This week we would like to revisit a topic that we first wrote about more than two years ago and one which seems particularly prescient in the current global situation. In a world of lofty valuations and increasing volatility, wouldn’t it be nice if we had a way to systematically make a profit by identifying mispriced securities? Well there is, it is in the world of mergers and acquisitions.
Having the ability to identify where they might take place or which companies might make particularly good targets can make for an exceptionally lucrative investment. Just ask the shareholders of Headwaters Inc. the US company that an acquisitive Boral bought three years ago, though how the good and patient shareholders at Boral feel, especially in recent times, is another story altogether.
While literature has consistently shown that the vast majority of both mergers and acquisitions tend to fail post transaction, it seems that firms continue to undertake deal making. After all, what do pesky academics with their ‘studies’ know about business anyway. Outside of this, private capital is increasingly looking at the listed space for opportunities as the institutional money flows in on the eternal quest for yield. Hot sectors locally include financial services (especially insurance), telecommunications and energy. The most recent news being Steadfast getting ready with a war chest in excess of $100m as well as the post Royal Commission firesales over at AMP (insurance business) and CBA (i.e. CountPlus). Though overzealous regulators have managed to put a damper on the party at TPG and Vodafone, we have a sneaking suspicion that regulators won't be enough to stop Teoh in the long run.
Getting back to the purpose of this article, which is by no means to bore our readers with details about the relative advantages and disadvantages of M&A but rather to identify if we can be on the right side of the investment. After all in the vast majority of acquisitions the acquirer makes a bid that is typically on a premium to the last trading price, not to mention any whiff of potential takeover puts some positive momentum in play even prior to the acquisition eventuating. These premiums are likely to continue to go higher in a world unencumbered with having to take on considerations of cost of capital or debt. As investors this offers an interesting way to profit and manage risk (for those of you more adventurous) by shorting the company that is doing the acquisition (if listed that is).
As a disclaimer, this form of investment is not necessarily for the weak hearted as recent bids for Vocus and Santos have shown. In addition, takeover bids can be relatively rare in the grand scheme of things and target companies often display signs of stress and/or management upheaval. To quote our esteemed global equities manager Robert Swift, ‘you can be a long time waiting for a takeover which never materialises and end up suffering a poor share price performance in the meantime.’
So how to identify these companies?
Firstly we shall start with the sectors. Companies that have good potential for organic growth typically do not prefer to pay premiums to acquire, simply for the reason that their return on investment (ROI) would be better spent developing their internal capabilities. Hence the most M&A usually occurs in very mature and saturated industries/sectors. A recent example might be the acquisition of Carlton & United Breweries (CUB), now owned by Anheuser-Busch. Sectors where the incumbents have substantial market sizes and high barriers to entry enable firms to either seek what is termed in economics as rents (essentially by reducing competition) or cut costs via synergies. These sectors are also likely to be where private equity is much more likely to look since the alternative would be to buy high growth companies which already trade at a premium on an even higher multiple. Remember the incentive of private equity is a transaction life cycle of five years duration after which they flip for a higher earnings multiple than that which they bought for through either a listing or, alternatively, selling to an acquirer. In addition, private equity by nature uses leverage to make outsized returns which means that they would require existing cashflow for serviceability and are looking to make cost outs (with some exceptions). The more famous bids in recent times have been KKR’s bid for Vocus and BGH’s for Healthscope and Harbour Energy for Santos (though in all cases the acquiring firms were unsuccessful, it is easy to see the similarities).
There is an exception to this rule however in that high growth companies can be targets when an acquiring company wishes to develop capabilities that they would otherwise not have and which become complementary to their existing value proposition. Typically this happens in consumer-facing or technology sectors, think about beer companies who acquire high growing craft beer brands or a firm such as Unilever acquiring T2. The key here is to watch out for fast-growing smaller players in mature sectors, one of the more recent players we have been following quite closely has been brewing company Gage Roads.
In terms of the companies to look for, the acquiring companies are typically incumbents, larger in size that have low growth potential and where there is a clear case of the cash problem. On a global front, a company that has had this problem recently has been Apple. Cash on the balance sheet while good can nevertheless become a problem when it puts downward pressure on total return. In Australia, we saw this rather disastrously with the Big Four banks with their bolt-on acquisitions and forays into wealth management. To further illustrate this point, think of Facebook and its acquisition of WhatsApp or SAP with its recent acquisitions of Ariba and Concur. The key here is to ask the question, who are the major players that are finding it hard to grow organically within a segment and then from that point ask where might that company access growth? Management is driven by one motive, profit. Profit can either come from top line or bottom line growth, so if they have a cost out incentive, what would they seek to buy in this market environment that provides them with the easiest way to do so? Most often a competitor. Alternatively, which adjacent categories make the most sense for an acquirer and who are the fastest growing players in that new category. The acquisition target in this instance, by the way, is not the leader but typically the close second or third (especially if they’ve had some under-performance in the near past) which saves the acquirer the hassle of paying up and using synergies or balance sheet power to chip away at the market leader post acquisition.
It is also worth remembering that takeovers come in bunches especially in markets where there is monopolistic competition. Think about when one of the Big Four banks moved into wealth, the other three followed suit quickly for fear of losing out or to protect their turf. Again, the modern-day equivalent will be in the telco space and, to a certain extent, utilities. As the market for mobile gets increasingly saturated, the big telecommunications companies will start to seek alternative routes of growth just as their global counterparts did. This may be through additional investments in adjacent categories (like Amaysims investments into Energy, ironically this has been their best performing segment) like digital or media. Globally, this is exactly what occurred with AT&T’s acquisition of Time Warner and Verizon’s acquisition of AOL and Yahoo. A little closer to home, we saw Optus make similar moves in acquiring the broadcast rights to the football in Australia while across the ditch the telco Spark (SPK.ASX & NZX) acquired the broadcast rights to Rugby World Cup 2019, a valuable asset in New Zealand. We also have the added advantage of knowing that bankers like to recycle some of their best ideas and pitchbooks, sell the same ideas to multiple parties (no blame, of course, there are only so many ideas that one can come up with that can justify the kind of fees they became accustomed to).
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.