Thu, 10 Jul 2014
With the uptick in merger and acquisition activity, whether it be for tax-inversion or strategic reasons, investors should focus on the target company, which can benefit from the deal immediately.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Merger and acquisition activity continues to pick up. I'm here today with Matt Coffina, editor of Morningstar StockInvestor, for his take on this trend.
Matt, thanks for joining me today.
Coffina: Thanks for having me, Jeremy.
Glaser: We talked a couple of weeks ago about a surge, particularly in the health-care sector, of companies doing M&A deals for potential tax benefits. Can you give us an update on that? Are we seeing a lot more deals in that space?
Coffina: Yes. If anything, the trend has picked up steam since we talked about it a few weeks ago. We're seeing more of these health-care deals involving tax inversions where companies in the U.S. are trying to acquire companies in Europe in lower tax jurisdictions and redomicile to be able to take advantage of those taxes themselves.
The two big deals that people have been paying attention to recently, Medtronic agreed to acquire Covidien, and AbbVie made an offer for Shire. In both cases, there's the same theme: These companies want to move their domicile to Europe where they can see lower tax rates going forward.
Glaser: Are these deals being driven exclusively by these tax benefits, or are there other reasons why companies are looking to bulk up?
Coffina: I think there are strategic reasons, as well. In general, health-care companies that are larger with more product diversity and more scale tend to have more bargaining power with hospitals and other customers. They can achieve some scale efficiencies, cut some costs, maybe share salesforces between multiple product lines, and so on.
A deal like Medtronic and Covidien probably makes a lot more sense on that front. They're dealing with a similar customer base and have very complementary product portfolios.
But I think most of these deals probably would not be happening if it weren't for the tax aspects of the deal. And in particular, I think people are worried that this loophole that's out there right now that enables companies to pull off these tax inversions and change their domicile internationally, that that loophole is going to close at some point. And the more deals get done, the more political tension is going to be focused on this area, and the more likely it is that that loophole does close at some point. So, I think there's a bit of a rush going on right now to get in before the window closes, so to speak.
Glaser: What is that legislative risk then? If this loophole were to be closed, could these deals that have already happened or that have been announced all of a sudden become impaired, and the math just wouldn't work anymore [in favor of the deals]?
Coffina: Yes, I think you would see a lot of the companies back away from these deals if we saw some kind of political solution in the near term. I'd say [a political solution is] pretty unlikely. There's a lot of gridlock in Washington, especially about tax issues. A lot of people don't want to take on this issue specifically without a broader tax reform, and really, we see very little momentum in Washington for actually getting anything done. A lot of people will complain about it and will put some proposals on the table, but I don't see that much momentum right now to actually get something done in the near term, which means that the deals that have been announced so far probably have time if both sides are willing to actually make them happen.
That said, a couple of years from now, I think it's entirely possible that it won't be possible to do these kinds of deals anymore, in which case, companies that don't get it done right now are potentially going to be left behind.
Glaser: Outside of the health-care space, there's been activity in a lot of different sectors, some unrelated to these tax issues. More broadly, what do you think that these deals mean and what managers are seeing in terms of internal investment opportunities, in terms of maybe not doing share buybacks? Why is the capital allocation all of a sudden shifting more toward M&A?
Coffina: I think the strong stock market has bolstered a lot of management teams' confidence in their own companies' prospects, and their ability to do large deals funded potentially with equity in part or potentially to borrow more against the value of the company.
I think also companies are seeing these deals as a somewhat safer way to bulk up and gain size versus internal investment in, say, research and development. When you're acquiring an existing product with an existing market, maybe there are synergies in your cost base that you can take out by doing the deal, and companies see it as a somewhat lower-risk way to grow versus internal reinvestment.
I don't know how good that is for the health of the economy over the long run. I think right now, investors have been enthusiastic about merger and acquisition activity. In general, they've been embracing both the acquirer's stock and the acquisition target's stock, which is a bit unusual. You more commonly see the acquirers tend to go down when acquisition news is announced. And that may just be a sign of the overall optimism in the stock market right now.
Glaser: How do you approach analyzing if these deals actually do create value for shareholders or not? What are some of the metrics you look at in deciding if [an acquisition were] a good idea or not?
Coffina: Well, in general, I'd say I'd rather own the target than the acquirer. I think the target gets that big payout right away. They're going to get a big premium to whatever their stock was trading at before in order to get the deal done, and you sort of have that gain in the bag.
If you're the acquirer, I think the longer-run history of large-scale M&A has not been particularly good. I think it's very hard for companies to really create value through mergers and acquisitions, with some exceptions certainly. But the biggest problem being that premium that you pay upfront, where you're giving a lot of the value of potential future synergies, or potential tax savings in this case, you're giving it away to the acquisition target's shareholders right up front, and then there is uncertainty about whether or not those synergies are actually going to be realized.
So, I think five years from now, we'll be able to tell pretty well if these deals worked out or not for the acquirers. But the acquisition target benefits right away, and that's probably the better place to be.
Glaser: This sounds like a trend that's probably not going to let up anytime soon. So, thanks for your take on it today, Matt.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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