Mergers, acquisitions and divestitures tend to accelerate when profits are nearing a cyclical peak says Moody’s.
Once it becomes apparent that organic revenues will fall short of expanding rapidly enough to supply sufficient earnings growth, companies often either look to the outside to acquire growth or attempt to divest underperforming businesses.
The previous two record highs for yearlong M&A activity involving at least one US-based company as either buyer or target occurred in the third quarter of 2007 and 2000’s first quarter. The cycle peaks for the yearlong averages of pretax profits from current production were set prior to the tops for M&A, in Q4-2006 and Q4-1997, respectively.
Between the peaks for profits and M&A, yearlong M&A posted scintillating average annualized growth rates of (i) 32.5% from Q4-2006 to Q3-2007 and (ii) 37.2% from Q4-1997 to Q1-2000. Similarly, M&A advanced by 15.9% annually, to a record $3.325 trillion, between profits’ latest peak of Q1-2015 to Q1-2016’s new zenith for M&A.
Latest Ratio of M&A to Profits Hints of Final Stage for Current Upturn
Since 1988, the ratio of M&A to pretax operating profits has averaged 90%. Nevertheless, the ratio of M&A to profits changes considerably throughout the business cycle. For example, the ratio of M&A to profits increased from its 73% average of the first four years of 2002-2007’s business cycle upturn to 121% during the recovery’s final two years. Moreover, after averaging 58% of profits during the first seven years of 1991-2000 economic recovery, M&A soared to 197% of profits during the upturn’s final three years.
The current recovery has followed the same pattern. Through the first five years of the current recovery through June 2014, M&A averaged 74% of pretax profits from current production. However, for the following two years ended June 2016, M&A averaged 144% of profits. As inferred from the recent historical trend, the 154% ratio of M&A to profits for the year-ended June 2016 suggests that the current business upturn is much closer to its demise than to its inception.
Rebound by Equities Contradicts What Occurred Following M&A’s Prior Two Record Highs
The continuation of subpar profitability offers no assurance of new record highs for M&A, especially if some combination of higher share prices amid above-average earnings uncertainty increases the risk of overpaying for business assets. At some difficult to define inflection point, persistently soft profits begin to weigh on M&A.
The previous two record highs for M&A suggest that M&A is likely to recede amid below-trend profits once the market value of US common stock crests. Immediately after M&A’s yearlong sum peaked in Q3-2007, the market value of US common equity set a new record high in October 2007. Similarly, March 2000’s then record high for the market value of US common stock occurred at the very end of an earlier record high for the yearlong sum of M&A.
Though the moving yearlong sum of M&A is likely to continue to fall from its latest zenith of Q1-2016, the market value of US common stock’s moving 20-day average has rebounded by 16% from its most recent low of February 15, 2016. Nevertheless, M&A has been unable to respond positively to higher share prices owing to how both business sales and profits have yet to convincingly establish rising trends. The fact that Q3-2016’s moving yearlong sum of M&A was down by -12% from its Q1-2016 peak hints of a growing sense among prospective buyers that business assets are grossly overvalued. The longer M&A slides amid a rising trend for share prices, the greater the likelihood that an equity market bubble has formed.
