Corporate Confidence Continues to Wane

I closed my review of the 2012 prospects for mergers and acquisitions with this paragraph: “Let’s hope the boom in M&A business does take place. Let’s hope that the corporate cash and corporate borrowing do not go just to corporations buying back their own stock. Let’s hope that the unwinding and restructuring takes place because that is one prerequisite for business to get back to the capital investment activities that do drive economic growth.”

(http://seekingalpha.com/article/321037-the-outlook-for-mergers-and-acquisitions-in-2012)

However, at the end of January we see the headlines: “M&A volumes at lowest for a decade.” (http://www.ft.com/intl/cms/s/0/f23718f6-4a76-11e1-8110-00144feabdc0.html#axzz1kx2Cicvs) “Dealmaking has had its slowest start to a year for nearly a decade, as companies’ appetite for mergers and acquisitions remains suppressed by the uncertain outlook for the global economy.”

The deal volumes announced so far this year…about half the level of 2011 at this time according to S&P Capital IQ.

Additionally, we read “Hordes of hoarders,” concerning corporate cash hordes…with corporate entities holding onto well over $1.7 trillion at last count. “ (http://www.ft.com/intl/cms/s/0/4cd6cb8c-48e0-11e1-974a-00144feabdc0.html#axzz1kx2Cicvs) “At present, cash accounts for more than 6 percent of US non-financial companies.”

In one specific case, Apple has almost $100 billion in cash on its balance sheet, about level with the market value of firms like McDonalds, or ConocoPhillips, or Cisco Systems.

This pales against the cash holdings of US commercial banks who in January 2012 hold almost 13 percent of their assets in cash balances, up from 9.3 percent at the end of 2010.

I know that this is early in the year, but with everyone looking for positive signs that the economy is picking up steam we need to consider other signs as well. Furthermore, the current situation is not unlike the situation that existed at the start of last year…and the actual commitments never really came about.

The one word that seems to be on almost everyone’s lips concerning this situation is…uncertainty.

There is just so much uncertainty that exists in the world right now that people are unwilling to commit substantial resources to acquisitions…or capital investments.

Where is this uncertainty coming from?

In my mind this uncertainty exists from the lack of economic leadership in the world today.  Europe continues to dither…and so does the UK…and so does the US. 

No one seems to know where they are going…or where we are going. 

How can anyone commit in such an environment?

Who knows what economic policies are going to prevail in these areas over the next year or two…let alone the next three months?

Who knows how the people in these areas are going to react to whatever economic policies are going to be enacted by their governments?

We’ve seen how the governments have acted in the recent past…and these examples cannot give anyone much confidence.

Right now, I am concentrating on factors such as these to try and understand the state of the economy.  Business leaders may be prepared to commit in the future and certainly they have the means to borrow additional funds if they need them.

These leaders still face the following question: “Why should I commit to buy another company now when the economy could get worse and I could buy the same company for a lower price at some time in the near future?” 

Right now, the probability of this happening is still apparently large enough that it is causing these business leaders to hesitate to commit on acquisitions…or capital investment. 

I keep asking people to name one person in a position of political authority in the world that they would apply the title “leader” to…and I keep coming up with silence.

Unfortunately, I don’t believe that business leaders are going to commit resources until some sort of political leadership is forthcoming. 

I still believe that we can look at how corporations are using their “cash” as an indicator of future economic performance. 

For right now, though, the “cash” stays on the balance sheets!

Another Sign of a Weak Economy: Stock Buy Backs?

Over the past year or so, I have been arguing that the substantial build up in the cash balances of many large United States corporations has been for the purpose of merger and acquisition activity.   And, earlier this year, M&A activity seemed to be proceeding aggressively. (See my post “The Latest Merger Binge and the Economy,” http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.)

Now, it seems as if these cash balances may be trending into more stock buy-backs than into the buying of other companies, at least in a relative sense. “US companies are buying back their own stock at the fastest pace since 2007…” (http://www.ft.com/intl/cms/s/0/381e8c26-9c14-11e0-bef9-00144feabdc0.html#axzz1Q0PX4bjp)  

Today’s attention on stock buy-backs has been caused by the announcement made yesterday by electronics retailer Best Buy of a proposed $5 billion buyback program. (http://professional.wsj.com/article/SB10001424052702304070104576400062744226034.html?mod=ITP_moneyandinvesting_10&mg=reno-secaucus-wsj)

Analysts have been wondering what these large corporations were going to do with the huge cash balances on their balance sheets.  These companies were producing profits, they were able to borrow at ridiculously low interest rates, and ample liquidity seemed to be available to them around the world.  Also, there were a lot of other companies or divisions of companies “out there” that were really struggling and seemed to be possible “sitting ducks” for growth hungry large corporations. 

Of course, one of the reasons for the build up of cash in some of these companies was the tax implications associated with bringing monies earned around the world back into the United States.  But, this was not really the major reason.  For example, Microsoft, a cash rich company, did not have to go out and borrow more than $10 billion in the United States, the first time Microsoft has even made use of the bond markets in its history. 

