Merger mania sign of slowing growth
Two major deals were announced in the beaten-down energy sector Monday: In one, General Electric Co. agreed to combine its oil and gas operations with Baker Hughes Inc. to form a US$ 32- billion giant; In the other, Suncor Energy Inc. announced it was selling its lubricants division to HollyFrontier Corp. for $1.13 billion.
While it is too soon to know if these deals will achieve their individual strategic ends, they are also part of a larger trend that has us fearing bond and equity markets may have more negative surprises than positive ones in store in the coming months.
What worries us the most about the markets are the abating organic growth rates at this late stage of the market cycle and the focus instead by companies on financially engineering growth by essentially dressing up their income statements.
This can be done either through share buybacks or mergers and acquisitions as long as capital is inexpensive and easily accessible — something central banks are keen on ensuring.
Over the past few years, the focus has clearly been on share buybacks whereby a company issues low cost debt and/or uses its cash on hand to repurchase their shares instead of reinvesting it in future growth projects. This reduces the denominator and thereby inflates their earnings on a per-share basis.
It’s been so successful that in total, U. S. companies spent $ 561 billion on share buybacks last year, which according to Morningstar is a 40- per- cent increase from the year prior and represents the highest activity level since the market highs in 2007. Additionally, over 70 per cent of S&P 500 companies undertook a buyback last year, with more than 20 per cent of these companies reducing their year- overyear share count by five per cent last quarter.
However, t he l aws of diminishing returns are kicking in, as recent FactSet data shows that share buybacks fell by 6.8 per cent year-over-year in the second quarter. That said, this could be a temporary blip as U. S. sales of investment- grade non-financial corporate debt has reached epic proportions with a record $ 674.3 billion being i ssued this year, according to Moody’s.
U. S. companies have also been using this cheap and readily available capital to go on a shopping spree via industry consolidation. According to Dealogic, U. S. M&A activity in October was valued at more than US$251 billion, surpassing the previous monthly record of US$240 billion in July 2015.
In the technology sector there was the monster AT&T Inc. agreement to buy Time Warner Inc. for US$ 85 billion and then Qualcomm Inc.’ s announcement that it would buy NXP Semiconductors NV for US$39 billion.
Then there were Monday’s energy deals. The new publicly traded GE- Baker Hughes entity (62.5-per-cent owned by GE and 27.5- percent owned by Baker Hughes shareholders) will be a powerhouse to contend with in this low oil-price environment.
Meanwhile, the Suncor deal will make HollyFrontier the fourth- largest lubricants producer in North America, with a capacity of 28,000 barrels per day representing approximately 10 per cent of North American production.
Interestingly, while these deals are all very strategic in nature, they are also expected to be accretive to earnings, thereby achieving their purpose and financially engineering growth. While this may inflate earnings growth in the near term, most will require a bit of time following the integration to show the true value of the deal. That said, unfortunately, there are plenty of examples of unprofitable deals that lead to large writedowns when the dust eventually settles.
In the end, while share buybacks and mergers and acquisitions can add value especially in this spooky environment of ultra-low interest rates, high valuations and margin compression, they are not without risk, especially if too much leverage is deployed.