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Cross-border M&A is on the rise, with US companies increasingly making acquisitions in Europe and the UK. We consider the implications for equity investors.
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Warren Buffett, chairman of Berkshire Hathaway, is no stranger to a sizeable acquisition – but even by his standards, Kraft Heinz’s takeover bid for Unilever was a blockbuster. On February 17, the US food giant, which is backed by Berkshire Hathaway and private equity firm 3G, confirmed it had made an unsolicited offer of $143 billion for the Anglo-Dutch consumer goods company.
Unilever rebuffed the bid on the basis that it “fundamentally undervalued” its shares. But the episode spurred the company’s management into action. Within weeks, chief executive Paul Polman announced Unilever would sell its underperforming margarine spreads business, review its corporate structure and boost returns for shareholders. The message was clear: with hungry US companies lurking, there is no room for complacency.
“Unilever has announced significant changes to its financial and corporate structure to deter further bids,” says Trevor Green, Head of UK Equities at Aviva Investors. “But perhaps even more importantly, the Kraft Heinz-Unilever saga has woken up the whole fast-moving consumer goods sector, because it has demonstrated that if companies aren’t creating value, US firms might come in with hostile bids and do it for them.”
Unilever’s overhaul aims to deliver increased operating profit margins of 20 per cent by 2020, up from 16.4 per cent in 2016. Shareholders will also benefit from a €5 billion share buyback scheme and bigger dividends this year.1 Unilever’s share price has continued to rise gradually since news of the Kraft Heinz bid on February 17 – as of April 21, the company’s shares were trading at €47.70, up from €44.80 in the immediate aftermath of the takeover offer – partly as a consequence of these proposed reforms.
Unilever isn’t the only European company battening down the hatches in anticipation of a surge in mergers and acquisitions in 2017. European M&A totalled $215.3 billion in the first quarter, higher than at any comparable period since the financial crisis. US companies are leading the way with aggressive overseas purchases: Cross-border deals involving American firms totalled a record $114 billion over the first three months of 2017, a new record, according to Thomson Reuters data.
“US companies are increasingly looking to acquire British and European rivals, and that’s an interesting theme from an equity perspective,” says Richard Saldanha, Global Equities Fund Manager at Aviva Investors. “Businesses across all sectors are under scrutiny, and that’s focusing minds among both investors and company managements.”
The biggest deal so far this year was US pharmaceutical giant Johnson & Johnson’s $30 billion purchase of Swiss biotech company Actelion.2 Johnson & Johnson recently lost patent protection on its biggest-selling drug, Remicade, and rival Pfizer has launched a copycat version. The acquisition will give Johnson & Johnson access to a new range of products.
Figure 1: European M&A deals
Source: Thomson Reuters Datastream, April 2017.
Other cross-border M&A has been driven by a technological arms race in certain industries. In March, US multinational Intel agreed to purchase Mobileye, an Israeli tech start-up, for $15 billion. Mobileye develops software for use in autonomous vehicles and the purchase will enable Intel to keep up with rivals such as Nvidia in the effort to create driverless systems that can be deployed by car manufacturers.3
Beyond these sector-specific concerns, a confluence of economic factors is contributing to US companies’ rediscovered acquisitiveness, says Helen Driver, Head of Global Equities at Aviva Investors. “First and foremost, we’ve seen a recovery in earnings growth: that has generated confidence, which is always a key indicator of future M&A. Equity markets have also risen since 2016, which means companies planning share transactions have more currency to play with.”
The so-called ‘Trump trade’ – a market bet that the US president will deliver on his promises to cut taxes and boost economic growth – has sent the S&P 500 Index soaring to record highs since late-2016. Nevertheless, Trump has yet to pass his tax reforms and US companies are understandably reluctant to sign off on domestic acquisitions while the financial and economic implications of the policy are unclear, especially as the new administration has sent mixed signals as to how it would respond to big corporate mergers on US soil.4
Domestic policy will have less of an impact on cross-border deals, however, and the continuing strength of the US currency is making overseas takeovers more attractive. As of April 21, the pound had fallen about 14 per cent against the dollar since the UK referendum on EU membership on June 23 last year, while the dollar is now trading at near parity with the euro. While M&A will not happen simply because of currency depreciation, it may be the clinching factor for a company considering a deal. And with interest rates expected to rise further in 2017, albeit modestly, there is a sense the window of opportunity to obtain cheap financing for M&A deals may be closing.
