Published February 20, 2014
Shares of companies making a big splash in the M&A market typically sell off as investors worry about execution risk, poor use of cash or share dilution.
That trend appears to be reversing in recent weeks, with shares of bidders rallying after deal announcements as investors applaud the aggressive moves.
The recent phenomenon appears to be triggered by the fact that shareholders want companies to strategically deploy their record-setting cash hordes amid years of low interest rates and robust share buyback programs.
“Buybacks and dividends are great, but shareholders are looking very favorably upon deals that can drive growth,” said Jeff Porphy, head of M&A at JMP Group’s (JMP) JMP Securities.
Investors Cheer Strategic Deals
Take drug maker Actavis (ACT), which saw its share price jump 5% after shelling out $25 billion in cash and stock to acquire Forest Labs (FRX) earlier this week. The same was true for Kay Jewelers parent Signet (SIG), which surged 18% in the wake of unveiling a $690 million buyout of rival Zale (ZLC).
“The market is like the desert parched for rain. It is drinking up any good deal and rewarding the company,” said Anthony Michael Sabino, a professor at St. John’s University.
Historically, companies that have the courage to make a big deal must factor in an immediate negative reaction from shareholders.
According to a study of more than 5,000 bids over a 20-year period, the three-day return for a bidder is -1.5% and the median is -0.9%. The three-day return measures the stock price between the day before the deal is announced and the day after the announcement.
“The markets tend to think they are overpaying for the target or there is a transfer of wealth,” said David Becher, a professor at Drexel University, who co-authored the study.
Not Your Father's M&A Market
Other reasons for a knee-jerk decline in a bidder’s share price include concerns about a poor use of cash or share dilution in deals that are paid for in part or entirely with stock.
But with the U.S. economy growing at less than 3% a year and interest rates at rock-bottom levels, these aren’t normal times.
Cash records continue to shatter records. According to FactSet (FDS), the S&P 500 (excluding financial stocks) cash and marketable securities balance jumped 18% year-over-year to a record $1.36 trillion at the end of the third quarter of 2013.
“The dynamics nowadays are different. You’re seeing shareholders rewarding strategic acquirers for deals that are accretive to earnings,” said Porphy.
Accretive acquisitions are ones that management believes will pad their company’s bottom line. For example, shares of Forest Labs surged double-digits on January 8 after the drug maker said its $2.9 billion buyout of privately held Aptalis would boost the company’s 2015 non-GAAP EPS by about 78 cents.
“There is such an unprecedented level of cash being held by companies. It’s nice having that cash cushion but at less than 0.01% interest, it’s not a very productive use of capital,” said Sabino.
Facebook Bucks the Trend
Could this string of positive stock reactions to acquisitions be a coincidence?
“Coincidences are for fairy tales, not the market. This is the market crying out, ‘Please, someone put your cash to use!’” said Sabino.
Of course, not every deal has been greeted with smiles from investors.
Facebook’s shares retreated about 2% on Thursday after Mark Zuckerberg agreed to pay a whopping $19 billion in cash, stock and equity rewards for WhatsApp, which The Wall Street Journal says is the largest-ever takeover of a venture-backed firm.
Yet considering the enormous price tag on the deal, which represents about 8% of Facebook’s market cap, the 2% dip seems modest. That’s because many analysts were generally bullish about the strategic merits of the transaction.
“We won't know how financially successful this deal is for a while, but its short-term P&L impact should be limited and its strategic rationale is sound, in our view,” Cantor Fitzgerald analyst Youssef Squali wrote in a research note on Thursday.
Wave of Deals Ahead?
So what does the positive stock reaction trend say about the outlook for the M&A market?
Observers said it suggests companies could be incentivized to pursue more deals in the short to medium term.
“The CEO confidence level helps drive M&A business. When you have companies being rewarded for good strategic deals, I think people take notice of that,” said Porphy.
Becher said the downside to potentially seeing the beginning of a wave of deals is that history shows deals further down the line won’t be as positive for bidders as they begin to chase the market.