KEEP your eye on the cash.
As long-dormant merger-and-acquisition activity starts to get active again, shareholders are getting a chance to assess how executives feel about their company’s prospects. One way is to watch how a company uses cash when making an acquisition.
In general, acquirers who pay in cash – not stock – do better in the market after the deal is announced.
“When they feel their stock is undervalued, they don’t want to part with something that would also cause some dilution in earnings,” said Richard Cripps, chief market strategist at Legg Mason.
Tom McManus, a strategist at Banc of America Securities, agreed, offering up a metaphor that every home owner can understand. He said completing an acquisition is like buying a house. Usually, you pay with a mix of cash and debt. Even if you take on debt, the interest rate you’ll be expected to pay on that debt is straightforward, so you know how much you’ll be paying over time. Companies paying with stock, on the other hand, are buying by wagering on their future earnings.
It’s up to the investor – and the company being acquired – to interpret the signal, especially if stock is on the table.
“Really what you’re looking at is a strongly held view on the part of the acquirer that the assets to be acquired are more reasonably valued than the assets of the acquirer,” said McManus of stock-fueled acquisitions, adding, “No-one should know better than the insiders at a company what assumptions are underlying the price of a common stock.”
In that vein, Best Buy’s acquisition of Musicland in January can be seen as a bullish sign. It made the purchase for $685 million (including $260 million in debt) in cash. The stock has doubled year-to-date.
The legendary Warren Buffet prefers cash, as well. All of Berkshire Hathaway’s recent deals have been made in cash.
And maybe it’s just as well for General Electric investors that the European Union has blocked the merger of GE and Honeywell. Under the proposed $45 billion deal, no cash would be exchanged.
Of course, most buyouts are a mix of cash and stock. Last week, Washington Mutual merged with Dime, and only $1.4 billion of the proposed price of $5.2 billion will be cash. Tyco bought CIT Group in June for $10 billion, about $2.5 billion of that was cash.
Market conditions can make one or the other more attractive. Right now, cash is preferable. It’s been relatively easy for a company to pay in cash and raise money in the convertible bond market.
There may seem to have been a surge in cash deals, but Kevin Caron, associate strategist at Gruntal & Co., said there’s been a return of sorts to dealmaking of the early ’90s, before stock glittered more than gold during the Internet boom.
And Caron pointed out that cash doesn’t merely indicate insider sentiment – it buys, as currency is supposed to do. It’s a good time for companies sitting on a hoard of cash to be investing some of that cash in companies with depressed stock prices. Likewise, it’s not a good time for a company in a cash crunch to be buying with its own, depressed stock.
So cash is not a perfect indicator, and there are bona fide reasons to complete a deal using stock rather than cash. A deal is a dance between the acquirer and acquiree – but it also includes customers, employees, the press, Wall Street, management and suppliers. There are many views to take into account – and some parties may not want cash.
The acquired company, for example, may want to use stock for capital gains purposes. When Cendant bought Galileo last month for $2.9 billion, using cash preserved the tax-free nature of the deal for Galileo stockholders.
But even cash, of course, can’t save a lousy deal.