Another factor is increased political risk in Europe, which has contributed to a disparity in valuations between US and European companies. In France, far-right presidential candidate Marine Le Pen – who has pledged to hold a referendum on the country’s membership of the EU – is set to contest a run-off vote with centrist Emmanuel Macron on May 7.
“Everyone has been busy talking about political risk in Europe, while, at least until recently, the political situation in the US has been viewed more positively. This has allowed a valuation gap to open up. It may be that corporates are taking a more benign view of political risk in Europe and taking advantage of the cheap equity valuations on offer,” says Driver.
You’re going to need a bigger boat
So which companies could be next in line for deal-hungry US firms? One potential indicator of future targets is comparative valuations, says Green. “Companies in the European building materials industry look undervalued compared with their US peers. CRH, for example, trades at a material discount to its US peers such as Martin Marietta. European paper and packaging companies appear similarly undervalued.”
Green also points to potential targets in the UK real estate sector. REITs including Helical, St. Modwen and British Land all traded at a discount of more than 30 per cent to net asset value during April 2017. “Those discounts look too attractive to be ignored,” says Green.
So what does this mean for equity fund managers? The rewards for investors in a sector that sees a big transaction can be substantial, as a single deal often catalyses further M&A among companies eager to keep up with their peers by realising synergies and cutting costs, boosting share prices. This was the case with UK port operators in the mid-2000s, when P&O’s £3.9 billion takeover by Dubai Ports World in 2006 was the starting point for a wave of acquisitions that saw all quoted port operators being taken over during the following decade.
Saldanha believes a similar surge of M&A activity could be brewing in the European chemicals sector following the proposed $66 billion merger between German chemical giant Bayer and US agrochemical company Monsanto. US paints and coatings maker PPG Industries has already submitted a bid of $26 billion for AkzoNobel, its Dutch rival. AkzoNobel’s board has rejected the offer but its major shareholders are urging it to come to the negotiating table.
Even the mere prospect of a rise in M&A activity can benefit shareholders, as companies keen to preserve their independence are motivated to implement productive reforms. This has been the case in the consumer goods sector following the abortive Kraft Heinz bid.
While equity investors can benefit from increased M&A, positioning portfolios solely on the basis of expected deal-making activity can be a dangerous game. Before Kraft Heinz made an offer for Unilever, the market was expecting it to bid for US food and beverage company Mondelez. On February 17, when it became clear Unilever was the preferred target, Mondelez shares fell by 6.3 per cent.
“I can’t tell you how many analyst notes were written about how Kraft Heinz’s bid for Mondelez was a matter of when, not if. Many investors were completely wrong-footed by Kraft Heinz’s approach for Unilever,” says Driver.
Then there is the risk that an anticipated deal runs into regulatory trouble. In March, the UK government referred 21st Century Fox’s £11.7 billion takeover offer for telecoms giant Sky to both the communications watchdog Ofcom and the Competition and Markets Authority. And earlier this year, a long-mooted tie-up between the London Stock Exchange Group and the Deutsche Bourse was scuppered by the European Commission, which cited concerns over a potential monopoly in the European fixed-income clearing business.
“Investors need to take into account the regulatory backdrop,” says Saldanha, who points to potential antitrust sensitivities in the European telecommunications sector. “The European telecoms industry wants to consolidate to stay competitive and help fund further investment. But [EU Competition Commissioner] Margrethe Vestager has signalled she will resist consolidation if it leads to customers paying more for their phone bills.”
Even where deals are approved, M&A is not always good news for shareholders. There are numerous examples of mergers and acquisitions that did not create value, either because the deal lacked strategic logic, the structure was flawed or the timing was wrong. Or in the worst cases, all three, as with Royal Bank of Scotland’s disastrous £49 billion takeover of ABN Amro in 2007.5
More recently, in January 2014, British engineering group Amec bought Swiss rival Foster Wheeler for £1.9 billion, seeking to bolster its presence in the oil and gas sector. But the deal was highly-leveraged and the fall in energy prices soon afterwards put even more pressure on the combined group’s balance sheet. Eventually Amec Foster Wheeler became a takeover target itself: in March 2017, British oil services company Wood Group agreed to acquire it in a £2.2 billion deal.
