Industrials and Basics – We Should be Deal Shy

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@sector-sovereign.com

May 29, 2012

Industrials and Basics – We Should be Deal Shy

  • Eaton Corp’s plan to buy Cooper Industries (announced this month), reminds us that the Industrials and Basics group has flexible balance sheets and is generating plenty of free cash. Outside Metals and Mining, companies in these sectors rarely generate shareholder value through acquiring that is close to the premium obtained by the sellers. However, analyzing over 175 deals across the sectors over the last 25 years, 12 month forward returns (relative to the sector) from the acquirer post announcement are positive – averaging 6%, with a median of 1.2%.
  • More risk for acquirers occurs post close than post announcement, with average returns relative to sector 200 basis points lower than post announcement. The sectors where you are most likely to get negative returns post both announcement and completion are Capital Goods, Conglomerates and E&C – with E&C showing a terrible record.
  • Acquisition in the period from 2000 – 2010 provided more relative upside for acquirers than prior to 2000 or recently. Metals and Mining is an overall positive outlier because most deals took place between 2000 and 2008.
  • In an environment where high cash flows and more limited international growth are expected to drive greater deal flow, in search of growth, we would stay away from the more obvious acquirers. By contrast, building a portfolio of potential targets would seem appropriate. We provide screens based on free cash flow and valuation.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In general, we have not been big fans of the “growth through acquisition” strategy within Industrials and Basic Materials. There have been some spectacular examples of shareholder destruction though acquisition. History shows that acquisitions tend to happen at the higher part of the cycle (today we are in the upper half of the valuation cycle for most sectors), when the seller thinks he has achieved a reasonable price and when the buyer can afford it. Generally you do not get this sort of alignment at any other point in the cycle with the exception of distressed sales at the bottom of the cycle and generally the sales are then to private equity.

Interestingly, the long term data does not support our view and the average deal in the Industrials and Basic Materials space over the last 25 years has resulted in positive performance for the shareholder of the acquirer (relative to sector aggregate) over 12 months from the announcement of the deal and from the closure of the deal. The relative return is small and is dwarfed by the volatility (average 6% – one SD 36%).

While this positive result is counterintuitive, it is perhaps explained by human nature – we tend to remember the losses more clearly than the successes and have done more analysis to understand the losses. They tend to be driven by a combination of the reasons listed below:

  • Buyers tend to justify pricey acquisitions by asserting high levels of cost synergies which are almost always harder and more costly to achieve than originally expected. In some sectors we have seen some spectacular acquisition miss-steps, where overpaying coincided with a cyclical downturn and in a couple of cases resulted in bankruptcy or something close to it.
  • If a company with a lower historical multiple buys or is bought by a company with a higher historical multiple the combined business migrates to the lower multiple, not the other way. It is much easier to make a less cyclical business look more cyclical through acquisition than it is to do the opposite.
  • In already fairly consolidated businesses, a “consolidating move” will generally result in lower sales growth rather than higher, as customers avoid supplier concentration by buying less from the combined entity.
  • Competitors see any acquisition or merger as an opportunity to gain share as however well any combination is handled, the companies involved in the deal take their eyes off the ball as they are distracted by internal processes.

Some companies are very good at business combinations, most often those that grow through a series of smaller “bolt-on” acquisitions where lessons learned from one deal are quickly applied to the next. Big deals tend to be “one-off” in nature and not frequent – there is often no experience at integrating large businesses and what may have been learned from a prior deal has been forgotten over the years in between.

We have seen a recent spate of cash based deals – or attempts to sell for cash. On the part of the seller this is a low risk approach as the selling shareholders then do not risk participation in any cyclical or integration issues post deal closure. Cash deals amplify the risk to the buyer and there is a list of very good examples of deals that have either crippled or severely hamstrung the buyer – mostly in the chemical space over the last 15 years: Access Industries/Lyondell; Dow/Rohm and Haas; Georgia Gulf/Royal Group; Lyondell/Arco Chemical.

The Industry In Aggregate Has Capacity to Buy

At the end of 2011, the companies that make up our index (excluding GE) had a combined total of $110 billion of cash and short term investments on their balance sheet (so a little more than Apple!). This is a slight decline on 2010 (2%), but it is almost double the cash of the same group at the end of 2006. Cash as a percent of Revenues and Net PP&E is summarized in exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

The cash is to a large degree surplus to operational needs, as PP&E spending is stable, though up from a cyclical low in 2009/2010. Commodity chemicals is a sector where we would expect to see an increase in PP&E spending as companies invest to exploit the lower cost natural gas opportunity in the US, but cash flows are higher as a result of the cheaper natural gas so there is considerable offset. Capex as a percent of installed PP&E by sector is summarized in Exhibit 3 and while we have bounced back from the fear driven lows of 2008 and 2009, we would still expect to see some further increases in all sectors. However, as can be seen in the prior exhibit there is plenty of cash available to do this and have plenty left over.

Exhibit 3

Source: Capital IQ and SSR Analysis

The Data Show That All Things Are Possible

Exhibit 4 shows the spectrum of 12 month returns relative to sector for 175 M&A transactions in the Industrials and Basics sectors that we cover. The chart shows a very large number of deals in the +25% to -25% range, but plenty of outliers in both directions.

