Introduction
M&A activity in 2015 has surpassed the peak from 2007 driven by deals in pharmaceuticals, energy, and consumer sector. Many of the factors that helped the dealmakers in 2015 are still in place, but the bond market turmoil and geopolitical instability might play a role in 2016 together with other factors that are yet to be discussed.
A bit of “history”
During the crisis, there was a lot of volatility and anxiety which brought uncertainty and decreased the willingness of the CEOs to spend company’s money and invest. Moreover, in the wake of the financial crisis, companies hunkered down and slashed costs. Eventually, margins picked up even if global economic growth was uneven. The GAAP S&P profit margin peaked in late 2014. But slow economy and deflation combined to make it hard for revenues to grow organically. There were $450bn of annual buybacks among the S&P 500 but EPS for the index did not grow in 2015, and the outlook for 2016 is not that much better.
If a company cannot grow organically, it has the other option – merge and acquire. In fact, some of the factors that pushed mergers and acquisitions in the past 2 years were hunger for growth in a weak economic environment, cheap financing and continued pressure from activist shareholders to boost returns. Many of these factors are still in place and those factors positively affect the environment. 2015 has brought the global M&A value to about $5tn. It is important to mention that it was a year abundant of the so called mega deals. These are deals that surpass $10bn in value. A record 67 deals with a value of more than $10bn have been agreed, worth a total $1.86tn. That’s more than double when compared to 2014 total of $803.4bn. There have been 9 deals announced worth more than $50bn, also a record.
2016, are you up to the task?
The story of 2016 started in a ‘slightly’ different fashion. This year has already seen 4x the value of withdrawn M&A deals compared to the same period last year ($375.8bn vs $90bn) and with the US Department of Justice suing to block a $25bn deal between Halliburton and Baker Hughes, that figure could get higher. The value of 2016’s withdrawn deals is the highest since 2007 in which, during the same period, we saw $405.9bn of value in withdrawn deals. It is interesting to mention that there have been only twelve M&A deals announced with a value above $100bn in the history of M&A. Two of those deals happened in 2016 and were both withdrawn: Pfizer’s acquisition of Allergan ($160bn) and Honeywell’s acquisition of United Technologies($102.8bn).
In fact, M&A deal value in Q1 2016 ($293bn) has seen a decline when compared to the previous quarter ($790bn) and is at the lowest level since Q1 of 2014 ($261bn). Unfortunately for the dealmakers, Q2 of 2016 has continued the slow pace from Q1 bringing the overall M&A deals value ($287.3bn) to its lowest level since 2012. The decline in value is driven, among other reasons, by a drop in the previously mentioned mega deals. The cause behind the decline in value of these megadeals is due to concerns over slowing economic growth, rate rises, and expected decline of S&P 500 profits.
It is interesting to mention that analysts expect the global level of M&A to stay close to the one from 2015. 2016 has seen outbound Chinese investments towards the US and Europe. This is something that might keep global value of deals in check. Chinese companies want to invest their capital outside. Some are speculating that RMB will depreciate which could be one of the reasons they would like to invest in the dollar and euro denominated assets. On the other hand, volatility of the stock market is back and so is anxiety. Dealmakers would need these two to calm down to get mergers back on track i.e. to restore the confidence of CEO’s. When there is volatility in the market, it gets harder to properly price the transactions. Moreover, many analysts are predicting that 2016 will bring deals but they will be smaller in size. We could expect this because, given the recent stock price declines, the lower valuations have made these companies more attractive acquisition targets.
Politicians play the music, the rest have to dance?
Continuing the story of the blocked or withdrawn deals, we ought to mention that 2016 was not the only year the big deals didn’t go through. Under Obama’s administration (2009), in order to protect competition, jobs and US tax base, a total of $370bn of large deals have been abandoned. We will explain the story behind Pfizer’s failed deal and the story of the largest US cable TV company (Comcast) who tried to buy the second largest (Time Warner Cable).
Only one large deal was blocked during Bush’s administration ($27bn takeover of Hughes Electronic by EchoStar) and two under Clinton’s administration ($12bn takeover of Northrop Grumman by its larger rival Lockheed Martin, and MCI WorldCom’s $125bn bid for Sprint). Since 2009 there has been series of tax inversions, but also an unprecedented level of dealmaking. The regulators believe some sectors are in danger of becoming uncompetitive after decades of consolidation. Namely, if the sector is too consolidated, the prices will go up. Moreover, the output is likely to go down and so is the quality and innovation of products. This all means that there’s a misalignment between what increases the value for the investor and what helps the individual consumer.
