Capital Wave Investing: Is it Time to Profit From the Cash-Rich Technology Sector?

A little more than one year after the economy hit bottom during the Great Recession, American companies are sitting on nearly $1 trillion in cash, a capital wave serving as a call to action for a long-moribund mergers-and-acquisition market.

And history shows that a burst of M&A activity can be just what the doctor ordered for a stock-market rally that's looking for a booster shot: After a near-record-breaking rally in the first year of the current bull market, a flurry of dealmaking could be the catalyst that fuels Year Two of the rally - perhaps even pushing stock prices back to, or even past, their previous highs.

As a rule, an increase in M&A activity is a bullish sign for both the economy and the stock market, says Money Morning Contributing Editor Shah Gilani, who tracks deals for his own advisory service, The Capital Wave Forecast. As far as capital waves go, this surge in cash-driven deals is one of the most powerful around, and will have substantial spillover effects.

 "Deals getting done is indicative of a positive outlook for the economy in that acquiring companies are looking to expand their businesses," Gilani explained. "In the current environment, most dealmaking is centered on extending the acquirer's market share and reach with regard to existing business lines - and that's healthy."

When Cash is King

Wall Street Journal analysis of data from Capital IQ shows that the 382 non-financial firms in the Standard & Poor's 500 Index that have reported results for the fourth quarter of 2009 are now holding $932 billion in cash and short-term investments - the largest cash hoard the group has ever held. That's up 8% from the third quarter and is up 31% from a year ago.

In an atmosphere of record low interest rates, an economy that keeps flirting with a rebound and lenders that are slowly loosening their purse strings, companies with cash seem inclined to use it for attractive acquisitions.  In years past, acquisitive firms might use borrowed money or their own stock to do a deal. But now cash is king, creating a promising capital wave.

In dealmaking, the appeal of cash is obvious. Cash offers a cleaner exit for investors and it has a value that doesn't fluctuate the way stock prices can between when a deal is announced and when it closes.

Through the first two months of the year, the percentage of all-cash deals in the U.S. market more than doubled from the same period in 2009, according to an analysis by Thomson Reuters. Almost half the deals announced this year have been all-cash offers - roughly the same as the healthy-economy periods of 2006 and 2007 - and well in excess of the 24% of deals done in cash in 2009.

Even such staid companies as drug store chain Walgreen Co. (NYSE: WAG), which last month spent $618 million for New York City drugstore chain Duane Reade Inc., are shunning debt to finance deals.

"We are sitting on a lot of cash and generating a lot as well," Walgreen Chief Financial Officer Wade Miquelon told The Journal.  "Sitting around on all that cash and have it earning very little interest really does not make a lot of sense."

Like a lot of U.S. companies, Walgreen cut costs during the past year, in its case by stopping new store openings and reducing inventory.  Miquelon said those tactics saved the company roughly $2 billion in cash-freeing up the money it later used in the Duane Reade deal.

"We are conservative with our cash, but hoarding it right now isn't probably the best use of it," he said.

That wasn't the corporate approach over the last two years. As the economy stagnated in 2008 and 2009, corporate executives assumed a defensive posture, slashing jobs and capital expenditures, and waiting out the financial-crisis storm.

CEO's Told to Raise Cash

More than a few companies have tied top executives' 2009 compensation by setting incentives for increasing the company's stash of cash. Aluminum giant Alcoa Inc. (NYSE: AA) cut 28,000 jobs, or 32% of its work force in 2009, and chopped capital spending by 53%. Despite posting a 31% drop in sales, the company almost doubled its cash to $1.5 billion.

Some executives will look for cash-only deals, because a huge cash hoard may be deemed undesirable by institutional investors.  Some institutional shareholders worry that management may use a big war chest as a red herring to divert attention from problems or bad decisions, or that the cache serves as a signal that CEOs can't figure out how to use it to grow the business.

Indeed, while 62 companies announced share buybacks in February, and many more are raising dividends, most big shareholders would rather see the money spent to expand the business through acquisitions.

"In many cases, if you use cash for share buybacks or dividends, you are signaling to the market you don't have a better use for the cash," Paul Parker, Barclays Capital (NYSE ADR: BCS) head of global M&A, told The Journal. "For most CEOs, that message is the last one they want to send."

Given the record low interest rates that banks are paying on deposits, companies sitting on huge piles of cash believe it makes more sense to use some of the money for deals - instead of merely settling for the low-yielding alternatives.

M&A Helped Drive Market to Previous Highs

It's no coincidence that M&A activity last peaked in 2007, the same year the Dow Jones Industrial Average hit its all-time peak of 14,093.
U.S. deal volume hit a record $1.57 trillion in 2007 - the biggest buyout frenzy since 2000.  In all, 42 Fortune 1,000 corporations were acquired, led by AT&T Inc.'s (NYSE: T) purchase of Bellsouth for $85.6 billion.

For Wall Street, the increase in M&A activity restores confidence in share valuations, while also providing a sense that things are getting back to normal. It also helps create a floor under the prices of stocks in the industry groups seeing the most play.

And the bigger the percentage of cash that's deployed in a deal, the better investors seem to like it. A 2006 study by McKinsey & Co. found that in all-cash deals, a much smaller percentage of acquirers overpay, compared with all-stock deals.

