The Merger Binge and the Economy

We wondered what Microsoft was up to when it started issuing long-term debt last year, something that it had never done all the rest of the time it has been a public company. 

This money was not going to go to expand operations.  It already had tons of cash to do that!

The best bet was that Microsoft was going to go acquiring…but, what.

Now we have a partial view…Microsoft…and Steve Ballmer…is buying Skype!  The estimated cost?  More than $8 billion.

What about all the other money Microsoft raised in the bond market?  My best guess is that we will see more acquisitions in the future!

But, Microsoft is not alone in this.  Hertz is going after Dollar Thrifty and outbidding Avis.  Southwest Airlines acquired AirTran Holdings to get into the Atlanta airport, the world’s busiest. 

And the beat goes on.

AT&T is intent on acquiring T-Mobile for around $39 billion; Johnson & Johnson has a $21.5 billion deal in the works for Synthes; Duke Energy plans to merge with Progress energy, the deal totaling a little less than $14 billion; and there is the bid for NYSE Euronext for more than $11 billion.

I have been arguing for at least a year now that much of the cash being built up at many large corporations was going to contribute to a major acquisition binge…worldwide. 

And, this binge would include companies from more and more nations.  The Chinese are looking to put $200 billion into corporate acquisitions globally.

Roger Altman, Chairman of Evercore Partners, Inc., argues that the deal making will be at an all time high in 2011, surpassing the $4 trillion record total that was achieved in 2007. (http://www.bloomberg.com/news/2011-05-06/altman-sees-dealmaking-recovery-surpassing-record-4-trillion-of-2007-boom.html)

Some analysts argue that the growing stability of the economy is contributing to this.  Others attribute this movement to the strength in the stock market. 

Whereas these support the cumulative rise in the amount of M & A activity taking place, I still believe that this record-breaking rise in acquisition activity is being subsidized by the monetary policy of the Federal Reserve System. 

The first to benefit from this subsidy are those companies that came through the Great Recession with little or no debt on their balance sheets. 

The second group to benefit have been those that have been able to use leveraged loans and junk bond issues to refinance billions of dollars of debt borrowed during the credit inflation of the past decade or so. 

These companies are now buying other companies and strategically positioning themselves for the future.  And, in a real sense, the big are getting bigger…and more complex.  Industry is following the banks on this as the larger firms are getting greater market share and expanded market space. 

And, in my experience, there is only one way to really make acquisitions work.  The acquirers, after the deal is made, must become the biggest “bastards” in the world.  That is, the acquirers must become ruthless in rationalizing their purchase…otherwise…the acquisition just won’t pay off.

The effect on the economy?  In the longer-run…good…very good!  In the short run…continued pain.  Jobs must be cut, un-economic facilities must be disposed of, and, in general, spending must be reduced. 

“In AT&T’s pending deal for T-Mobile USA, the companies estimate cost savings of $40 billion over time, including expected layoffs, starting from the third year after the merger is completed.” (http://professional.wsj.com/article/SB10001424052748704810504576305363524537424.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

But, this gets into another point I have been trying to make for the past two to three years.  During this time I have argued that about one-in-four to one-in-five people of working age are under-employed.  Forget the unemployment rate as it is measured…there are a lot of individuals that have either left the labor market or are not fully employed but would like to be.  And, this has been a growing problem over the past half-century. 

The merger and acquisition binge is not going to help this situation…one bit!

David Brooks in his New York Times column this morning emphasis this problem. (http://www.nytimes.com/2011/05/10/opinion/10brooks.html?_r=1&hp)  Brooks reports that 80 percent of “all men in their prime working ages are not getting up and going to work…there are probably more idle men now than at any time since the Great Depression and this time the problem is mostly structural, not cyclical.”

And, the primary factor that distinguishes the unemployed?  Not sufficient educational training.  “According to the Bureau of Labor Statistics, 35 percent of those without a high school degree are out of the labor force.”  Not unemployed…but, “out of the labor force”!  And, while this number goes down the more education one has, there is still a close correlation between the number of individuals “out of the labor force” and the amount of education that an individual has.   

And, as the mergers and acquisitions take place, the trend will just worsen.  For too long a time, when unemployment arose, we have tried to put people back into the jobs they had formerly held, even though those jobs became less and less economically justified.  The expectation was that the government would stimulate the economy and people would get their old jobs back.

Now we are going through a transition in which those “old jobs” are no longer there. 

And, the monetary stimulation coming from the Federal Reserve System is now resulting in a continued reduction in the less productive jobs through the merger and acquisition banquet going on and is doing very little toward helping these people get back into the work force.

This is consistent with the argument that I have continuously made in these posts that the credit inflation created by the monetary and fiscal policy of the United States government over the past fifty years has done a very good job in splitting the labor force into two segments, the less educated and the more educated, and the society into a much more highly skewed income distribution than earlier.