Pfizer – Allergan $160bn tax inversion deal
Pfizer Inc. (NYSE: PFE) has been seeking a company to merge with since 2014. The main goal of one of the world’s premier biopharmaceutical companies never was a secret – shift to a low-tax jurisdiction – Pfizer is based in the US with the corporate tax rate reaching up to 35%. Though, the story behind the need for tax inversion is deeper. After the patent expiration in 2011 of the biggest-selling drug in Pfizer’s portfolio, and also in history, Lipitor, the company has suffered growth issues. That loss of patent made a hole in Pfizer’s P&L lowering company’s sales for around $10bn compared to 2011.
Pfizer made an attempt to merge with AstraZeneca in 2014. The deal with a value of almost $120bn was supposed to become the largest in the pharmaceutical industry. As Mr. Ian Read, Chairman and CEO of Pfizer, stated, the deal was beneficial for both shareholders and patients by bringing an expanded portfolio. Although later it turned out that the main reason behind the deal was the desire to lower tax costs. AstraZeneca is based in the UK with a corporate tax of 20% which was lower than the rate that Pfizer was taxed with. The deal failed mainly because of British political opposition and concern for the hostile nature of the deal.
Another vain attempt was made the year later. Before approaching Allergan, Pfizer unsuccessfully negotiated with GlaxoSmithKline, the largest drug maker in the UK. So far, Pfizer has spent $21bn on acquisitions.
Unlike other deals, the acquisition of Allergan was obviously a tax inversion deal. In the absence of potential for organic growth, this was the only way for Pfizer to keep its stock price in check. Throughout the recent years, it has spent $44bn on buybacks just to keep its EPS stable.
However, the largest tax inversion deal in healthcare industry has been stalled due to new proposed regulations by US Treasury Department. According to the new rules, the formula for calculating shareholder structure of a merged company has changed. Before, the ownership of the merged Pfizer-Allergan company would’ve been 56% to Pfizer (US), 44% to Allergan (non-US). That would’ve given an opportunity to the company to change tax domicile from the US to Ireland. However, since Allergan has been actively acquiring US healthcare companies during last three years, substantial part of its shareholders are US residents. According to new rules, more than 80% of the company will result in ownership of US residents, while less than 20% of non-US. Therefore, the new company will not be able to switch its tax domicile, because the ownership of non-US residents shall be more than 20% to be able to do that.
The second major change in regulation concerns “earnings stripping” technique, used by many multinational companies. The idea of this technique is that non-US headquarter grants a loan to its US subsidiary, and since interest payments are tax deductible, this reduces taxable profit. According to new rules, this kind of loan will be treated as equity with no tax deductible interest payments. However, this new regulation will affect many multinational companies who invest in the US so some safeguards have been stipulated. If the amount of the loan is less than $50m or if it is actual business investment, such as building new plant or equipping it, interest payments will be still tax deductible.
The break-up of the deal is widely seen as a failure of Mr Read to assess political risk. The merger agreement called for a fee covering Allergan’s integration-planning expenses of up to $400m in the event that tax-rule changes rendered the deal unworkable.
Market reaction
Typically, the announcement of the M&A deal induces stock prices to go down for the acquiring companies. This is due to the perception that the upcoming deal is a costly and a time-consuming process. In terms of Pfizer’s stock price behavior, it can be seen that when the market received the news about an offer to AstraZeneca, there was a decrease in the price of 6% from $30.75 to $29.02 in 3 trading days. Although, the interesting fact is that when the deal with Allergan was announced, Pfizer’s stock price went up quite significantly in the next few days (+5% in 2 trading days). The trading volumes increased significantly on the day of announcement. That fact means that the market was quite positive about the upcoming deal. Reaction to the withdrawal of the deal was negative, -3% in 3 trading days. Although, the day before the official announcement of the withdrawal, Pfizer said that it would make the final decision in the upcoming days, this information gave a rise of 5% to the Pfizer’s stock which was then followed by the decrease due to the deal cancelling.
Comcast – Time Warner Cable Deal
In February 2014 Comcast, the largest American cable and broadband provider, announced an acquisition of the second largest, Time Warner Cable, for $45bn. The market share of the combined company would have been around 30%. Though the company argued that the acquisition would allow to provide better quality services and agreed the disposal of 3.9m customers to Charter Communications, after 14 months of investigations the Department of Justice decided to block the deal, stating that the tie-up will result in Comcast as “an unavoidable gatekeeper for internet-based services that rely on a broadband connection to reach consumers”. In April 2014, Comcast withdrew its bid. This didn’t entail any break-up fee for TWC, meaning from the very beginning the deal was designed so that Comcast can easily walk away. Upon the withdrawal the share prices of both companies rose.
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