We knew US companies weren’t going to sit on their hands (or in this situation—piles of cash) waiting for a magical uptick in sales forever, and they have finally begun taking action. While there is no hard and fast rule about M&A (mergers and acquisitions) and its effect on the overall economy, it is no coincidence that we tend to see periods of high M&A activity during economic expansions and far less in economic recessions. Three major deals have taken place so far in February alone:
(1) American Airlines and US Airways announced an $11 billion merger that will make American Airlines the largest airline in the world. Shareholders of American Airlines’ parent company AMR will own 72% of the new company while US Airways (NYSE: LCC) shareholders will own the remaining 28%. (February 14, 2013)
(2) Berkshire Hathaway (NYSE: BRK.A) and private equity firm 3G agreed to a $28 billion joint acquisition of H. J. Heinz Company (NYSE: HNZ) which will take the company private pending lawsuits from minority shareholders and an SEC investigation regarding suspicious trading ahead of the announcement. (February 14, 2013)
(3) Michael Dell and private equity firm Silver Lake Partners announced a $24.4 billion leveraged buyout (LBO) of Dell Inc. (NASDAQ: DELL) which is supposed to save Dell between $4 and $5 billion in taxes. (Feburary 5, 2013) In a LBO, the purchase of the company is financed through a combination of debt (“leverage”) and equity and the cash flows/assets of the target are used to secure and repay the debt.
Effect of M&A on shareholders
If you own shares in the target company (the company that is acquired by another), you are usually bought out at a nice premium over the stock’s current price (at least before rumors eventually begin circulating). This explains why even unsubstantiated rumors of a company potentially being overtaken will usually cause a major spike in its stock price, which we have seen a lot of lately. Dell’s shareholders will receive $13.65/share in the buyout, a +25.46% premium over Dell’s closing share price ($10.88) on January 11, 2013 (the last day of trading before rumors of a going-private transaction were first published). Heinz shareholders will receive $72.50/share, a +19.87% premium to its closing share price of $60.48 on February 13.
It’s a bit more complicated when you own shares of the acquiring company, and covering this topic thoroughly could take an entire book. Generally, if the acquirer pays cash to acquire a smaller company, the acquirer’s stock price will fall, mainly due to the large outlay of cash. In non-cash deals (financed by issuance of debt or equity) the effect is less clear and varies on a case-by-case basis depending on a multitude of factors.
Effect on everyone else
Mergers and acquisitions have a significant impact on investors, even those who have no stake in either the acquirer or the target. An acquisition (such as the Heinz deal) establishes a new valuation for a company, which is important to its industry peers. At its February 13 closing price of $60.48 (with 320.66 million shares outstanding), Heinz’s market capitalization (the value of the company—calculated as price per share times number of shares outstanding) was $19.39 billion. Clearly Buffett and the other participants in the deal thought this price was too low, evidenced by their willingness to pay $72.50/share, indicating a “new” company value of $23.25 billion (an increase in value of +19.87%, as previously stated). If the value of Heinz’s business increases nearly +20%, it is fair to say that a hypothetical similarly sized/positioned food manufacturer (since there really isn’t a comparable to Heinz) would see an increase in the valuation of its overlapping lines of business as a result.
Another potential benefit of M&A activity to investors is industry consolidation, a benefit that American Airlines and US Airways hope they will realize as a result of their merger. Consolidation has been particularly prevalent among US airlines, with the Delta/Northwest merger in 2008 and the United/Continental merger in 2010. Hypothetically, a merger between two companies (that operate in the same line of business) takes place to exploit synergistic opportunities–they believe the sum of their parts creates value greater than the two firms could have created alone. This added value usually arises due to increased economies of scale, which basically means that cost advantages are realized because fixed costs are spread over more units of output. The combination of two firms that operate in the same line of business should also lead to increased technological innovation, since the two firms are now working together to optimize their operations and not competing against one another. Finally, since there are fewer airlines (or ketchup makers, or what have you) to choose from, existing participants will likely find themselves with increased pricing power, which of course means airline passengers will see ticket prices increase. Good for investors, not so good for consumers.
The main point of all this is that Warren Buffett and other CEOs are finally feeling confident enough to spend some of the cash they have been hoarding for years since the financial downturn in 2008. Increased M&A activity over the long-run tends to be a sign of economic expansion, so hopefully we will see many more mergers and acquisitions in the months and years ahead.