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

Last year saw global merger and acquisition (M&A) activity rise to an all-time high with companies spending a total of $5.7tn across 59,748 deals. This reflected not only an uptick in the amount of money spent on acquisitions, but a rise in the number of deals.

There are several reasons for last year’s corporate shopping spree – 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 like more of the same. In fact, some companies might be feeling even more pressure. Central banks in the UK and US are expected to start tightening monetary policy – raising rates and paring back bond purchases – to temper rising inflation. But even if rates in the US and UK rise as predicted, the cost of debt is still relatively low historically speaking.

BoE base rate

Source: Bank of England.

With that in mind, lots of businesses could be looking to take advantage of lower rates by making debt-funded purchases as soon as they can. But just having the ability to buy another company isn’t enough to justify a merger, there needs to be a compelling reason.

There are lots of reasons a company might decide to buy another business, ultimately the purchase has to deliver value that will drive growth moving forward. In many cases, it’s a complementary business that provides goods or services that sit well alongside the existing business.

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

Sometimes, the new company comes with a presence in attractive markets the acquirer is looking to break into. Other times it’s two competitors looking to get a leg up on the rest of the industry. This was the case for US retailers Office Depot and OfficeMax when they merged in 2013. The two were fighting an uphill battle against a surge in e-commerce. But their combined businesses helped them make significant cost savings, which were ultimately used to transform the business.

This year, supply chain issues could be a major driver behind M&A activity. 2021 saw lots of companies struggling to keep their shelves stocked and keep up with demand. While that’s expected to ease somewhat this year, having control over 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 confident that the benefits of combining the two companies are greater than the cost of the transaction.

That’s 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 business. It’s calculated by adding net debt to market capitalisation.

EV= Market Capitalisation + Net Debt

The higher the EV, the more it costs for the buyer. For example, two companies each have a £10bn market cap. Company A has no debt, but Company B has loans worth £1bn. In this scenario, Company B is more expensive because the acquiring company will have to service those debts going forward. In this way, debt repayments are considered as part of the purchase price.

EV on its own is a useful way to determine the cost of a business, but it means very little if you don’t consider the value. In the above example, Company A looks like the better choice because it’s less costly. However, if we take profits into account, we get a better understanding of which company is more valuable.

Imagine Company A has cash profits of £2bn while Company B’s are £2.5bn. Keep in mind that the acquiring company will take on the excess debt, but it also gets to keep hold of profits. To account for this, you can use the enterprise multiple. To calculate this, divide EV by profits – the lower the multiple, the more valuable that company is.

Enterprise Multiple= Enterprise Value/Profit

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

Remember, ratios and figures shouldn’t be looked at in isolation, it’s important to consider the bigger picture.

Sectors ripe for consolidation

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

Global M&A Value (Billions of USD)

Source: Wall Street Journal and Dealogic. 2021.

The sell-off among tech stocks means market capitalisation for this group has fallen. All things being equal, a prospective takeover target whose share price just fell by 10% now has a much lower EV. If the tech sector doesn’t recover, this will make some of these companies more attractive than they have been.

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

Big pharma is shifting away from consumer-oriented businesses as these companies drill down on specialised treatments and biotechnology. These companies tend to have big cash piles, giving them the firepower to pick up smaller businesses focused on specific treatments and technology. We could start to see some of GSK’s peers follow suit, spinning off parts of their business to unlock greater value in their pharmaceutical arms.

This type of transaction is often referred to as a ‘demerger’. It can draw interest from prospective buyers, as it did with Unilever. A growing market for health and wellbeing products means many of the world’s consumer goods companies will be looking at these demergers with interest.

Medical device makers and private healthcare providers are another part of the healthcare industry to watch. The pandemic’s severely depressed the number of elective surgeries performed over the past two years. Easing restrictions mean pent up demand should be released, and we could see a marked increase in discretionary procedures, boosting the profits of those involved. All things being equal, that should drive their enterprise multiple lower and ultimately make them a more attractive takeover target.

Don’t buy on M&A

M&A rumours can cause share prices to rise and fall considerably. For a long-term investor, these peaks and troughs tend to be little more than a blip on the radar. Even when two companies agree to a deal, they still have to gain regulatory approval. For some of the highest-profile combinations, this can take years and still end without a merge.

Still, it’s sensible to evaluate whether you think a prospective deal makes sense, particularly if you hold one of the companies in question. M&A news shouldn’t be ignored, but it shouldn’t be the main reason behind your investment decisions either.

The share 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 investor information. Sign up for our share insights email to have it delivered straight to your inbox.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value, so you could make a loss.

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