Many economists were hoping that this build up of cash would result in a boom in corporate investment in physical capital, a stimulus to further economic spending and subsequent economic growth.

This physical investment has not yet surfaced. 

My belief has been that this cash build up was for acquisition purposes.  The companies that had the cash were strong and were “on the hunt” for their weaker brothers and sisters hoping to build their economic base by acquiring companies that were not in good positions, had too much debt, and were struggling to make ends meet.  What a way to build markets and enlarge the company’s footprint!

This seemed to be happening…and I believe will continue to go forward.

However, the world economy seems to be stalling.  Perhaps economic growth will not be as robust as originally thought…even three months ago.  Thus, even though the merger binge may continue to some degree, the pickings may not be as lush as once thought. 

And, the stock markets seem to have reached a near term peak.  All the major indices, the Dow, the S&P 500, and the NASDAQ, peaked at the end of April.  Many analysts are saying that with the stagnant economy and the high levels of under-employment, the chances are not very great that the stock market will show much resilience in an upward direction. 

Thus, there is some drop off in the corporate enthusiasm for more and more acquisitions.

So, what does a company with a lot of cash on hand and with dwindling appetite for acquisitions do with all their loot?  Managements with so much cash around and with very little hope that the economy will become more robust, just does not see these excess balances as a good use of resources.

The only viable alternative is to buy back their stock.  They see this as the “best” investment available to them.  And, so they buy back their stock.

Neither one of the latter two uses of the cash really do anything for the economy and the acquisition path could even result in worse economic results…at least in the short run.

Acquisitions, of course, can lead to plant closings, layoffs, and other efforts to combine firms, which increase productivity in the longer run, but does not contribute to capital investment or human employment in the short run.  Obviously, these outcomes are not what the policymakers are looking for.

Stock buy-backs also do not stimulate capital investment or a reduction in unemployment in the short run and may not achieve either of these goals in the longer-run.

Therefore, if the economy is weak and more and more corporations seem to believe that the “best” investment of the cash they have accumulated is to buy back their own stock.  it would seem that this is evidence that more and more corporations are not seeing a very bright economic future ahead of them.  In my mind, this is not very good news. 

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.

Merger Trend Heats Up

For the last 18 months or so, I have believed that one of the most important factors affecting the American (and world) economy would be a growing number of mergers and acquisitions. Individuals at Credit Suisse Group AG estimate that “The value of global takeovers may increase 15 percent to 20 percent this year, extending a 27 percent rebound in 2010.” (http://www.bloomberg.com/news/2011-03-30/new-deal-rush-pushes-takeovers-to-most-expensive-since-lehman.html) Not only is the economy growing (however modestly) but the better off corporations have lots and lots of cash assets, borrowing costs are exceedingly low, and there are lots of other corporations that are not so well off and whose best outcome is to be acquired by someone larger and healthier. Last week the AT&T and T-Mobile deal was announced. Recently we have also had deals announced by Duke Energy Corporation and Deutsche Boerse AG. And, yesterday, Canada’s Valeant Pharmaceuticals International put out a hostile offer for Cephalon, Inc. General Electric has engaged in a string of acquisitions, the most recent one was just announced, a $3.2 billion deal for GE to acquire the French company Converteam. And, there are many others. Deals are also taking place in the commercial banking industry. Although there were 157 banks closed in 2010, the number of banks in the industry fell by 310 indicating that lots of acquisitions were going on behind the information relating to the regulatory closures taking place. And, the big companies are getting bigger. The prices of an acquisition are rising. In the first quarter of this year, the price of an acquisition reached the highest level since before the collapse of Lehman Brothers Holdings, Inc. There are three aspects of this activity that are important for our future. First, consolidations are taking place across virtually all industries. There are many targets “out there” and companies with lots of cash and lots of borrowing power are “on the prowl.” This activity will have two effects on economic growth. In the short run, consolidations slow down economic growth because they lead to a rationalization of industry where plants and offices are closed and people are let go. Over the longer run, productivity increases as organizations become more efficient and effective producers of goods and services. Second, companies that have built up too much debt are in the process of deleveraging and, at the same time, are spinning off some of the subsidiaries they acquired with the debt. Thus, firms are getting back to more manageable levels of debt in their capital structure and they are also returning their operational focus to their core businesses. Both of these moves will also tend to keep economic growth from speeding up in the near future. The reduction in the debt of these companies will not be replaced in the near future and this will moderate the increase in bank lending and other corporate borrowing. Furthermore, the return of companies to their core businesses tends to result in the closing of plants and offices and the reduction in the number of people these companies employ. Third, investors will have the opportunity to participate in the restructuring of the economy that is now taking place. However, investors must be careful because not all acquiring companies are equal and not all acquisitions will turn out well. The current merger and acquisition boom is still in its early stages. As such, premiums received by selling companies are low, “the lowest since the third quarter of 2007.” Premiums are always low at the start of an M&A boom! Yet, not all deals are attractive to investors. Whereas AT&T stock has climbed 7.6 percent since it disclosed the T-Mobile deal and Valeant Pharmaceuticals stock jumped 15 percent late yesterday on the news of its bid for Cephalon, other transactions have not fared so well. If there is a chance to participate in this investment swing, it is now, when the purchase premiums are low. These will rise, and in the typical cycle, the rise will approach a level in which all new M&A deals are suspect. How soon the rise will occur is, of course, problematic. With so much cash on company balance sheets and the Federal Reserve holding market interest rates so low, one could imagine that the bidding could become pretty hot. But even if the bidding becomes “hot” this will not do much good for the economy in the short run because consolidations and the rationalizing of companies will result in plant and office closings and the laying off of people. It will also result in big companies (and big banks) getting bigger.

