But in a market that has little tolerance for wasted capital and is scrutinising each deal closely, what does “good” and “ugly” look like? And what are the red flags that investors look for that signal a “bad” deal?
It has been said for many years that Australian fund managers would prefer companies to retain their capital and continue to pay full franked dividends, but this isn’t entirely the case. Some fund managers actively look for opportunities where M&A can accelerate growth and while there have been many high-profile errors over the last two decades, there are also plenty of examples of Australian companies accelerating their earnings and strategic positions too. At First Sentier Investors, we believe companies should seek to use their financial and management resources to create the capability to grow internationally, but this must be done prudently.
The good, the bad and where the jury’s out on M&A
There are many great examples of Australian M&A success stories. CSL’s (ASX: CSL) 2003 acquisition of Aventis Behring and 2015 acquisition of Seqirus has seen it emerge as a global leader in blood products and influenza vaccines. Similarly, Aristocrat Leisure (ASX: ALL), Macquarie Group (ASX: MQG), BlueScope Steel (ASX: BSL), Computershare (ASX: CPU), and WiseTech Global (ASX: WTC), among others, can all reference financial and capability growth through international acquisitions.
However, investors are also able to point to a proliferation of “bad deals”. While BHP Group (ASX: BHP) made a series of company-making acquisitions in Queensland coal, Chilean copper, and Western Australian iron ore assets back in the 1980s, its track record since has been poor. The dollars wasted in the Billiton merger and the expansion into US shale assets have been seared into the stock market’s memory. More recently, the “jury’s out” on the OZ Minerals acquisition made in 2023 and there was natural investor scepticism around the complicated proposed Anglo American acquisition earlier this year.
Beyond M&A, consolidation has also been rife across corporate Australia and there have been examples where this has benefited consumers and shareholders. In the retail supermarket space, companies like Coles Group (ASX: COL) and Woolworths Group (ASX: WOW) have been able to access volume and scale advantages that has significantly reduced the cost to serve consumers. In the banking sector, the big four banks have been able to bring scale and balance sheet resilience, particularly during periods of economic stress, that have benefited both shareholders and customers.
The red flags of bad M&A
When companies make acquisitions, they provide real insight into their financial strategic thinking and discipline.
At First Sentier Investors, we consider factors such as whether a company is buying from private equity (where we are naturally sceptical), whether the financial metrics are heavily reliant on revenue and/or cost synergies, the level of financial disclosure provided around particular acquisitions, the financial accounting used and, importantly, why the acquisition is being made. For instance, is it being undertaken to fill an upcoming earnings hole?
As an investor, it is somewhat difficult to assess the merits of a company’s choice of software supplier or the location of its distribution centres; however, the financial and strategic merits of an acquisition are more distinct and therefore more easily judged. Return on capital (or equity) when an acquisition is made and on an overall basis are the key drivers of our investment process.
Why this investor thinks EBITDA is a poor measure for valuations
When it comes to looking at the valuation of a company, the First Sentier Australian Equities Growth team use a discounted cash flow technique supported by 10 years of earnings forecasts, which allows us to capture the longer-term value of a company.
This can be crosschecked using a PE ratio (market capitalisation to net profit after tax and amortisation) or an EV/EBITA (enterprise value to earnings before interest and taxes) multiple. This facilitates a quick comparison across the market among stocks in very different sectors.
One measure that is frequently used by investment banks and their analysts, private equity vendors and the financial press that we feel is entirely inappropriate is EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortisation). This measure does not capture the capital intensity of a particular company, for example Telstra (ASX: TLS) needs to spend far more capex per dollar of EBITDA than Computershare or Aristocrat are required to do, and therefore their respective EBITDA multiples are not comparable.
So, with M&A activity having accelerated over the past 12 months, we have been busy scrutinising both the financial and strategic merits of M&A and what the particular company is telling us about their financial and strategic future.
David Wilson, deputy head of Australian equities growth, First Sentier Investors
