Even mediocre M.&A. deals are getting a thumbs-up from investors. Kroger’s $2.4 billion purchase of rival Harris Teeter looks mildly value-destructive. The value of savings from combining the grocers equals about half the premium being paid. Yet investors added about $500 million to Kroger’s market value. The more puzzling riddle is why so few deals are being done, given the market’s seemingly indiscriminate hunger for them.
Kroger is paying a premium of around 33 percent, or more than $600 million, to snag its upscale rival. In order not to alienate its loyal clients, the company promises to keep most everything the same - it is even keeping the brand name. That, combined with limited overlap, means synergies are small. The company estimates $40 million to $50 million of savings. Taxed and discounted, these are worth only about $300 million or so today.
Moreover, Harris Teeter isn’t cheap. The company should make under $200 million in operating profit this fiscal year. Even with the cost cuts, that’s around a 10 percent return on investment for Kroger. That’s hardly spectacular. Instead, it seems investors are latching onto two things. Harris Teeter’s focus on high-end customers may protect it better than much of Kroger’s business against big-box competition from the likes of Target and Wal-Mart. And second, the company is financing the deal with debt. Given how cheap borrowing is, that gives a low cost of capital hurdle rate.
A better question however, is why investors aren’t receiving more deals to greet warmly. Sure, the total amount of capital of agreed U.S. mergers and takeovers is up 20 percent so far this year to $327 billion, according to Thomson Reuters. But much of this is explained by a few, very large deals, such as SoftBank’s $22 billion purchase of Sprint Nextel.
The total number of deals in the biggest corporate finance market has stagnated. With debt still cheap, and investors quacking for more, it’s probably a matter of time before bankers and company boards throw investors more deals, including a lot more crummy ones, to nibble on.
Robert Cyran is a columnist for Reuters Breakingviews. For more independent commentary and analysis, visit breakingviews.com.
