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Mergers and acquisitions - our view

Our thoughts on deals in the financial markets.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Mergers and acquisitions (M&A), where one company buys or merges with another, are common in the markets.

A few examples of FTSE 100 companies where M&A is likely to dominate the near-term outlook include GKN, Sky and SSE.

After more than 50,000 mergers and acquisitions worth a collective $4trn went through last year, I take a look at deal-making, and explore how asking the simple questions can help shareholders going through the M&A process.

Does it add value?

M&A deals can come in a variety of shapes, sizes and structures. But all are designed to add value to the buyer (acquiring company). There are two main ways M&As can do this.

Combining two similar businesses offers the potential to find cost synergies by removing production, administrative and corporate costs. Alternatively there’s the potential to drive sales up, known as revenue synergies.

Sainsbury’s purchase of Argos is a recent example that includes both revenue and cost synergies.

Since coming under the Sainsbury’s umbrella, cost savings have been strong. There’s been improvements in the underlying business too. Argos has delivered better like-for-like sales growth, and management is confident a new model of opening up Argos concessions in Sainsbury’s superstores can drive sales growth in both Argos and the core foods business.

While plenty of challenges remain around the business, in our view, the merger has gone some way towards easing investors’ worries.

Read our latest view on Sainsbury plc

Rather than combining two similar businesses, another way of adding value is to merge businesses that operate along the same supply chain.

Suppliers will only sell products on at a price they can make a profit at, so why not cut out the middle man’s business by buying him out?

How much?

It’s all well and good for a company to be making sensible acquisitions that tie in with its business model, but investors should be wary of the price being paid.

Shareholders should think about how likely it is the synergies will be achieved, and whether the deal justifies the price being offered. Because of the chance to cut costs and increase revenues, the price tag on M&As is often up to 40% above market value.

If a deal doesn’t go as well as planned, the acquirer will be forced into a write down, effectively admitting shareholder money was wasted. For example, in 2002, the newly merged AOL – Time Warner business took a staggering $99bn write down to address the failure of the deal.

Where’s the money coming from?

M&As can be financed in three ways. The acquiring firm is obliged to pay shareholders of the target company in cash, new shares, or a combination of both. This choice is important as it tells you where the risk lies.

A cash buyout transfers ownership away from shareholders of the target company, ending the interest of its shareholders. In this instance, the buyer gets the right to all the combined group’s future profits.

However, it has all the risk too, which means cash deals have a relatively high risk/reward profile for the acquirer. This is especially true of those deals financed with debt, after all the bank will need repaying regardless of how well the merger does.

Alternatively, the buyer could issue new shares and use these as payment. By giving shareholders in the acquired firm a stake in the combined group, the risks and potential rewards are shared between the acquirer and target.

Do I want to own the new business?

If the buying company is offering payment in shares, shareholders of the target group will need to think about whether they want to stay invested in the new business. A successful integration can add value in the short-term, but there’s no guarantee the combined company will have compelling long-term attractions.

A big acquisition can be an apt time to revaluate a holding in the acquiring company too.

M&A is often used to quickly expand into new geographies or business areas. It can bring exciting growth opportunities, but taking steps into the unknown comes with risks attached for shareholders.

Therefore we often view big deals in untested waters with more suspicion than small, more manageable ones.

Companies like WPP and RPC have proven they can bolster organic growth with a series of small bolt-on deals. It’s helped both build impressive records of shareholder returns. Of course, the future might be different and there are no guarantees that this will be repeated, so investors considering investing in these companies should think about taking a look through our factsheets first.

RPC share price, charts and research

WPP share price, charts and research

Our view on M&A

Spending on mergers and acquisitions is just one of several options CEOs have at their disposal. Others include share buybacks, paying out dividends and reducing debts.

All of these have their place. However, M&A is higher risk than the others, and CEOs can include a fair degree of blue-sky thinking when evaluating potential M&As. We’re also wary decisions on a merger can be swayed by management’s desire for the business to expand ‘on their watch’.

We have no problem with companies that have proven capable of adding value through a string of earning-enhancing bolt-on deals. But in the case of big, game-changing deals, our default setting is one of scepticism.

Please note George Salmon owns shares in RPC group.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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