Making sense of mergers and acquisitions – what investors need to know

Last year, global mergers and acquisitions (M&A) activity hit a record high, with companies spending a total of $5.7 billion in 59,748 deals. This reflects not only a slight increase in the amount of money spent on acquisitions, but also an increase in the number of transactions.

There are several reasons for last year’s corporate buying frenzy – many companies were sitting on a lot of cash raised during the pandemic, the cost of debt was cheap and the market was buoyant.

So what’s next for 2022? It looks more like the same. In fact, some businesses might feel even more pressure. Central banks in the UK and US are expected to start tightening monetary policy – ​​raising rates and reducing bond purchases – to temper rising inflation. But even if rates in the US and UK rise as expected, the cost of debt is still relatively low from a historical perspective.

BoE base rate

Source: Bank of England.

With that in mind, many businesses may be looking to take advantage of lower rates by making debt-financed purchases as soon as possible. But just having the option to buy another company isn’t enough to justify a merger, there has to be a compelling reason.

There are many reasons why a business may decide to buy another business. Ultimately, the purchase must provide value that will drive growth. In many cases, it is an add-on business that provides goods or services that fit well with the existing business.

This was the case in 2019 when IBM bought RedHat. The deal brought RedHat’s services under the IBM umbrella and increased cross-selling potential to existing customers.

Sometimes, the new company is accompanied by a presence in attractive markets that the acquirer seeks to penetrate. Other times it’s two competitors looking to get a leg up on the rest of the industry. Such was the case for US retailers Office Depot and OfficeMax when they merged in 2013. The two were fighting an uphill battle against an increase in e-commerce. But their combined activities helped them achieve significant cost savings, which were ultimately used to transform the business.

This year, supply chain issues could be a major driver of M&A activity. In 2021, many businesses struggled to keep their shelves stocked and keep up with demand. While that should ease somewhat this year, having control of your supply chain is a powerful strategic advantage – it helps control costs and improve efficiency.

The price is right

Price is another important part of the equation. The buyer must be convinced that the benefits of combining the two companies outweigh the cost of the transaction.

This is where Enterprise Value (EV) comes in. EV is a measure of a company’s debt and equity – it ultimately tells us how much it would cost to buy a particular company. It is calculated by adding net debt to market capitalization.

EV= Market Capitalization + Net Debt

The higher the EV, the more it costs the buyer. For example, two companies each have a market capitalization of £10 billion. Company A has no debt, but Company B has loans worth £1 billion. In this scenario, company B is more expensive because the acquiring company will have to repay these debts in the future. In this way, debt repayments are considered part of the purchase price.

Company A Company B
Market capitalisation £10 billion £10 billion
Net debt 0 £1 billion
Enterprise value £10 billion £11 billion

EV by itself is a useful way to determine the cost of a business, but it means very little if you don’t factor in value. In the example above, company A seems to be the best choice because it is less expensive. However, if we take profits into account, we get a better understanding of which company is more valuable.

Imagine that company A makes cash profits of £2 billion while company B is £2.5 billion. Keep in mind that the acquirer will assume the excess debt, but will also retain the profits. To take this into account, you can use the company multiple. To calculate this, divide EV by earnings – the lower the multiple, the more valuable that business.

Business multiple = business value/profit

In this case, Company B is more expensive to acquire, but its higher earnings make it a more valuable acquisition target.

Company A Company B
Market capitalisation £10 billion £10 billion
Net debt 0 £1 billion
Enterprise value £10 billion £11 billion
Cash benefits £2 billion £2.5 billion
Multiple enterprise 5 4.4

Remember that ratios and numbers should not be considered in isolation, it is important to consider the bigger picture.

Sectors ripe for consolidation

Last year, the technology sector saw the most M&A activity, a trend that may continue this year.

Global value of mergers and acquisitions (in billions of dollars)

Source: Wall Street Journal and Dealogic. 2021.

The sell-off in tech stocks means that the market capitalization of this group has fallen. All things being equal, a potential takeover target whose stock price just dropped 10% now has a much lower EV. If the tech sector doesn’t recover, it will make some of these companies more attractive than they have been.

Healthcare was the second biggest contributor to M&A activity last year and could remain the epicenter of deal-making in 2022. The failed combination of Unilever and the division GlaxoSmithKline’s consumer healthcare company was the first, but probably not the last, attempt at a big deal we’re going to see in this sector.

Big pharma is moving away from consumer-focused businesses as these companies focus on specialty treatments and biotechnology. These companies tend to be cash-rich, giving them the firepower to take over smaller companies focused on specific treatments and technologies. We could start to see some of GSK’s peers following suit, divesting parts of their business to unlock greater value in their pharma arms.

This type of operation is often called a “split”. It can pique the interest of potential buyers, as it did with Unilever. A growing market for health and wellness products means that many global consumer goods companies will be looking at these spinoffs with interest.

Another part of the healthcare industry to watch is medical device manufacturers and private healthcare providers. The pandemic has severely reduced the number of elective surgeries performed over the past two years. The easing of restrictions means that pent-up demand should be released, and we could see a marked increase in discretionary procedures, increasing the profits of those involved. All things being equal, this should lead to a lower multiple for their business and ultimately make them a more attractive takeover target.

Don’t buy on M&A

Rumors of mergers and acquisitions can cause stock prices to rise and fall dramatically. For a long-term investor, these peaks and troughs tend to be little more than a dot on the radar. Even when two companies agree to a deal, they still need to get regulatory approval. For some of the more publicized combinations, it can take years and end without a merger.

Still, it’s a good idea to assess whether you think a potential deal makes sense, especially if you own one of the companies in question. M&A news should not be ignored, but neither should it be the primary reason for your investment decisions.

The equity research team covers over 120 of the most widely held stocks. We offer updates and analysis on upcoming mergers, company reports and a range of other important information for investors. Sign up for our information sharing email to receive it straight to your inbox.

This article is not personal advice. If you are unsure whether an investment is right for you, seek advice. All investments and any income from them may fall or rise in value so that you could suffer a loss.

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