Blake Henricks, Deputy MD & Portfolio Manager
The GFC was a decade ago. Since then, companies have focused on cost control and balance sheet repair to drive shareholder returns. From here on, we strongly believe that companies around Australia are set to embark on Mergers and Acquisitions (M&A) to grow faster. Our thesis is based on:
- Cyclical upswing driving risk tolerance,
- Stronger balance sheets, and
- Build vs Buy opportunities
While our preference is for organic growth, the potential to add shareholder value through acquisitions cannot be ignored. In this note we outline the case for M&A and what it means for investors in equities.
Cyclical upswing giving confidence
It’s human nature to take on more risk when you are feeling confident. We all do it. And right now, companies are feeling very good, driven by improving global economic conditions. The data below shows PMI, the Purchasing Managers Index. It represents how many orders are being made in the manufacturing and services sectors. Conditions above 50 are expansionary and in the past year, the good conditions have been getting better.
Closer to home, while asset prices may have peaked, business conditions are great. Interest rates remain low, east coast infrastructure is creating jobs and mining services have turned in the West. NAB Business Confidence shows a continued improvement in business confidence over the past 7 years.
Stronger Balance Sheets
Company balance sheets have improved significantly. A combination of cost cutting, non-core asset sales and a focus on working capital have reduced debt across many companies. Some of Australia’s best-known companies, such as Woolworths and BHP, are set to rapidly reduce their debt over the next 3 years based on consensus expectations. Surprisingly, Bluescope Steel could be in a position of holding $1bn of net cash in two years’ time!
Build vs Buy economics
With confidence high and balance sheet firepower, we believe many companies will now turn their attention to growth. Companies with the opportunity to grow must decide whether they will build or buy. Does the company ‘build’ growth organically by investing capital and expertise with a five year plus horizon? Or are they seduced by the accelerated benefits of ‘buying’ growth to improve market structure or diversify? At Firetrail, we prefer organic growth because the culture is embedded in the new business. But we also understand there can be some compelling opportunities through inorganic M&A.
Implications for investors
History shows, companies and their shareholders can make (and lose) a lot of money from M&A. Consider the shareholder returns after some of the recent acquisitions in Australia over the past few years. Obviously, not all returns can be attributed to the acquisitions, but it is interesting to see the large changes in share prices.
|Aristocrat||20/10/2014||288.1%||VGT – Gaming||US|
|Treasury Wine||14/10/2015||161.2%||Diaegeo – Wine||US|
|Metcash||23/08/2016||51.9%||Home Timber – Hardware retailer||AU|
|Boral||20/11/2016||29.8%||Headwaters – Building products||US|
|Link||25/06/2017||10.6%||Capita – Financial administration||UK|
|Downer||20/03/2017||(8.4%)||Spotless – Contractor||AU|
|JBHiFi||12/09/2016||(9.4%)||Good Guys – White goods retailer||AU|
|Slater & Gordon||29/03/2015||(99.5%)||Quindell – Law firm||UK|
Source: Firetrail, Factset. Stock returns to 31 Mar 18.
Investors must be vigilant when analysing acquisitions. Too much optimism can blind you from the risks. Too much scepticism and you may miss the opportunity. It’s a delicate balance.
At Firetrail, we believe a combination of good economic conditions and improved balance sheets will lead Australian companies to focus more on growth. One outcome will likely be increased M&A. From history, we know shareholder returns will be amplified positively or negatively through such periods and while there are opportunities, there are also risks. Successful investors will be the ones to strike the balance between optimism and scepticism through deep dive research.
Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.
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