Cash Choices: Merge or Buy Back?

Compared to the 1990s, companies are getting more bang for their buck from acquisitions than stock buybacks.

For some time, conventional wisdom has held that investors punish companies for mergers, which studies have shown rarely perform as expected. Likewise, corporate management has long seen stock buybacks as a slam dunk when it comes to pleasing investors.

But now, with companies awash in cash, and spending far more on both acquisitions and buybacks than they did five years ago, it may be time to reassess the conventional wisdom.

Investors, in fact, react quite differently to those two uses of cash—and quite differently than they did a decade ago. A recent study shows, in fact, that investors are warming up to mergers and acquisitions. Buybacks on the other hand, elicit a far more limited (though still positive) reaction.

That’s quite a change, notes Marc Zenner, global head of the financial strategy group at Citigroup. While M&A has often hurt an acquirer’s stock price, the market’s historical reaction to a share buybacks, even before the 1990s, tended to be positive in the long-term, significantly outperforming broad indexes, he observed.

But in an environment in which the median cash holdings as a percentage of assets for larger U.S. companies in the S&P 500 have jumped from 3.1 percent in 2000 to 6.4 percent by the end of 2005, the volume of buybacks, mergers, and acquisitions have soared. Buybacks in 2002 totaled $143 billion; in 2005, they topped $367 billion. Mergers and acquisitions grew from $312 billion to $798 billion during the same time period. As CFO.com has reported, 2006 saw deal activity approach record levels. What’s more, the liquidity glut that fueled that activity is global.

A recent study by Zenner’s financial strategy group set out to help companies grappling with how best to employ their cash holdings. To achieve that, Zenner’s group examined all U.S. and European acquisitions with a minimum $250 million deal value between January 2000 and the end of 2005. Each deal also represented at least 5 percent of the buyer’s equity market capitalization.

The results? “Companies announcing acquisitions have done quite well in the short-term,” says Zenner, “and extremely well in the long-term,” that is, the one-year period following the acquisition. “Even buyers paying in stock instead of cash have, on average, been doing well recently,” he adds. Of course, many factors determine investor reaction to a deal, including the transaction amount, the way the acquisition is financed, and the suitability of the merger itself, explains Zenner. Yet, he says, even the market response to those factors has shifted.

For example, says Zenner, investors commonly interpreted stock-financed acquisitions as a sign that the buyer felt its stock was overvalued. And using such inexpensive currency, rather than debt capacity, to complete the deal led investors to question the acquirer’s level of commitment. Stock tended to drop accordingly in response to such deals.

In the past few years, however, stock-financed acquisitions have outperformed the market in the long-term (one year after the announcement), with a median excess return of 14.5 percent; short-term returns were slightly positive at 0.8 percent. Still, despite rising confidence in stock deals, all-cash deals generated a higher median return of 18 percent after one year.

Regardless of the way deals are done, investors clearly are more receptive to mergers than in the past. This may reflect more sensible deals than in the past, Zenner says. “The strategic fit of acquisitions has increased,” he notes.

A positive response to a stock buyback, however, is no longer a sure thing, warns Zenner. Buybacks now tend to result in just a one percent boost in the stock price. Still, he cautions against interpreting this as a sign that the market dislikes buybacks. Rather, he says, the market now anticipates buybacks, particularly when companies conduct a series of small purchases over time.

“If everyone else does it, you almost need to do something else to get noticed,” said Zenner. And indeed, “Buybacks of more than 10 percent of market cap tend to generate higher returns,” he adds. Such transactions, he says, result in a median 13.8 percent return in one year.

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