The acquirers have the cash, they can still borrow at ridiculously low interest rates, and these conditions are expected to stay in place for “an extended period.”  Continue to watch all the M&A activity taking place.  I think this will be a time to remember.

The Worldwide Cash Buildup In Corporations

One of the most wildly optimistic articles I have seen on the economic recovery recently appeared yesterday in the Wall Street Journal: its title, “Corporate Cash Hoards Offer Hope.” (http://professional.wsj.com/article/SB10001424052748704858404576133800157070140.html?mod=ITP_moneyandinvesting_8&mg=reno-wsj) This article begins

“Time to splash the cash? The corporate dash for liquidity that started in 2008 and accelerated in 2009 is starting to reverse. Spending on capital goods, advertising and software is rising. With consumers deleveraging and governments feeling the pinch, corporate spending is key to the recovery. And the conditions may favor acceleration.

There are certainly no capacity constraints on spending. Nonfinancial corporates globally have $4 trillion of cash, up 38% from 2007, according to Citigroup's corporate-finance advisory group. Even allowing for higher liquidity buffers in an uncertain world, some $2.4 trillion could theoretically be surplus to requirements. The profit recovery and rising revenues mean companies are throwing off free cash. Borrowing conditions look good, too: The bond markets are wide open, and banks are lending more freely.”

By-the-way, did you see that Microsoft, a company that has tons and tons of cash, issued more bonds on February 4, 2011. It raised another $2.25 billion (over $6.0 billion offered) which goes along with the $3.75 billion raised in May 2009 and the $4.75 billion was raised last fall. That is almost $11.0 billion!

Our author states that corporate spending is now going for “capital goods, advertising, and software.”

Really...

Microsoft has continually stated that the funds it raised could be used for “stock buybacks, building up working capital, or corporate acquisitions.”

People who have read my posts before know where I stand.

I believe that a large portion of this cash buildup is going to be spent on...”corporate acquisitions.”

And, the phenomenon is worldwide. The following chart accompanied the Wall Street Journal article. As we can see, the buildup in cash is not just a United States thing. And, the acquisition binge we have started on is global, not regional or national. A lot of acquisition have already taken place or are in the works. Many more are on the way. Acquisitions to take advantage of the rise in commodity prices. Acquisitions to get into new markets. Acquisitions to get into major nations. Acquisitions to build scale. And, so on.

This is a time of transition...worldwide. The emerging nations are becoming stronger relative to the developed nations. The middle east is facing major upheaval. We are transitioning from a manufacturing world based on the worker to an information world based on knowledge. Old thought patterns are changing. The way to run governments is changing. Literature is changing. Political commentary is changing. Religions are in turmoil. We communicate by twitter, chat, and text. Nothing is settled.

Information is spreading, as it always has, only the speed is accelerating and this is causing major adjustments in the way people live and do business and govern. And, it is changing the way businesses are structured and organized.

Can you imagine a non-American organization owning the New York Stock Exchange! Can you imagine a Chinese bank owning an American bank! Part of the re-structuring of the world is that the barriers are really breaking down and in a way that has never happened before. And, so on and so on.

When I discuss the subject of corporate cash I always get comments regarding the amount of corporate debt that is still outstanding with the argument that the corporate debt is just the other side of the balance sheet from the cash that is being accumulated. Therefore, the buildup is just a lot of noise.

I would argue that non-financial businesses, as well as financial businesses, are divided into those that are still overly leveraged and are not doing so well and those that are doing very well, thank you, yet are issuing debt that costs them very little, so as to build up cash treasure chests.

The question I ask those that are doing very well is, “why are you issuing debt if you are just going to buy back your stock or build up your working capital.” These companies are profitable and are generating sufficient cash to buy back their stock or build up their working capital. They don’t need to issue debt to do these things.

The companies that are not doing very well and are highly leveraged are another story. They are not generating sufficient cash flow to de-leverage or they cannot raise any cash to reduce their leverage.

The picture is simple. There are a large number of the latter firms that are not going to be able to re-structure their balance sheets in such a tepid economic recovery. These firms will eventually succumb to the need to seek buyers in order for the existing organization to have any chance in the future, even as a part of another company.

And, a lot of the cash rich companies or organizations are “off shore”…that is, these potential acquirers are not American companies; yet they are seeking to purchase American enterprises.

And, whether or not you like it, a lot of organizations are going to get a lot bigger and everything is going to become more global. The most direct way this is going to happen is through mergers and acquisitions. But, M&A will not add jobs nor will it result in faster economic growth immediately. In fact, they will do just the opposite.

Where the Action Is

Commercial banks aren’t lending. That we know.

But, there is action elsewhere and, I believe, that this behavior tells us a lot about how the recovery is working itself out…although it is not a recovery like the ones of the recent past.

