Instead of investing to build their businesses, companies are taking a shortcut to growth by buying other companies.
The deals keep getting bigger…and one of the gravest financial warnings of 2015 keeps growing in relevance.
Last month, legendary investor Carl Icahn publically warned that cheap money is fueling a bubble in dealmaking. Icahn said:
…[W]hat [companies] do with the money is almost perverse. They just go in and buy another company to show analysts on Wall Street that earnings are going up, so their stock will go up and it’s financial engineering at its height.
Icahn is known for buying huge stakes in “broken” companies…taking a seat on the board…and trying to turn the companies around. He knows more than almost anyone about buying companies.
• Last week, we were reminded of Icahn’s warning…
On Thursday, pharmaceutical giant Pfizer (PFE) revealed plans to buy drugmaker Allergan PLC (AGN).
Pfizer is the 12th-largest publicly-traded U.S. company. It’s worth $213 billion. Allergan is another huge drug company. It’s worth $123 billion.
If the deal goes through, it would create the sixth-largest publicly-traded company in the U.S. The new company would dethrone Johnson & Johnson (JNJ) as the world’s largest healthcare company.
Pfizer-Allergan would be biggest deal in a monster year for mergers and acquisitions. On Sunday, Financial Times said 2015 is shaping up to be the biggest year ever for global dealmaking:
With close to $4tn worth of deals already announced this year, 2015 is on track to beat the all-time record of 2007, when the credit bubble helped generate $4.3tn worth of transactions.
• Pfizer has already made a big acquisition this year…
In September, Pfizer completed its $15 billion purchase of pharmaceutical company Hospira.
Pfizer’s management hopes these deals will help the company start growing again. Pfizer’s annual sales have declined, for the last four years, by an average of 6.5% per year.
If management’s track record is any indication, the acquisition of Allergan won’t create value for Pfizer’s shareholders. Since 2000, Pfizer has spent more than $235 billion buying other companies. However, Pfizer is only worth $213 billion today.
Pfizer isn’t the only company in the healthcare sector making big deals. Last week, Financial Times reported global healthcare companies have announced $850 billion worth of deals this year.
In July, health insurance company Anthem (ANTM) agreed to buy rival Cigna (CI) for $48.3 billion. The deal will create the nation’s largest health insurer.
And last Tuesday, pharmacy chain Walgreens (WBA) bought rival Rite Aid (RAD) for $17 billion. It was a pricey acquisition…Walgreens paid more than a 50% premium to Rite Aid’s share price, and 21 times Rite Aid’s book value.
• Record low interest rates are driving the massive increase in dealmaking…
During the 2008 financial crisis, the Federal Reserve dropped its key interest rate to effectively zero. The Fed has held rates near zero ever since.
Seven years of zero percent rates have made it ridiculously cheap to borrow money. Many companies have used this as an opportunity to buy out competitors with borrowed money. According to the Securities Industry and Financial Markets Association, U.S. corporations borrowed a record of $1.2 trillion in the bond market through the first nine months of 2015.
• Buying a competitor can boost sales and profits…
But Carl Icahn notes the “high” usually wears off quick.
Last month, Icahn said buying a company with borrowed money was like “taking a drug.” It can cause sales and profits to jump, but the benefit usually only lasts a year or two.
Icahn says U.S. companies are buying up rivals to goose their earnings numbers. He says this is masking major problems in corporate America. And the facts back up his claim…
Last week, The Wall Street Journal explained how U.S. business investment has stalled since the financial crisis:
Business investment in the real economy is weak. While U.S. gross domestic product rose 8.7% from late 2007 through 2014, gross private investment was a mere 4.3% higher. Growth in nonresidential fixed investment remains substantially lower than the last six post-recession expansions.
Instead of investing to build their businesses, companies are taking a shortcut to growth by buying other companies. In July, Forbes reported that 54% of CEOs in the U.S. plan to complete an acquisition by the end of the year.
• Earnings growth has been sluggish…
Earnings for companies in the S&P 500 have only grown 6.9% annually since 2011. That’s far less than during past economic expansions, according to The Wall Street Journal. Earnings grew 12.9% per year between 2003 and 2007. They grew at 11% per year between 1995 and 1999…
As of Friday, 340 companies in the S&P 500 reported third-quarter results. So far, earnings have declined 2.2% from last year. We can’t know for sure until all the results are in, but it appears that earnings will decline overall this quarter. If that happens, research firm FactSet says it will be the first time since 2009 that earnings have declined two quarters in a row.
If you’ve been listening to Icahn’s warnings, this bad earnings news shouldn’t be a surprise. Instead of investing in their businesses, companies are using cheap money and financial engineering to boost profits. That can work for a while. But once the “high” wears off, you’re left within shrinking profits and no growth.
Chart of the Day
Don’t buy into the “recovery” hype…
Today’s chart shows the number of people enrolled in the U.S. federal food stamp program. As you might expect, the number of people on food stamps surged during the financial crisis.
However, food stamp usage kept rising through 2013. More than forty million Americans are still on food stamps today, nearly double the pre-crisis number. This isn’t what a healthy, growing economy looks like.
This article first appeared on Casey Research.com.