M&A Has Surged. It Doesn’t Always Work Out for Buyers.

Salesforce is an example of a buyer that hasn’t yet convinced the market that it will have success. (David Paul Morris/Bloomberg)

Key Points

About This Summary

• Mergers and acquisitions are up 35% this year, driven by solid company financials and lower borrowing costs due to Federal Reserve rate cuts.
• Historically, acquirers, especially those with larger market capitalizations, often see their stock underperform peers after deal announcements.
• Union Pacific’s $85 billion bid for Northern Southern and Salesforce’s Informatica acquisition have both led to share price losses for buyers.

Deals aren’t always so great for the buyers.

Mergers and acquisitions worldwide have reached $2.48 billion in total deal value this year, up 35% from the same period last year, according to London Stock Exchange Group.

Driving the increase: more companies in a solid financial position, especially with the cost of borrowing money dropping. The Federal Reserve cut interest rates three times last year and signed off on another quarter-point reduction just Wednesday. At the same time, companies looking to sell have seen their value increase, as the stock market has gained this year, and companies expect more earnings growth.

The whole picture speaks to the health of the economy, which should keep growing—especially with lower rates. This can unlock deals across the board, though tech has been particularly active. Large software companies want to buy smaller assets that can help them build, among other things, their artificial intelligence capabilities.

The M&A activity is good for sellers. A deal usually happens at a substantial premium to the seller’s trading price, so the announcement of a deal drives up the target company’s stock.

For buyers, it’s a different story.

For the past 25 years, acquirers with larger market capitalizations see an average stock price movement on the first trading day after the announcement that underperforms industry peers by more than 1%, according to Trivariate Research. That shows the market’s first instinct: A deal drains shareholder value rather than increases it. The smaller the buyer, the better the stock performance after the announcement.

Part of the poor performance is the way larger companies finance transactions. Companies that buy using all cash, regardless of their market cap, see an average stock price movement that’s about 0.5% better than industry peers the day after the announcement.The market likes to see deals that the buyer finances on its own—meaning reduced risk for the buyer—and it likes to see that the buyer didn’t need to issue new shares to the target company. That’s why an all-stock deal, and even a cash-and-stock deal, causes the acquirer’s stocks to underperform the day after.

A truer gauge of a successful deal: stock returns for the buyer a few years after an announcement. For all acquirers, the average return in the two years after brings them to almost 6 percentage points of annualized underperformance versus industry peers. Even companies that make all-cash purchases see share price underperformance in the two years after a deal. The more stock that’s used in a transaction, the greater the underperformance.

Lately, M&A has appeared—on the surface—to have been a slightly better idea. In 13 of 17 transactions this year, the buyer has seen its stock gain, sometimes by double digits. But all of the companies that have seen their stocks gain double digits are smaller ones that completed transactions from $310 million to $1.8 billion. Consistent with history, the larger deals have translated into losses.

Union Pacific’s attempt to buy Northern Southern for $85 billion in cash and stock has resulted in a 1.4% share price loss for Union Pacific since it outlined the deal in late July. In that time, the Dow Jones Transportation Average is up a touch.

One concern, if regulators approve the deal, is the tens of billions of dollars of debt that Union Pacific would have to raise to pay the cash portion. It only has just over $1 billion billion of balance-sheet cash and generates less than $10 billion in annual free cash flow.

Another example of a buyer that hasn’t yet convinced the market that it will have success is Salesforce, the $232 billion software provider. The trading day after announcing its agreement to acquire Informatica for $8 billion, Salesforce saw its stock underperform the iShares Expanded Tech-Software Sector Exchange-Traded Fund by four-tenths of a percentage point. From the announcement to now, the stock is down, while software is up.

The deal is part of a larger narrative that Salesforce’s growth is slowing. It’s feasible because Salesforce generates more than $13 billion in annual cash flow, has more cash than debt, won’t borrow money for the deal, and will see earnings rise because of Informatica’s profitability. But the market is concerned that, because Salesforce has bought several assets over the years, the deal is yet another signal that the company has to look to the outside to piece together a winning software and AI strategy.

“Salesforce has bought many companies, so it’s not as integrated [versus peers],” says Rhys Williams, chief investment officer of Wayve Capital.

Be careful about investing in big acquirers.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com