Merger and acquisition activity is heating up towards year end, but investors need to be wary of rewarding companies that launch takeovers as most are done for the wrong reasons and many will end in tears, Perpetual says.
M&A activity has ramped up in recent weeks, with a flurry of activity in the mining services space including Cimic’s $524 million bid for UGL but also with the likes of JB Hi-Fi’s takeover of The Good Guys and on Friday, the $361 million takeover of Fantastic Holdings by the South African-based owner of Snooze and Freedom, Steinhoff Asia Pacific.
The environment was ideal for M&A where interest rates were low, debt was cheap and management was searching for earnings-per-share accretion, Perpetual portfolio manager Anthony Aboud said, but he was wary about the “extraordinary market reactions” in rewarding companies simply for making an acquisition.
“For every Berkshire Hathaway, a company that has continually bought businesses that have added growth, there are hundreds that pour shareholders’ money down a drain marked ‘diversification’,” Mr Aboud said.
“Generally speaking, acquisitions over the medium to longer term are value destructive for the acquiring company,” he said.
A recent example is the $1.3 billion takeover of British firm Quindell by Slater & Gordon, which resulted in an $800 million write-down and contributed to the decimation of the company’s share price from $7.85 in April 2015 to 38¢.
The rise in activity comes after what has been a quieter year for M&A compared with last year’s record-beating number of deals. According to a Mergermarket report, political uncertainty and a fall in confidence in boards has resulted in $US2.2 trillion ($2.9 trillion) deals globally, 20 per cent fewer than in the first three quarters of this year compared with the same period last year.
But statistics show the majority of M&A deals end badly. According to the Harvard Business Review, between 70 and 90 per cent of M&As fail.
Mr Aboud, a speaker at the upcoming Hearts & Minds Investment Leaders conference in November, has a list of “red flags” for companies acquiring for the wrong reasons.
The first is when chief executives pursue EPS-accretive acquisitions because of financial incentives, including where thier base pay increases as the size of the company does.
“When companies justify acquisitions by the size of the EPS accretion, we see a red flag,” he said.
Another is when a company pays too much for goodwill.
“Could it be cheaper, albeit slower, to poach the key people than it would be to buy the company?” he said.
Companies that acquired others just to diversify, and failures in due diligence due to the sheer number of acquisitions being completed in a short period were other red flags.
However, Mr Aboud, who runs Perpetual’s SHARE-PLUS Long Short fund, said M&A for the wrong reasons could be used as short selling opportunities.
“When companies make a strange acquisition, or ‘di-worse-ification’, it often means the core business isn’t going as well as what people think,” he said.
Another red flag was companies making an acquisition to beef up their balance sheets, which he said was identifiable by analysing its cash flow.
The most successful were those where a genuine synergy existed between the two companies.
“It has to be part of the acquiring company’s core competency. There is a clear strategy and synergy and where value is being added to the acquiring company,” he said.
The story Perpetual wary of red flags for bad M&A deals as season heats up first appeared on The Sydney Morning Herald.