US Videos

Big M&A: Better for Investment Bankers than the Market

Pat Dorsey, CFA

Pat Dorsey: Hi, I am Pat Dorsey, director of equity research at Morningstar.

As I'm sure you know, there is only three things a company can do with its excess cash. It can basically reinvest that cash back into the business. It can pay you a dividend or repurchase shares, basically return it to the shareholder. Or it can go out and buy another company--and that is what we're seeing quite a lot of lately with the bidding war out there for 3Par between Dell and HP, and a $7 billion deal for McAfee from Intel, one which could turn out that Intel is crazy like a fox, but we were frankly scratching our heads a little bit over that one. And then of course the Big Kahuna: $40 billion proposed takeout of Potash Corp. of Saskatchewan by BHP Billiton.

Now, the popular media likes to portray M&A as kind of good for the market. It's certainly good for investment bankers' pockets; there is no question about that. So it's probably good for the high-end jewelry market in Lower Manhattan.

I am not quite so sure that it's good for the market if you think about the market being a place where capital gets allocated efficiently, because of course the historical stats show that most mergers frankly stink. Most mergers do not create shareholder value. And generally, if you think about mergers being sort of two axes: size and its relationship to the existing business, the bigger the merger and the less well-related it is to the company's core business, the less likely it is to succeed. AOL/Time Warner, of course, being the poster child, but we can look at Tyco and CIT and tons and tons of examples like that. But in contrast, small deals by experienced acquirers in their area of core competency--you might think of a company like Illinois Tool Works, or ITW, that has lots and lots of deals every year and does very well at them, creates a lot of value from them--those tend to succeed.

But of course, if you're the CEO, and you're looking to go out and deploy lots of cash that's been piling up on your balance sheet, you are not looking for lots and lots of little deals. You're looking for the big score. You are looking for the transformative deal, which frankly I think the shareholders of the acquiring firm should be looking at with some skepticism. Shareholders of the acquired firms, of course, should be jumping up and down and selling as soon as possible. That's a whole separate ball of wax.

Read Full Transcript

But I bring this up because we are still seeing I think a little bit too much of an aversion in the U.S. to returning capital to shareholders. Some of that, of course, is justifiable. It has to do with the uncertainty about a dividend tax raise in the future, and in fairness, we are seeing some dividend hikes coming from areas where you wouldn't have expected to see them in the past.

One of my favorite tech companies, a chip equipment firm called KLA-Tencor, hiked its dividend from $0.15 to $0.25 in July and currently yields 3.5%. And if I were to describe to you a business that's growing quarter-to-quarter its order book at 50%, yielding 3.5% with the dividend rate and then with a cash return or free cash flow as a percentage of enterprise value of 10%, you wouldn't be thinking it was a tech company. You would think it was in a different industry.

So, you are seeing a change in thinking about capital allocation in some areas, which is positive. But again, I think this worry, this fear that companies will destroy value through overpriced M&A, it's real, and it's something I think that as an investor you should be on your guard for, especially when there are quotes like this running around the media.

I've actually brought this quote with me, which was from the head of M&A, head of global M&A at a very large bulge-bracket firm: "Given current interest rate levels, cash sitting on the balance sheet is actually dilutive, it's not earnings anything."

The last time I checked, dilutive meant value destroyed. So the quote here from this guy is that the cash sitting on companies' balance sheets is actually destroying value at the companies that are holding it. Of course, he is talking his book in a sense because he wants people to do more deals and thus earn him more fees because, of course, the investment bankers earn the fees whether the deal does well for shareholders over time or not. It's a nice business to be in.

But what I would say to this gentleman and any CEOs who might be paying attention to that comment out there is that if you think your cash is dilutive, if you are a CFO, CEO, you run a business, and you think that cash is actually destroying value at your company, I'll be happy to buy it from you at the bargain rate of 95 cents on the dollar.

I am Pat Dorsey and thanks for watching.