NEW YORK (Reuters) - After years of responding to shareholder calls for stock buybacks and dividends, major American companies are hearing a different demand from investors: buy growth.
In a low-growth economy in which earnings gains have trailed a run-up in share prices, investors are ready to endorse big deals if that’s what it takes to boost revenue and profits.
While stock price gains in the past year have made it tougher to find cheap targets, it also means buying back shares has become much more costly for companies. Using their own expensive stock for deal making may reap companies more benefits than repurchasing shares at what might be the top of the market, some investors say.
About 72 percent of announcements of acquisitions worth $1 billion or more in value in the first quarter were followed by gains in the stock prices of the buyers, up from 60 percent in the previous quarter and compared with a seven-year average of 50 percent, Thomson Reuters data shows.
The trend has emboldened CEOs into striking large deals this year and has contributed to a 52 percent jump in global deal volumes to $756 billion in the first quarter, the best start for
deal making since 2007. While the recent pullback in prices of some of the biggest gainers of 2013 may delay some deals, that is largely seen as a temporary blip.
Buying growth through acquisitions - which often come with job cuts and other cost reductions - may not be entirely good news for a U.S. economy that is desperate for increased capital spending to boost a low growth rate and employment. Many companies are opting to buy an established entity with a proven track record rather than investing in developing their existing businesses at a time when demand from consumers and businesses is still stuttering.
“We’ve had a long period after the recession where companies were afraid to invest their capital, and money was going into buybacks and dividends,” said Lew Piantedosi, portfolio manager at Boston asset management firm Eaton Vance Corp.
“That’s all good, but ultimately you want to see companies invest in their business,” Piantedosi said.
Shareholders have historically pushed stocks lower when companies announce a takeover, because buyers have to offer a substantial premium to make a deal worthwhile for sellers and can easily be tempted to overpay. Taking on additional debt to fund a purchase can weigh on credit ratings, and some of the largest deals in the past 20 years have failed, leaving plenty of wreckage and hurting shareholders.
Some investors say they’re prepared to swallow deal risks, though, provided that an acquisition has clear strategic benefits, such as consolidating a fragmented industry and generating significant cost savings.
“Companies cut down costs and tried to become more profitable, yet revenue growth rates haven’t really changed so companies should be doing more than just stock buybacks, which don’t change revenue,” said Mike Obuchowski, chief investment officer at Boston-based Merlin Asset Management. “One of the ways to do this is through acquisitions,” he said.
Among examples of buyers’ stocks gaining after deals, drugmaker Actavis PLC saw its shares jump 8 percent in February when it announced a $25 billion acquisition of Forest Laboratories Inc, while shares of construction materials producer Martin Marietta Materials rose 6 percent after announcing in January its $2 billion takeover of rival Texas Industries Inc.
To be sure, shareholders are not endorsing all deals at any cost.
Facebook Inc shares came under pressure after the social network giant announced two deals in a span of just a few weeks, both of which raised eyebrows for their lofty price tags - the $19 billion takeover of messaging service WhatsApp and the $2 billion deal for virtual-reality startup Oculus VR.
Facebook stock is down 14 percent since February 19 when the WhatsApp deal was announced, as tech and biotech investors have been hammering down the shares of companies whose valuations had soared to levels that may not be supported by their earnings prospects.
Another to suffer a share price reversal was specialty drugmaker Mallinckrodt Plc, which dropped as much as 10 percent on April 7 when it announced a $5.6 billion deal for Questcor Pharmaceuticals Inc, a rival hit by regulatory inquiries into its marketing practices.
Analysts said much of the deal’s allure is in financial engineering - it is the latest in a series of transactions structured to take advantage of Ireland’s low corporate tax rate, and the problems Mallinckrodt is taking on may outweigh any tax savings.
“Companies have to prove to the investors they are growing their business as opposed to making accounting changes that make them look better,” Obuchowski said.
Not only does the company being acquired need to be the right target, but the price paid can’t be too heady, investors say. Bidding wars are not encouraged.
So far this year, acquirers have remained relatively disciplined, with premiums paid to target companies averaging 25.8 percent over their average share prices in the four weeks before the deal became public, down from premiums of 27.7 percent last year and more than 30 percent in the prior two years, according to Thomson Reuters data.
In addition, investors say they are comfortable with recent deals because companies are either deploying a portion of their huge cash piles or using their own appreciated stock as currency, rather than relying largely on borrowing.
In the United States, 45 percent of all deals have had a stock component so far this year, including Comcast Corp’s all-stock acquisition of Time Warner Cable Inc for $45 billion, the year’s largest deal. That is up from 17.7 percent for all of 2013 and the highest since 2001.
“Using stock as a currency for M&A, I think that’s the right way to do it right now. What is a danger sign is when they’re using balance sheet leverage,” said James Swanson, chief investment strategist at Boston-based MFS Investment Management. “I think this cycle could go longer because corporate America is not on a borrowing binge,” he added.
In the years after the 2008-2009 financial crisis, many companies used excess cash first to pay down debt and then keep shareholders sweet with dividends and share buybacks. U.S. companies spent $463 billion on buybacks last year, the most since 2007 and compared with $131 billion in 2009 when companies were focused on hoarding cash, Thomson Reuters data shows.
The rising payout to shareholders at the expense of capital investment recently caught the attention of Larry Fink, chairman and CEO of BlackRock Inc, the world’s largest asset manager.
“We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons... it can jeopardize a company’s ability to generate sustainable long-term returns,” Fink said in a March 21 letter to S&P 500 companies.
Fink’s letter was widely seen as a shot back at activist investors, who have pressured companies to use cash or borrowings to buy back shares or pay dividends to shareholders.
But it also underscores a growing consensus among investors that companies may have done enough to clean up their balance sheets, and now is the time to use the cash stockpiles for growth.
“I think you’re going to see more M&A activity because the market is rewarding it,” said Swanson at MFS Investment. “Now if you ask me what they should do, I think they should invest in capex, M&A activity isn’t always the best way to go.”
Reporting by Soyoung Kim and Olivia Oran in New York, additional reporting by Ross Kerber in Boston; Editing by Martin Howell