Any time someone spends more than $1 billion to buy a company with little revenue and no profits, someone’s going to raise an eyebrow or two. But Yahoo’s acquisition of Tumblr, announced Monday morning, makes sense not just as a particular strategy for the businesses in question but as part of the larger macroeconomic landscape. All the pieces are falling into place for a large wave of mergers and acquisitions, particularly of privately held companies.
The key fact is that even though a handful of high-profile deals like Facebook buying Instagram or Yahoo buying Tumblr continue to make the news, the actual pace of mergers and acquisitions activity over the past year has been modest. David Gelles and Michael Mackenzie reported over the weekend in the Financial Times on a new analysis from S&P Capital IQ showing that only 25 percent of corporate loans are funding acquisitions, way down from the 60 percent share seen in 2006. Where’s the money going instead? As Bernard Condon wrote on Saturday, we’ve lately seen firms investing huge amounts of cash in buying their own stock.
That’s resulted in what Condon termed a “narcissist’s rally,” as so far in 2013 “big U.S. companies have given the go-ahead for $286 billion of buybacks, up 88 percent from the same period last year according to Birinyi Associates.” These repurchases have been a key driver of the most recent phase of the stock market rally that’s driven the S&P 500 index up to nominal record highs.
Those inclined toward paranoia see the foundation for a new bubble here. But the fundamentals in corporate America are very different from what we saw back in 1999. The truth is that in the wake of the great 2008 financial crisis and the deep recession of 2009, most stocks became extremely cheap relative to the profitability of corporate America. For years we got sob stories about how corporate profits had recovered but wages hadn’t, with few noting the fact that stock prices had stagnated along with wages. The more recent wave of sob stories about how the stock market has recovered but the labor market hasn’t is just the next logical step. A recovery for capital but not for labor is frustrating, but a recovery for corporate profits and not for share prices was absurd. So companies with cash on hand found themselves in the curious situation where a narcissistic investment strategy made perfect sense. A total breakdown of confidence and trust had made established, profitable businesses cheap. The low interest rate environment meant that investing in just about anything was cheap, but far and away the easiest investment for any firm to analyze is an investment in itself.
But now that markets are back up, we should expect the trend to change. Most shares aren’t particularly cheap anymore, but cash still is.
Wall Street types are becoming increasingly antsy and vocal about what they characterize as “artificially low” interest rates, but there’s nothing artificial about it. With inflation low and stable there’s simply no reason for interest rates to rise. That means holding cash and cash-like assets is a very unattractive proposition. Whether or not buying Tumblr will pay off for Yahoo in the long run, it’s clear that buying something was a smart play. Sitting on cash is a weak move. In normal times, firms might hoard cash for the sake of “strategic flexibility”—worrying that an acquisition today will make them unable to make an even better acquisition tomorrow. But even junk bonds pay less than 6 percent interest these days. At those rates, a target firm would only need to earn slightly above-average profits to pay off. So there’s no reason not to do a good deal today simply because you’re worried that a great deal might come along tomorrow. If you’ve got the cash, you might as well spend it.
For the sake of the broader economy, the hope would be that cash-rich firms won’t just buy up other companies. We’d like to see corporate America invest in lots of new office buildings and storefronts and buy up gobs of trucks, machines, and other capital equipment. That means jobs for the people building the trucks and buildings and jobs for the people managing the equipment. But buying up a whole company is a good shortcut method of obtaining capital goods. And in the technology sector, it’s almost the only way to do it. You can’t purchase Web traffic, mobile engagement, or a youth-oriented brand identity on the open market the way you might get a forklift, a parking garage, or a new deep fryer. Inventing great new ideas in-house is going to be any sensible company’s preferred growth strategy, but if you’ve already got money in the bank, there’s no better move than trying to identify a solid private company and swallow it whole.
But just because acquisitions make sense right now doesn’t mean that all acquisitions will turn out well. Corporate history is full of absurd takeovers and mismanaged mergers. The time is right for companies to buy other companies, but the ones that prosper will be the ones that show good judgment in their shopping sprees. A strong track record of mergers and acquisitions isn’t typically how executives rise to the top in Silicon Valley, but it could make or break many of today’s leading tech firms.