There is a lot of money in the financial markets…in the shadow banking system…and worldwide.

Where is the action taking place?

Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates. For example, Microsoft just completed a new bond deal. On September 23, 2010, Microsoft Corp., the world’s biggest software maker, sold $4.75 billion of bonds, “at some of the lowest rates in history for corporate debt.” The offering information stated that “Proceeds may be used to fund working capital, capital expenditures, stock buybacks and acquisitions.”

This follows Microsoft’s “first ever” debt issue which came in May 2009. An analyst noted at the time, “Redmond, Wash.-based Microsoft is sitting on $25 billion in cash, so the company doesn’t need the bond proceeds ‘unless they have something big in mind.’”

And, Microsoft is not the only major company taking advantage of the AAA bond market.

Then there is the “Junk Bond” market. The New York Times trumpets “Junk Bonds Are Back on Top.” (http://www.nytimes.com/2010/10/08/business/08bond.html?scp=1&sq=junk%20bonds%20are%20back%20on%20top&st=cse)

Jim Casey, “one of today’s junk-bond kings” and who runs the junk-bond business at JPMorgan Chase claims that “even those heady days of the 1980s” when Michael Milken ruled Wall Street and who Mr. Casey worked for at Drexel Burnham Lambert, “seem a little tame.”

So far this year, it is reported, that in the first nine months of this year corporations have raised $275 billion in this market worldwide, up from $163 billion in 2009.

“In high-yield, it’s undeniable that these are the best years that anyone has seen in their career.”

Whew!

It is estimated that “about 75 percent of the deals are aimed at refinancing, rather than taking on additional debt.” The risk profile of the companies has gone up!

And, who are big players helping to underwrite these deals? Let’s see, JPMorgan, Bank of American and Merrill Lynch and Citigroup…the top four!

Further action?

Well check out the private equity interests. They are raising capital in the billions. To do what? “Many banks are looking to sell large portfolios of commitments to private equity funds that they made during the credit bubble.” Banks are doing this because these “assets” are underwater and also because new higher capital requirements will make their “ownership” very expensive.

This just points to a whole host of private equity interests moving into the area of distressed assets. And, they are moving in aggressively. We read the article in the New York Times this morning about short-seller David Einhorn, the founder of Greenlight Capital. (See “A Bear Roars”, http://www.nytimes.com/2010/10/14/business/14views.html?ref=todayspaper.) One of the interesting insights relating to the work of Mr. Einhorn is the detail that Greenlight Capital put into its “due diligence” of the target.

The attention being focused on “distressed assets” today is not just a casual thing. Fund managers are aware of the risks they are under taking, just as they are aware of the potential returns that are available. As some have said, they are “taking care.”

One analyst remarked on the condition of the market: “We are seeing a steady river of deals” and “we expect this stream to carry on for some time.”

This is all part of the movement I reported on in “Corporations are Hoarding Cash and Keeping Their Powder Dry,” (http://seekingalpha.com/article/228507-corporations-are-hoarding-cash-and-keeping-their-powder-dry).

There seems to be a tremendous re-structuring of the economy taking place. I now believe that the re-structuring that is going on is beyond the power of the government to reverse. I believe that a similar re-structuring took place in the 1930s and 1940s, a re-structuring that the government, at that time, could not reverse. The 1950s represented the start of a “new era”.

The structure of the industrial base of the United States is dis-located with American industry using only 20% to 25% of its capacity. The structure of the work force is dis-located as 20% to 25% of the age-eligible workers in the United States are under-employed. And, the income/wealth distribution in the United States has become more and more skewed over the past fifty years.

These “dis-locations” will not be resolved by what corporate America seems to be doing now. Large companies, large banks, private equity funds, hedge funds, and other money sources are building up their cash reserves. They are looking, I believe, to buy assets, to buy “distressed companies” and so forth.

Imagine that Microsoft, a company that had never issued any debt in its history, has raised over $8.5 billion in new cash over the past 18 months or so while it is sitting on $25 billion in cash. Can you picture this money going to fund working capital and capital expenditures? I can’t but I can certainly see it going to fund stock “buybacks” (which raises its ability to purchase other companies) and to fund acquisitions.

Actions like this, however, will not result in higher levels of employment or greater investment in capital that would spur the economy along. If anything, a re-structuring, like the one I am writing about will have exactly the opposite effect.

Yet, this may be how the economy goes about recovering!

As I said above, I now believe that the re-structuring that is going on is beyond the power of the government to reverse. If this is true, neither a further quantitative easing on the part of the Federal Reserve System nor additional fiscal stimulus on the part of the federal government will do much in the way of achieving a more rapid economic recovery. If I am correct, the economic re-structuring will take place at its own speed. But, this will require a different response on the part of the government.