Executive Compensation: A Study

The New York Times’ DealBook edited by Andrew Ross Sorkin recently carried an amazing headline, “Study: Boards Use Peers to Inflate Executive Pay.” (See, http://dealbook.blogs.nytimes.com/2010/07/26/study-boards-use-peers-to-inflate-executive-pay/?ref=business.)

And in this remarkable study we find the following:

“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”

Well, duh!

This was done in the 1970s and I experienced it first hand in the 1980s and 1990s. Yet the quote above states, with astonishment, that “over the last several years” this behavior took place.

The authors of the academic study being reported on, Michael Faulkender of the University of Maryland, and Jun Yang of Indiana University, ”found that companies usually benchmark their executive pay with peers in their industry group, but that they also choose peers that pay more than others.”

That is, not only did corporation use peer data to determine executive salaries, the peers chosen were generally those that had the highest pay among the similar companies.

“The motivation of corporate boards to consciously chose peers that are more generous than ones that are very similar but are just less generous helps to explain, at least in part, the huge increases in chief executive compensation over the years.”

Huge increases?

Oh, yes, “Executive pay has increased substantially over the last few years. For example, in 1965 chief executives at major American companies earned 24 times more than a typical worker, while in 2007 they made 275 times more,” according to the Economic Policy Institute, a nonprofit Washington D.C. think tank.

Note, we are talking about “major” American companies…the “big guys”. These are large bureaucratic organizations that have huge human resources divisions that are given responsibility for the remuneration and benefits of the employees of these companies.

Now, I am not disagreeing with results of the study and I am not disagreeing that these practices helped to contribute to the substantial relative growth in executive pay when compared to the “typical worker”, whoever that might be.

I am just astounded that the results of this study from the late 2000s seem to be such a surprise.

In the late 1960s and early 1970s, when the United States economy was growing at a relatively good pace and inflation began to become a part of the daily life of Americans, large companies had to seek a way to justify the compensation of their employees…all their employees.

Data from peer groups, companies of similar size and similar industry background, became useful in setting pay scales and in arguing with labor unions about worker compensation. Companies began collecting information from other similar companies that would share data and, as the use of peer data became more generally used, it started to be collected by consultants and agencies that could sell the information to interested organizations.

What could be a more reliable guide to executive, and worker, pay than information on what peer groups paid their executives…and workers.

To me, the use of peer data was ubiquitous in large companies by the end of the 1970s.

But, one must be careful with how incentives are administered. Executives found that pay scales based upon peer data could be very used to their advantage. As a consequence, executives became diligent students concerning the use of peer characteristics and of what items could contribute to higher and higher compensation packages.

Let’s see…of course…size, to pick one characteristic, makes a great difference in the compensation received by executives. Bigger companies paid their executives higher salaries.

So, let’s grow the company! Let’s engage in mergers and acquisitions! Let’s move horizontally as well as vertically! Anything to increase the size of the firm! Executives can almost always find reasons to grow their organizations.

Remember the companies we are referring to are the “big guys”!

What about the performance of these companies? That doesn’t seem to matter.

What about the fact that about 3 out of every 4 mergers consummated are unwound in seven years or less? We will just replace those assets with other mergers or acquisitions!

And, the argument can be extended to the “other” special characteristics that apply to the choice of “peers”.

That is, executives could design the strategic plans they used to guide their firms based upon the peer group they had chosen so as to achieve the largest compensation possible.

Could something like this happen? You may express some doubt if you have not read books like “Freakonomics” and “Super-Freakonomics.”

That is, you must be careful of the incentive scheme you choose to stimulate people because that incentive plan will help to determine the behavior of the people you are hoping to influence…and the results you get may not always be the ones you expect.

In this, top executives are no better or no worse than most of the rest of us. They too respond to the reward systems that are presented to them.

And, what about the workers?

Well, they could not choose either their peer group or the design of their company relative to the peer group they wanted to be compared with. Anyhow, ordinary workers competed in a whole different labor market, one that tended to have a lot of substitutes: all peer groups at this level were very similar. Thus, they could not expect much boost in pay from the use of this information.