Following the deepest recession the U.S. economy has witnessed in seven decades, the bull market that has followed has been equally monumental with the broad-based S&P 500 up practically 200% since its March 2009 low.
Beyond just seeing the S&P 500 rise, there are a number of other tangible clues that signify we're in thick of a bull market. The unemployment rate has ticked to a multiyear low of just 6.1%, consumer spending, home prices, consumer confidence, and factory orders are all up, and lending rates continue to traipse along near historic lows.
M&A returns with a vengeance
Perhaps the biggest indication of all, though, is the return of merger and acquisition occurrences. As noted by the Financial Times this week, the cumulative value of M&A activity hit $1.7 trillion (with a "t") in the first-half of 2014, which is up 75% from the prior-year period. It also represents the highest level of buyout activity we've witnessed since 2007.
The reemergence of M&A activity is important for a couple of reasons.
First and foremost, M&A activity demonstrates that acquiring businesses are willing to take on risk. Generally speaking, the company being purchased is bought at a premium to its previous closing price, meaning a purchaser is going to pay extra for what it perceives will be positive financial results from combining down the road.
Secondly, M&A activity also implies that a business has good earnings visibility and a positive long-term sector outlook. Think about it this way: What companies is going to pay a premium for another if it doesn't have a good idea of where the long-term business trends are headed? Simply seeing M&A activity pick up is a good sign that a sector or industry is expected to see robust growth over the long run.
Finally, M&A activity is also a source of cost synergies and improved operational efficiencies. For some companies, M&A helps expand their geographic reach or broadens their product portfolio. For other companies, M&A allows for duplicate business operations to be eliminated, ultimately saving on expenses and boosting profits for the combined entity.
The positive side of M&A in health care
One industry where we've witnessed a considerable amount of M&A activity of late is in health care. Long term trends, such as a growing global population that's living longer, certainly favors the idea that pharmaceutical drugs, medical devices, nursing homes, and hospitals are all going to see increasing demand as time goes on. In addition, the implementation of the Affordable Care Act, better known as Obamacare, has completely altered the dynamics and cost structure of receiving medical care, causing some companies to seek cost-cutting mergers.
But one potentially disturbing trend has also emerged out of the rampant M&A in the health care industry -- one with Catch-22-type potential. Namely, U.S.-based health care companies making offers for and/or acquiring overseas companies and then relocating their headquarters to these overseas markets.
"Why would a U.S. firm purchase an overseas company and then choose to relocate its headquarters outside the U.S.," you ask? With the exception of the United Arab Emirates, the U.S. has the second-highest corporate marginal tax rate in the world at 40%. By comparison, the global average corporate marginal tax rate is just 23.5%. In other words, U.S. corporations could purchase a company in just about any other country, relocate their headquarters, and reap the rewards of lower corporate taxes. The cost savings could, in turn, be used to expand the business or perhaps even boost shareholder incentives through share buybacks or dividend payments.
Since April we've witnessed a flurry of M&A offers in the health care sector. Pfizer (NYSE:PFE) was possibly the most prominent with its unsuccessful pursuit of U.K.-based AstraZeneca. Pfizer began with a bid of just shy of $100 billion and ultimately boosted its offer twice more to $118 billion before being rebuffed by AstraZeneca. Had the two been able to combine it would have created the world's largest pharmaceutical company and, with a peak marginal corporate tax rate of 21% in the U.K., could have saved the combined entity upwards of $1 billion annually.
But this was really just the beginning. Irish drugmaker Shire (NASDAQ:SHPG) confirmed last month that it had received an unsolicited bid of roughly $46 billion from AbbVie (NYSE:ABBV) in late May. Like AstraZeneca, Shire turned down the offer with Shire's board noting that it drastically undervalued the company given its potential to double its revenue between 2013 and 2020, and would unfairly deny existing shareholders the opportunity to take advantage of its growth potential. Ireland is a particularly attractive target for purchasing companies since its peak marginal corporate tax rate is just 12.5%, and for many businesses it can even be in the single-digits following deductions.
Even smaller companies are getting in on the action. A little more than a week ago Auxilium Pharmaceuticals (UNKNOWN:AUXL.DL) announced an odd buyout of Canada's QLT that'll see the company issuing 3.1359 shares of QLT common stock to existing Auxilium shareholders, essentially rolling Auxilium into QLT as opposed to the other way around. In return, Auxilium can relocate its headquarters to Canada where peak marginal corporate tax rates are just 26.5%.
But as I said, there's a Catch-22 here as well. Although corporate tax inversion, (i.e., purchasing an overseas company in order to relocate and gain a tax benefit) could help fuel the bull market rally, and it almost certainly cuts the tax bill for acquiring companies, it's also the "un-American" equivalent to tax dodging.
Take drugstore giant Walgreen (NASDAQ:WBA) as a good example. Shareholders in Walgreen have requested the company purchase the remaining unowned stake in Swiss-based Alliance Boots and relocate overseas. Switzerland's peak marginal corporate tax rate is a minuscule 17.92% according to KPMG and would save Walgreen in the neighborhood of $800 million annually. If Walgreen even returned half of these savings to shareholders in the form of a dividend it'd boost Walgreen healthfully above a 2% yield.
But consider this: Walgreen also generates about one-quarter of its $72 billion in annual revenue from government-sponsored Medicare and Medicaid programs. Walgreen relocating outside the U.S. would be the ultimate slap in the face to the U.S. government and taxpayers considering its intricate ties to the U.S. economy.
The concern here is that if too many businesses start relocating overseas then the U.S. government could begin to see its corporate revenue collected from taxes fall significantly. Last time I checked the federal budget was still running a sizable annual deficit, so this would be potentially bad news for consumers and the stock market over the long run.
Where do you stand?
This recent M&A trend leaves investors at a tough crossroad: accept that businesses could save money by relocating overseas and hope that the lower expenses translate into bigger profits, share price appreciation, and potentially a fat dividend; or rail against businesses attempting to avoid U.S. corporate taxes as it could create major U.S. budget shortfall headaches down the road.
There's certainly a viable case to be made for each side. Where do you stand?