Citigroup Report Urges Deal-Making, Activist Thinking

Citigroup has a stark message for its corporate clients: They are going to have to justify those lofty valuations.

Over the last year, even as stock prices have soared, global revenue growth has slowed and profit margins and earnings per share have declined. Many companies, it seems, are enjoying record high valuations not because of strong results but because of investor optimism.

“There is a dichotomy between the earnings environment and equity valuations,” said Ajay Khorana, global co-head of Citigroup’s financial strategy and solutions group. “Corporates have a challenge and are going to have to defend their valuations going forward.”

Mr. Khorana co-wrote a report, ”Corporate Finance Priorities for 2014,” that Citigroup is distributing to its clients this month. In it, the bank highlights what it calls a dichotomy between market performance and corporate results and suggests tactics that companies might use to improve earnings so their valuations are based not on wishful thinking but on the bottom line.

At the top of the list is deal-making. Though the volume of global mergers and acquisitions was basically flat in 2013, there is consensus that 2014 could be busier, especially in the United States. Citigroup suggests clients get off the sidelines and pursue transactions that are accretive. It also makes the case that companies ought to feel comfortable paying a bit more.

The median premium in M.&A. transactions was 24 percent last year, the lowest since 2007. Part of that is the result of the strong equity markets, which have pushed prices up. But it is also the result of the caution that has pervaded boardrooms and executive suites in recent years. However if M.&A. is to pick up, companies may have to pay up.

To a certain extent, Citigroup is talking its own book here. The more deals its clients do, the more fees it collects. But there is broad evidence that these days, M.&A. is good for a buyer’s valuations, too. On average, Citigroup’s report said, the share prices of buyers rose after a deal was announced, which is a departure from the historical norm. In some cases, the jump in a company’s stock price on news of the deal added market value equivalent to or even greater than the price of the deal itself.

Citigroup also cautioned clients against their continued reliance on share buybacks and dividends. Over the last three years, dividend distributions by nonfinancial companies in the S.&P. 1,500 have jumped 43 percent, to almost $300 billion, and share buybacks have risen 48 percent, to $429 billion.

But while buybacks and dividends are seen as a safe use of cash, they are not always rewarded in the markets. Companies that have relied on share repurchase programs have experienced contraction in their valuation multiples, and with share prices so high, buybacks are not necessarily the best use of a company’s capital.

“The amount of spending on share repurchases and dividends is off the charts,” Mr. Khorana said. “But the rate of return you can earn on a traditional buyback, given where valuations are, is going down.”

Another message in the report: prepare for higher interest rates. Citigroup said it expects the 10-year Treasury note to hit 3.5 percent by the first quarter of next year as the Federal Reserve scales back its bond-buying stimulus program.To hedge against this, companies can work on securing long-term financing for anticipated costs now while rates are at historic lows. They should also prepare for lower profitability, the report said. And a higher dollar could also put pressure on earnings at companies with meaningful overseas cash flows.

“The cost of debt capital is going to rise,” said Elinor Hoover, also global co-head of Citigroup’s financial strategy and solutions group. That means that for companies looking to finance a M.&A. deal with debt, there is only so much time to act before interest rates make transactions more expensive.

Citigroup’s final suggestion for boards and executives is to think like an activist. Activism has never been more prominent, with more than 200 campaigns started last year, Citigroup said. Companies of all shapes and sizes are under threat, prone to be singled out by hedge funds who think they know how to drive up a company’s stock price better than management does.

This is especially true for conglomerates, which trade at an average 7 percent discount to their pure-play peers, according to Citigroup. Activists have homed in on this, and half of their campaigns are now at companies with multiple business lines, the bank said. Instead of simply looking at capital allocation, activists are increasingly looking to break up companies. “The agenda is moving from the tactical to the strategic,” Ms. Hoover said.

Though it is hard to defend against activists once they begin a campaign, Citigroup suggests companies try and dissuade them from even trying by ruthlessly scrutinizing their own capital allocation, business mix and governance structures, even if it makes for some uncomfortable conversations in the boardroom.

Altogether, the report suggests that while companies have enjoyed a startling rebound from the depths of the financial crisis just five years ago â€" thanks largely to last year’s optimism of a recovery â€" they will need to work harder than ever to maintain their edge.

“A lot of the low-hanging fruit has been picked off already,” Ms. Hoover said.