“Shareholders should have put more pressure on Amec to lower the price for Foster Wheeler, or reconsider the deal entirely,” says Green. “The company is now being taken over by Wood Group, partly because of the problems it had with that takeover. The onus is on us as shareholders to challenge company managements when they want to do deals.”
This year, two of Tesco’s largest shareholders have expressed misgivings about the retail giant’s £3.7 billion takeover of wholesaler Booker, arguing the deal should be cancelled as it is an expensive distraction from Tesco’s core supermarket business.6
Creating long-term value
So what brings comfort to equity investors in an M&A transaction? Saldanha says he prefers the companies he owns to consider long-term strategic synergies rather than short-term cost-cutting initiatives when mulling deals. While the latter approach – which is favoured by private equity firms – may deliver a quick boost to a company’s share price, it can hinder value over a longer time horizon.
“For me, buying businesses solely to strip out costs is never a good thing,” says Saldanha. “You could argue in some ways the 3G model can be destructive of value over the longer term, because it involves cutting back on areas such as advertising, which are important for future growth. We try to find industries where M&A is serving a long-term strategic purpose, like semi-conductors.”
Figure 2: Total returns of semiconductor companies versus S&P 500
Source: Thomson Reuters Datastream, April 2017 (indices rebased).
The US semi-conductor industry has seen a series of M&A deals in recent years, many of them relatively small, ‘bolt-on’ strategic acquisitions, which has led to efficiencies and earnings growth across the sector. Share prices have risen as a result.
“The semi-conductor sector has massively outperformed the S&P 500 over the last couple of years, and that’s in large part down to recent strategic M&A activity. Margins have gone up among these companies and they have been well rewarded by investors,” says Saldanha.
Research from consultancy McKinsey & Co. suggests smaller, strategic acquisitions of the type observed in the semiconductor sector deliver better shareholder growth over the long term than blockbuster takeovers. McKinsey examined shareholder returns across the world’s top 1,000 non-banking companies over a decade from 2002-2012. Companies that engaged in ‘programmatic’ M&A – defined as many small deals that over time represented 19 per cent or more of the acquirer’s market capitalisation – on average performed better than those that relied on gargantuan M&A deals. McKinsey’s research also found that a growth strategy built around a series of small deals can be more reliable and sustainable than one built solely on organic growth.7
There are signs the kind of long-term strategic M&A Saldanha identifies could be on the rise in Europe, and not just among US companies hunting for bargains. For example, on February 10, UK consumer goods company Reckitt Benckiser Group announced plans to acquire its American rival Mead Johnson Nutrition Co. in a $16.6 billion deal. Reckitt Benckiser is keen to build up its emerging-market presence, and Mead Johnson’s large market share in the Asian baby-food business – where it is second only to Nestlé – made it a logical target.
“Reckitt Benckiser is emphatic that it isn’t just an opportunistic deal made possible by having capital available. Instead the company is keen to emphasise the strategic nature of the move, taking the group into a new product category and building its presence in an important market,” says Driver.
Driver also cites another recent strategic M&A deal – the €50 billion ‘merger of equals’ between Italy’s Luxottica, a leading manufacturer of glasses frames, and France’s Essilor, a maker of lenses and contact lenses, which is set to create the world’s biggest visual health and eyewear group – as evidence that intra-European M&A is beginning to emerge alongside US-driven deal-making. This may indicate Europe is entering a period of sustained M&A activity that will continue even if deal-hungry US firms pull back.
“Whether it is Luxxotica and Essilor, or Reckitt Benckiser’s bid for Mead Johnson, European companies’ confidence is growing as the economic backdrop shows signs of improvement. They are no longer sitting on their hands waiting for something to happen,” says Driver.
4. During his election campaign, Trump said repeatedly that he would oppose AT&T’s proposed takeover of Time Warner, although Makan Delrahim, a Trump nominee to the Justice Department (pending Senate approval), has since denied this deal would raise any antitrust concerns. See https://www.bloomberg.com/politics/articles/2017-03-21/trump-antitrust-pick-saw-few-hurdles-for-at-t-time-warner-nod.
5. By the time RBS and its consortium of partners had secured the deal – at a price more than three times ABN Amro’s book value – the Dutch bank had already sold its most prized asset, its US-based La Salle unit, to Bank of America. Weakened by its aggressive expansionism, RBS needed a government bailout during the financial crisis.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at April 24, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
The following fund managers contributed to this article