A step-up in dealmaking sends out bullish signals about future expectations - expectations for corporate profits, for economic growth and for the overall future of the country, says Money Morning's Gilani, a retired hedge-fund manager and expert on the dealmaking market.

The increase in M&A activity - especially using cash - is a capital wave that "signals that companies are focusing on consolidation and concentration, which will ultimately yield larger economies of scale, greater business efficiencies and lower product prices," Gilani says. "That typically translates into higher net margins and increased profits."

And 2007 still stands as the best year for all-cash M&A ever.  All-cash transactions in 2007 accounted for 54.5% of total dollar volume in the United States - or $796 billion worth of deals.

But the euphoria driving dealmaking in the first half of 2007 declined dramatically when the housing bubble burst and concerns about the subprime-credit markets spooked lenders.

By mid-July of that year, money became more expensive to borrow and lenders tightened up the conditions placed on loans - which made borrowing cash to make a deal prohibitive.

After that, it was all downhill: M&A transactions declined to $911 billion in 2008, and slid by another 10% to $804.8 billion in 2009. In the second half of 2009, total global merger activity declined 27% and U.S. activity fell 46%, Thomson Financial said.
And while the recent gains of nearly 70% off the March 2009 market bottom was fueled in part by the powerful capital-wave combination of government stimulus and liquidity, many observers think M&A may be just the thing to sustain the rally and push the bull market ahead as it enters its second year.

Technology Sector Leads the M&A Bulls

As the economy emerges from the Great Recession, a handful of cash-rich companies are consolidating power in the technology sector, using their wealth to expand into new businesses and making it harder for small and midsize competitors to compete.

Above all, these companies owe their strength to healthy balance sheets. 

Over the past two years, Apple Inc. (Nasdaq: AAPL) Oracle Corp. (Nasdaq: ORCL), Google Inc. (Nasdaq: GOOG), Microsoft Corp. (Nasdaq: MSFT), and six other large tech companies have generated $68.5 billion in new cash. Compare that with just $13.5 billion for the other 65 tech companies in the S&P 500 combined, according to a Wall Street Journal analysis of data provided by Capital IQ.

In fact, from the end of 2007 to the end of 2009, the 10-richest tech companies increased their cash levels by 48%, to an aggregate $210 billion, outpacing every other major business sector in the U.S. economy.  And seven of the Top 10 companies in the S&P 500 with the largest cash holdings are tech companies, topped by Cisco Systems Inc. (Nasdaq: CSCO) with more than $39 billion in cash.

That kind of cash gives the big boys the power to expand their horizons at a time when many others have been forced to pull in their horns. Over the past year, Oracle paid $7.4 billion to branch out into the hardware business by acquiring Sun Microsystems.  Dell Inc. (Nasdaq: DELL) bought Perot Systems to gain entry to technology services. And Cisco spent more than $7 billion to acquire six smaller companies.

Cisco has been particularly active in the M&A market.  Since it made its first acquisition in 1993, the world's No. 1 maker of computer-networking equipment has gobbled up an average of about one company every six weeks for 17 years.

Google, meanwhile, has tapped its savings to make at least eight acquisitions since October, funding moves into computer-operating systems and mobile phones.

Because of their massive cash accumulation, these top tech companies can afford to take risks at a time when the economic recovery remains fragile. The result is a rapidly consolidating sector, where the big fish swallow the little fish, Erik Brynjolfsson, a professor at the Massachusetts Institute of Technology's Sloan School of Management, told The Journal.

"Cash has become king to an even greater extent than in the past because of the credit crunch," he says. "A company with a lot of cash is in a disproportionately strong position now than it would be in normal times."

Investors looking to ride the consolidation wave to bolster their portfolio have several likely candidates to consider. 

Wall Street mavens say these four companies are among the tastiest takeover targets right now:

  • Brocade Communications Systems Inc. (Nasdaq: BRCD) in the storage-and-networking arena.
  • EMC Corp. (Nasdaq: EMC), the storage industry leader.
  • CommVault Systems Inc. (Nasdaq: CVLT), a leader in the back-up storage and data-protection sector.
  • And BMC Software Inc. (Nasdaq: BMC) for exposure to software used in servers.

If the risks involved with picking individual takeover targets seem too daunting, there are several mutual funds that specialize in playing M&A activity, although not specifically the tech sector.

A few you could look at include Franklin Group's Mutual Global Discovery Fund (TEDIX), the Arbitrage Fund (ARBFX) and the AQR Diversified Arbitrage Fund (ADANX). There's also a new exchange-traded fund (ETF), the IQ ARB Merger Arbitrage ETF (NYSE: MNA), which started trading in mid-November.

[Editor's Note: Money Morning Contributing Editor R. Shah Gilani - one of the key experts quoted in the preceding story - has seen it all. That's why his columns and analyses have been read by millions.

A retired hedge-fund manager and gifted analyst, Gilani regularly readers behind Wall Street's "velvet rope" - and into the world he knows so well - exposing the pitfalls that can inoculate investors against ruinous losses even as he highlights profit opportunities that most other experts never even recognize.

With his new advisory service - The Capital Wave Forecast - Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result.]

News & Related Story Links: