borrowing is cheap. Among S&P 500 companies, 88% of those with credit ratings are investment-grade, and bond yields of 2% to 4% are common.
Second, growth has gotten scarce. During the first quarter, S&P 500 companies increased their revenue by just 2.7%, based on reported results for 490 companies and estimates for the rest, compiled by FactSet. Earnings rose even less: 2.1%. Second-quarter guidance has been mostly weak. That makes now a tempting time for companies to pursue outside avenues for growth, including acquisitions.
Third, alternative uses of cash are looking less attractive. Debt repayment adds limited value with yields so low. Companies have rightly poured more cash into dividends; payments for S&P 500 companies have increased nearly 50% over three years. There's room for continued dividend growth, because companies are paying out less than one-third of their profits as dividends.
But managers who worry about the sustainability of today's high profit margins might prefer to spend cash on share repurchases rather than making long-term commitments on larger dividends.
During the fourth quarter of last year, S&P 500 companies spent $126 billion on repurchases, versus $81 billion on dividends, according to FactSet.
Studies on repurchases show, unsurprisingly, that they add the most value for shareholders when share prices are low relative to fundamental measures of value. Over the past two years, the forward price-to-earnings ratio of the S&P 500 has climbed from below 12 to over 15, which could make repurchases less attractive from here.
That leaves M&A, which shareholders now seem to embrace. Companies that made acquisitions last year enjoyed an average full-year stock gain of 48%, including an average gain of nearly 1% over the two days surrounding the deal announcement, according to Bank of America Merrill Lynch. Meanwhile, companies that spend heavily on share repurchases have underperformed.
Capital expenditures look poised to increase, too, for many of these same reasons, plus another: After years of companies skimping on capex, plants, and equipment are showing their age. But given the choice between new factories and buying out a rival, the latter is a faster way to put money to work.
Stock investors should watch M&A announcements carefully for signs of overly aggressive bidding and nonsensical business combinations. It's no coincidence that two top years for deals -- 2000 and 2007 -- preceded steep market declines.
Recent trends are mostly benign, however. Last year the average premium paid for an acquisition was 18%, the lowest since 2008. The 20-year average is 24%. Also, the M&A peaks in 2000 and 2007 started with surging deals in 1998 and 2005, respectively. S&P 500 returns in 1998 and 1999 averaged 25%. In 2005 and 2006 they averaged 10%.
ONE WAY TO SCREEN for companies that are priced for acquisitions is to compare "enterprise value" -- stock market value plus net debt -- to earnings before interest, taxes, depreciation, and amortization. Lower EV/Ebitda ratios are better. Solid free cash flow adds appeal, as does growth potential. Of course, some companies are just too big for deals. Apple (AAPL) screens pretty well on takeover metrics, and makes a fine long-term holding, but barring a joint bid from God and Warren Buffett, an offer seems unlikely.
Interpublic Group of Companies (IPG), the fourth-largest global advertising company, makes more sense. A proposed $35 billion merger between U.S. advertising giant Omnicom Group (OMC) and French rival Publicis Groupe (PUB.France) collapsed this month on a host of disagreements between the two sides. "Both of these companies are clearly going to try to make acquisitions going forward, and all eyes are on Interpublic," says Mario Gabelli, founder of Gamco Investors.
Interpublic's EV is 8.3 times the 2014 Ebitda forecast, versus eight for Omnicom and 9.3 for Publicis. It's expected to increase earnings per share at a double-digit pace in coming years, versus single digits for its larger rivals.
Small television broadcasters often have valuable, underused assets in the form of network airtime that can be gradually filled with more original programming, and hit shows that can be taken to new markets.
AMC Networks, best known for its zombie series The Walking Dead, and Scripps Networks Interactive (SNI), owner of the Food Network and Home and Garden Television, both generate double-digit earnings growth and plenty of free cash and trade at EV/Ebitda ratios of 9.9. That compares with 10.6 for Viacom (VIAB), 10.7 for Time Warner (TWX), and 11 for Walt Disney (DIS).
