Diageo is already the world’s No. 1 spirits company. To stay on top, it must continue to grow and that might be easier said than done if emerging markets remain a challenge. A notable feature of it recent results was a slow-down in the developing world, until recently the hot spot for luxury brands like Diageo’s Johnnie Walker.
Little wonder then that chief executive Ivan Menezes said that the company would be active on the mergers and acquisitions front. “We’re clearly looking at other things in the industry and we’ve got the balance sheet to move for the right ones” he said.
Diageo’s comments highlight two reasons why we should expect a pick-up in M&A activity this year: first, many companies are recognising the need to buy in the growth they will struggle to create organically in the face of a fragile economic recovery; second, many of these businesses have the financial resources to do so after years of erring on the side of caution, paying down debts and building up cash reserves.
Signs of resurgence
The first signs of a resurgence in mergers activity emerged last month – on one day alone, half a dozen deals worth a total of US$100 billion were announced. These included the proposed acquisition of bourbon maker Jim Beam by Japan’s Suntory, a deal that won’t have passed by Diageo’s Menezes.
The flurry of deals was all the more notable because 2013 was the worst year since 2001 for M&A, according to data from Mergermarket.
A note from Credit Suisse that just crossed outlined a string of reasons to expect more takeovers this year.
First, M&A makes financial sense when it is relatively cheap to raise debt finance – importantly the cost of funding that debt is less than the cash thrown off by many of the potential targets. Deals, in other words will pay for themselves and immediately enhance earnings, which not coincidentally is the basis on which company bosses tend to be assessed and rewarded.
Second, boardroom and investor confidence is rising and general economic uncertainty is falling. The level of M&A activity tends to rise about a year after the equity market picks up. Last year’s 30 per cent rise in the S&P 500 index is a great set-up for a takeover boom. When asked what they wanted to spend their companies’ cash on, newly confident chief executives recently put mergers at the top of their list, well above hiring staff or capital expenditure.
Third, balance sheets are in great shape. However you measure this – debts to assets, liabilities to market capitalisation, short-term borrowings to liquid assets – companies today are well placed to start spending again. They have also spent recent years extending the term of their borrowings so they can relax that they won’t be caught short by the need to pay back a loan.
Buying rather than building
Fourth, buying looks more attractive than building. Although the stock market has risen strongly over the past five years, it remains more expensive to build new capital assets than to go out and buy them on the stock market. And it’s not just a matter of price – the changing face of technology and the need for every business to have a viable internet strategy means that many companies just don’t have the expertise they need in house. They simply have to buy it in.
The final point is that M&A activity is at extremely low levels by historic standards. The value of deals as a proportion of the total size of the US and European stock markets is close to a 20-year low, according to Credit Suisse’s figures.
The good news for investors is that an increase in M&A is generally positive for markets. In fact, going back over the past 30 years or so, the six months following a bottoming out of M&A activity has coincided with a 9 per cent rise in the stock market on average. What is less clear is what the impact of more debt-funded deals might be on the corporate bond market, which looks increasingly priced for perfection. Other things being equal, more debt issuance should lead to a rise in yields, which anyway are likely to be under pressure from modestly rising government bond yields this year.
More and more, today’s market environment feels like the 1990s revisited – wobbly emerging markets, a recovering US alongside a strengthening US dollar, weakening commodity prices and a reawakening market for corporate deals. Of course, we know where that all ended but that doesn’t mean we shouldn’t enjoy it while it lasts.
