M&A is here to stay

Steve Clayton - Fund Manager

23 May 2018

There is a wave of Merger & Acquisitions activity sweeping around the world currently. Deal-making is at record levels as companies and private equity investors take advantage of cheap money. In the first quarter of the year alone we saw $1.2 trillion of deals announced globally, a 67% hike on the same period in 2017.

Economic growth is positive, if not rampant, just about everywhere which has reassured deal-makers that bold moves will not be quickly transformed into acts of grandiose folly.

Earnings per share, one of the key supports for share prices, can be strongly enhanced by a successful merger or acquisition if the deal is funded with low-cost debt. No surprise then that executives are trying to strike earnings-boosting deals, when so many of them have large quantities of shares and share options.

We see little sign of the deal-making coming to an end until central banks push interest rates up significantly, and so far, there seems little appetite for that on either side of the Atlantic.

What it means for you

The HL Select funds have benefitted so far from a takeover offer for Fidessa, which generated a significant profit for the funds’ holdings. Previously an approach to Unilever, a deal that would have been unthinkable until recently, boosted the value of our holdings even if it was rebuffed. Reckitt Benckiser has done deals of its own, acquiring Mead Johnson Nutrition (MJN) for almost $18bn to further increase its healthcare exposure (MJN is a US and China-focused baby formula producer).

More recently, we saw the value of two portfolio companies boosted by the reflections from another deal. Silver Lake Management LLC, a US technology investment firm announced a deal to buy ZPG Plc, best known as the owner of property listings website Zoopla. This led to a useful bounce in the prices of our holdings in Rightmove and Auto Trader.

Zoopla is the second-ranked player in property listings, a market clearly dominated by Rightmove. Auto Trader similarly dominates the online vehicle listings market in the UK. The fact that Silver Lake, a well-respected player in the technology investment world, was prepared to pay a 30%+ premium to acquire an online-listings business with a far weaker (in our view) market position than Rightmove or Auto Trader suggests that the value of their franchises is substantial.

There is of course no suggestion that either company will be bid for, now or in future. But the market tends to sit up and take notice when someone puts a marker in the sand like this. One of the key attractions of online listings companies is that they generate cash at prodigious rates.

The marginal cost to Rightmove and Auto Trader of adding incremental business can be extremely low. So rising revenues tend to feed through very strongly to profits. After all, there is no physical product to be created, their websites are already built and the data for the sites, the cars and houses for sale, will be uploaded by the customer’s staff, not theirs.

M&A or not, cash is key

We are of course, very focused on cash flow. That’s why the funds tend to have high exposures to sectors like technology, where we often find highly cash generative, web platform businesses. The flip side is that we have limited exposure to capital intensive industries like energy and mining.

Those sectors tend to require vast investments into mines and wells before any cash can flow back to the company and even then, the amount of cash is dependent on the commodity price at any given moment. That, of course is outside of the producer’s control.

When commodities and the shares of commodity producers are going up, as they are presently, that can cause the funds to lag the market. Longer term though, we believe it is highly cash generative stocks with robust and reliable profit margins that offer the best potential.

We would hold stocks like Rightmove and Auto Trader whether there was an M&A boom or not, because we believe them to be long term winners. If M&A helps their valuations improve in the short term, well we won’t complain about that. More broadly though, we tend to view M&A as something of a Jekyll & Hyde sort of character.

The final say on M&A

Done well, M&A can allow a business to scale up and add new territories and products fast. If the business can be bought for a price where the cost of funding the deal is less than the target company is making in profit, then earnings per share should be improved. All nice, Dr Jekylly stuff.

But if the culture of the target company is very different to the bidder’s own, there could be difficulties in bringing the businesses together. And if the bidder misjudges the risks, they might take on bank debts to fund the deals, but not get the benefits they expected. Mr Hyde picks up the reins at this point.

There is a fundamental point to M&A that makes it worthwhile always approaching it with caution. And it is this. The seller knows more about what is being bought than the buyer does. No surprise then that sometimes, deals go badly wrong.

At the moment, M&A is having a benign influence on the funds, and maybe we could see more of our companies attracting interest. Time will tell. But by and large, we prefer to see businesses expanding organically, or with bite-sized deals where even if the risks were misjudged, the downside potential is manageable.

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