Kohl's is coming off a 3.4% drop in same-store sales during the first quarter, its worst showing since the stock market bottomed in 2009. Its shares are down 7% this year. The first quarter brought bad weather and was a lousy one for many retailers.
Kohl's remains likely to gain market share this year on growth initiatives like a new loyalty program, expanded beauty departments, and the addition of two national brands, Izod and Juicy Couture, according to Piper Jaffray analyst Neely Tamminga. At its current price, Kohl's could make a tempting acquisition target for private equity. It's expected to generate $1.1 billion in free cash this year, equal to 10% of its stock market value. Kohl's turned up in a recent Citigroup screen for companies priced for takeovers.
That screen also highlighted Rock-Tenn (RKT) and Xerox. Rock-Tenn makes containerboard, and industry consolidation and price increases have improved profits. It's about one-third of the size of International Paper (IP) and slightly smaller than MeadWestvaco (MWV), which bought an India-based containerboard maker in December 2012. Rock-Tenn has a 10% free cash flow yield and based on 2014 EV/Ebitda ratios, it's slightly cheaper than International Paper and one-quarter less expensive than MeadWestvaco.
Xerox has been a stealth outperformer; shares have shot 34% higher in a year. While it's best known for its copiers, 55% of revenue now comes from outsourcing services, which makes Xerox a beneficiary of technological change rather than a victim of it, according to Susquehanna Financial analyst James Friedman. Yet at a 2014 EV/Ebitda ratio of 6.6, Xerox is priced more like copier rival Canon (7751.Japan) at 5.5, than outsourcing giant Accenture (ACN), at 9.7. Free cash flow for Xerox is expected to total $1.3 billion this year, more than 9% of the company's stock market value.
PFIZER'S BID FOR AstraZeneca has brought new attention to "tax inversions," where U.S. companies lower their tax bill through an overseas buyout and headquarters relocation. Since 2011, more than a dozen U.S. companies have done such deals. But while there has lately been a clamor by some lawmakers to tighten restrictions on inversions, Congress is unlikely to agree on action any time soon.
Ireland's Jazz Pharmaceuticals (JAZZ), which makes medicines for narcolepsy, cancer, and pain, looks temptingly priced even without the potential to confer to a buyer the Emerald Isle's lush tax breaks. Free cash flow is seen hitting $486 million this year, or 6.1% of the stock market value, before rising to $727 million over the next two years.
Alaska Air Group has spent $519 million on its stock since 2007 and recently approved another $650 million, equal to nearly 10% of its stock market value. Shares have doubled in price in a year but remain attractive; Alaska Air's 2014 EV/Ebitda of 5.6 compares with 5.9 for Delta Air Lines (DAL) and American Airlines Group (AAL) and 6.8 for United Continental Holdings (UAL). Delta has been adding more flights in Seattle, where Alaska Air has its main hub. That should prove a plus, as Alaska Air feeds passengers from nearby cities and Delta hauls them off to faraway ones.
A recent screen by BofAML for takeover targets turned up software maker Citrix Systems (CTXS), which specializes in application delivery and optimization. For example, its programs can allow makers of powerful desktop software to deliver it over the Web or on mobile devices. That makes it a good fit for a company trying to diversify away from slipping hardware sales. Revenue is expected to climb 9% on average over the next three years and while shares go for 20 times this year's projected earnings, they're only 13 times free cash flow. (For other potential deals in tech, see "What Will Google Buy Next," Tech Trader.)
The BofA screen also pointed to Fluor (FLR), which builds complex structures like oil refineries and power plants. Free cash flow, pegged at $732 million this year, works out to 6.2% of the company's stock market value. But that figure is expected to swell to $1.1 billion over the next two years as Fluor benefits from rising capex by companies and infrastructure upgrades by municipalities. The company also sits on net cash equal to 18% of its stock market value.