Exhibit 4

Source: Capital IQ and SSR Analysis

We have only included acquisitions that were either greater than $1.0B in value or were greater than 8% of the acquiring company in terms of market value. The complete list of transactions is shown in Appendix 1. For each deal we have looked at performance of the acquirer in the 12 months post announcement and the 12 months post completion. We have then cut the analysis in a number of different ways:

  • Absolute performance aggregated by sector
  • Performance relative to the S&P500 aggregated by sector
  • Performance relative to the specific sector (aggregate by sector)
  • Relative performance based on time period
  • Relative performance based on size of deal relative to acquirer.

A summary of the results is shown in Exhibit 5, but the most interesting conclusions are discussed following the exhibit.

Exhibit 5

Source: SSR Analysis

Recent Deals Have Driven Negative Investment Returns – Exhibit 6

Prior to 2000 we saw mixed results and a poor period of performance from acquirers from 1996 to 2000. The period from 2000 to 2010 saw aggregate acquirer stock performance well above the 25 year average. Since 2010 the average has fallen dramatically, and shareholders have lost absolute and relative money by owning acquirers. While the recent data point does not represent a long time period, we have a sample of 25 deals in this period. Part of the explanation of outperformance in the 2000 to 2010 period is explained by the outperformance of the Industrials and Basics groups in general over that period.

Exhibit 6

Source: Capital IQ and SSR Analysis

Outliers Distort the Analysis In Some Cases

If you look at the performance metrics relative to the S&P500 and take out the handful of deals that have extreme results – i.e. 12 month relative performance over 75% or worse than -75% you get a different picture in a couple of cases – Exhibit 7. The Chemical sector, which on the full analysis suggests that acquirers have outperformed post deal close, gives you the opposite answer when you take out the extreme cases, suggesting that the data is distorted by one or two positive outliers. Capital Goods and Metals and Mining also look worse with the outliers removed. E&C is changed completely – one deal that went extremely well, and was well timed, completely distorts the average and without it the track record is poor.

Acquirer 12 Month Performance relative to the S&P 500

Exhibit 7

Source: Capital IQ and SSR Analysis

The outliers excluded from Exhibit 7 are not necessarily good deals, they may have been well timed, to coincide with a cyclical recovery, or badly timed, to coincide with a cyclical collapse. There is no theme to the outliers from which we can derive conclusions about what is a good or bad deal – they simply distort the analysis.

Metals and Mining Deals Have Generated Good Returns.

This is partly because the bulk of the deals took place in the period from 2000 to 2008, when confidence in the sector was very high and when performance was good. The acquirers outperformed the sector materially during that period.

Surprisingly, Chemicals does not Have the Worst Track Record!

While chemicals has some of the more spectacular acquisition errors, as suggested earlier, in aggregate the acquirers have generated a positive return for shareholders relative to the sector post deal announcement and deal closure. As discussed above, the positive result is caused by a couple of positive outliers. One is Dow Chemical’s performance post the closure of the Rohm and Haas deal, where a cyclical recovery more than doubled the value of the stock in the 12 months following the deal closure.

The standard deviation is very high and in some cases the post 12 month numbers are more telling, such as GGC post the Royal acquisition and Lyondell post the Arco Chemical acquisition. The Dow/Rohm and Hass deal probably destroyed significant shareholder value, based on the decline in Dow’s stock post the deal announcement, but so did 2008 in general, and it is hard to separate one from the other. There have been some very good deals in the sector and enough to bring the average return above zero for acquirers relative to the rest.

Capital Goods, Engineering and Construction and Conglomerates have the Worst Results

We began this report by referencing the Eaton/Cooper deal, and it is noteworthy that Capital Goods is the sector where you should have been indifferent about owning the acquirer rather than the group. There is considerable variation but the average return relative to the sector is zero.

Engineering and Construction has seen one good deal and the rest have been very bad news for shareholders. Generally the acquirer underperforms post announcement and post closure.

Size Does Not Matter – (regardless of what they might say)!

As show in exhibit 8, size appears to be irrelevant – there is minimal correlation between the size of the acquisition relative to the acquirer and 12 month performance. While there are instances where deal post-mortem might have concluded that the “deal was just too big”, the data is not supportive.

Exhibit 8

Source: SSR Analysis

Given the variability of returns for acquirers and the almost guaranteed premium for targets – there is no question that you want to own the target not the sniper.

In the analysis above we are comparing results that have relatively small average returns relative to the market and the specific sectors, whether the average is negative or positive. In addition, in every sector and in aggregate the range of historical outcomes is extremely wide and it is not obvious what makes a good deal and what makes a bad deal at the margin.

By contrast, almost every target is taken out at a premium either to book value or to market value and that premium is earned quite quickly and with a high degree of certainty. Premiums paid for acquisition targets are multiples of average returns generated by acquiring companies, with the possible exception of Metals. Taking a sample of more than 25 public deals, we have an average acquisition premium greater than 30%.

There is little argument that you want to own the buyer.

In exhibit 9 – we show a list of companies in our coverage universe with valuations below normal and a market cap below $5bn. We would put these in the acquisition target camp.

Exhibit 9

Source: SSR Analysis

In exhibit 10 – we show a list of companies with a market cap above $10bn and net debt to capital below 25%. These companies sit in our potential acquirers camp.

Exhibit 10

Source: SSR Analysis

Appendix 1

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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