M&M’s and M&A

Story Highlights:

• Stock valuations are still off their highs from last fall.
• Plentiful amounts of cash and credit are available for M&A and share repurchases.
• M&A and share buybacks reduce the supply of stocks, sending prices higher.
• Mars Inc. yesterday announced an agreement to acquire Wrigley for $23 billion, a 28% premium to last Friday's close.

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(Editor's Note: MarketMinder does NOT recommend individual securities; the below is simply an example of a broader theme we wish to highlight.)

There's nothing more tempting than a sweet deal, especially when you're flush with cash. And Mars, who yesterday announced an agreement to acquire Wrigley for $23 billion, isn't the only one with a sweet tooth.

Cadbury Eyes Hershey As Mars Chews Up Wrigley
By David Jones, Reuters
https://www.reuters.com/article/ousiv/idUSL2847318620080428

But it's not just confectioners seeing a resumption of merger and acquisition (M&A) activity. Headlines are abuzz with M&A deals for airlines, tech stocks, even financials, to name a few. What gives? For starters, stock valuations, even given the recent run-up, are still off last October's highs and opportunities abound. And, very different from the recent bear market, many firms have lots of cash on hand. For US companies alone, "lots" is over a half a trillion dollars, and that doesn't include financial companies.

Of course, not every company has stashed cash for a rainy day, so some will have to borrow to finance any deals. Trouble, right? No one can borrow in a credit crunch. Maybe, so it's good we're not in one. It's true that high yield, or "junk" bond rates have risen from around 8% a year ago to over 10% today, but AAA yields have actually come down (currently in the 5% range) over the past year. In other words, shaky borrowers must pay more for a loan today, if they can get one at all, but strong borrowers have access to cheaper credit than they did a year ago. And the good news is, in aggregate, better-rated borrowers comprise a much larger part of credit markets.

So for big boys with good credit it's easy to acquire another firm, whether they have the cash on hand or must borrow. And why not do it? Done right—if they buy a firm with a higher earnings yield than their borrowing cost—the deal can be almost immediately accretive to earnings. They get essentially the same effect if they borrow to buy back their own stock. As long as cash is plentiful and credit remains relatively cheap, M&A and buybacks will likely continue.

Why care? First, stock prices are ultimately driven by supply and demand. Cash and debt-based M&A and buybacks reduce supply, helping offset supply infusions from recent IPOs and stock issuances. Further, in some sectors, like Materials and Energy, supply is shrinking, which is another bullish driver for areas already likely to perform well this year. In addition, we just wouldn't see firms awash in cash, nor any stepping up to pay a 28% premium, as Mars did for Wrigley, if times were as tough as many seem to feel. And we wouldn't see AAA yields in the 5% range if there was a true credit crunch. But what we are seeing is more M&A evidence pointing to a credit market that isn't imperiled but is functioning fine—and some pretty sweet deals.