Time for a New Corporate Buying Spree?
The slowdown in U.S. corporate profits has been swift and stunning. While earnings for companies in the Standard & Poor's 500-stock index grew a robust 14.7% in 2006, profit growth has screeched to a halt amid the troubled financial climate of 2007. With the income-reporting season kicking off the week of Oct. 8, average earnings for the S&P 500 companies are on track to grow just 1.9% during the third quarter, the slowest pace in more than five years, according to senior S&P index analyst Howard Silverblatt. That's down from 7.9% for the first quarter and 9.6% in the second. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)
The slowdown creates a dilemma for corporations, which face an imperative to "grow or die," Silverblatt says. How will they address their profit-growth problem? Many experts believe they will increasingly turn to mergers and acquisitions. "I don't think there's any question that growth will be harder to come by and that many companies will attempt to compensate for that by using M&A," says Hal Ritch, the former co-head of M&A at Citi (C); Donaldson, Lufkin & Jenrette; and Credit Suisse (CS), which acquired DLJ. He's now co-CEO of Sagent Advisors, an M&A advisory shop.
Ritch and other M&A advisers say they have detected a shift in their business during the last few months. The private equity firms that dominated M&A last year and during the first half of 2007 have been doing fewer deals of late. They are having a tougher time securing funding (BusinessWeek.com, 9/17/07).
"We have seen a shift toward corporate buyers during the last 90 days," Ritch says. One senior M&A lawyer agrees with that observation. "Our private equity pipeline has slowed. All of a sudden we're seeing strategic buyers who want to look at deals," says Bob Profusek, head of the M&A practice at global law firm Jones Day. U.S. private equity buyouts totaled $33.3 billion in September (BusinessWeek.com, 9/27/07), down 27% from $45.6 billion in August, according to researcher Dealogic.
Flush With Cash
The corporate world has the resources to support a big boom in M&A, should management choose that route. Earnings growth may be weak, and consumers may be drowning in debt, but corporate balance sheets are in stellar shape. Companies are flush with cash and operating at historically low levels of long-term debt. Excluding the financial and utilities sectors, companies in the S&P 500 had $622 billion in cash on their books at the end of September. That's near the all-time quarterly high of $640 million recorded in March, 2006, and nearly twice as much as the $328 billion on hand at the end of 2000. Cash as a percentage of long-term debt is 40%, well above the average of 31.2%, according to S&P's research. Debt as a percentage of market value is 14.8%, well below the long-term average of 21.7%.
Companies also can use their stocks as a currency to make acquisitions. Corporate executives have been under intense pressure from activist investors such as Carl Icahn to buy back shares. Stock buybacks in the second quarter of this year rose to a record $157 billion—$39 billion above the previous record set in the previous quarter. "We're in uncharted territory when it comes to buybacks. We've never seen anything like this," Silverblatt says.
If those shares aren't used for M&A, the alternatives aren't too appealing. Letting the stock sit in the corporate treasury is unproductive, and retiring shares reduces a company's size and market value, which is generally viewed as undesirable. The remaining choice is to put the shares back on the public market, which would dilute earnings—another grim option.
Less Pressure From Private Equity
Another huge impediment to M&A has been removed as well. During the last few quarters, activists have demanded that companies use their cash to repurchase shares and boost their dividends, essentially borrowing the techniques of private equity players. But as the private equity boom has settled back to earth, companies don't face as much pressure to emulate them. "Companies aren't as likely to get punished by investors for using their resources to make strategic acquisitions," Profusek says. And with fewer private equity firms in the market, asset prices are leveling off (BusinessWeek.com, 7/27/07).
Companies with the resources to make big deals are found across the corporate landscape. Thirty-eight companies in the S&P 500 have zero long-term debt. They include Microsoft (MSFT), which has $23 billion in cash; GOOG (GOOG), which has $13.5 billion in cash; Apple (AAPL), with $13 billion; and Walgreen (WAG), with $758 million. Many more companies within the S&P 500 have low levels of debt. Automatic Data Processing (ADP) has $43.5 million in debt and cash coffers of $1.8 billion. Starbucks (SBUX) has only $1.3 million in long-term debt and $330 million in cash.
There's some risk in a rush to M&A. Savvy buyers do deals on a steady basis, not just when business conditions are weak, says Donald Marron, chairman and chief executive officer of private equity firm Lightyear Capital. A sudden wave creates a risk that companies will pursue bad deals just to goose earnings. Marron, a finance veteran who ran PaineWebber and UBS America after PaineWebber's acquisition by UBS (UBS), also says it's possible that the economy will prove more resilient than some people think, which might make it easier to boost profits without M&A.
Even if the economy does shake off its summer doldrums, corporations still need to figure out what to do with all that cash burning a hole in their bank accounts. That means the case for spending at least some of it on M&A could be hard to resist.