Is a Consolidating Industry a Good Buy?

Here’s a thinking-out-loud post. And I have to warn you beforehand, I have no conclusions to draw. This is a lot of just me babbling. But bear with me.

The issue I’ve been pondering lately is: Is an industry undergoing consolidation likely to be a good or bad investment?

I lean towards thinking it’s a bad one, but I’m not fully convinced. The crux with a thought exercise such as this is that it deals with generalities, and it makes us focus on why a particular industry might be undergoing consolidation.

On the plus side, an investor can do quite well if they own the target of a buyout. He can make a handsome premium overnight. But obviously, there are risks as well. Even announced deals can fall though. The acquisition target usually has to be a smaller player that offers something the big boys don’t have. The economics of the industry have to reach a point where it’s easier to buy market share rather than go out and work for it. On top of that, if financing is important, then the bond market has to cooperate as well. Sometimes, that means the junk-bond market.

I often look at previous buyouts and quite frankly am baffled as to why a large organization which must have had a lot of smart folks working for it made such an obviously poor decision. Hindsight bias? Possibly. Yet all too often, Company A’s motives for buying Company B remain mysterious. It’s surprising how often the answer is nothing more complicated than they felt that they had to do it before Company C moved in. These moves are made by people who thought that they had no other option, or were choosing the least-worst option. Hence it’s good to be generous when judging the past.

So what causes a merger wave in an industry? There are times when the driving force is a change in regulations. In 1999, Congress repealed parts of the Glass-Steagall Act, which spurred a wave of banking consolidation. In fact, Citicorp bought Travelers (to form Citigroup) before Congress acted. They forced the issue and assumed, correctly, that Congress would change the law. With a regulatory-related change, I would be hesitant to say that the industry in question is either good or bad for investors because so many variables are in flux. For example, I’m inclined to believe the big-tobacco settlement was very bullish for tobacco stocks, yet I’m not sure of the specifics.

In my mind, the strongest bear argument against a consolidating sector is that it isn’t consolidating because it’s growing too fast. At some level, future growth is broadly seen as being in doubt. And that’s probably right.

In a commodity-related business, a fall in the price of the commodity can spark a wave of consolidation. In the late 1990s, the price of oil dropped sharply, and in 1999, Exxon merged with Mobil to form ExxonMobil (I’m still surprised they haven’t dropped the Mobil part). The year before, British Petroleum and Amoco got hitched.

It’s a matter of simple economies of scale: the variable costs are falling relative to fixed costs. You can bring two companies together and cut redundancy like accounting, legal and HR. Of course, these types of mergers are most likely preceded by lower share prices. If things turn around, then sure, it can be quite bullish.

Yet for as much attention as mega-mergers get, their track record isn’t so impressive. AOL Time Warner comes to mind. Many mergers look great on paper, but it’s not so easy merging two different cultures. If the fixed costs are high enough, that can be a high barrier to entry—which I could see being worth paying a premium for.

A merger wave can also be caused by surplus. There are simply more companies than are necessary. As an investor, I would be very wary of that situation.

I also worry about mergers ruining good balance sheets. The companies are saddled up with large amounts of debt, and that can hurt margins which are already under pressure. Perhaps a consolidating industry is neither bearish nor bullish; it’s something that just happens.

Overall, I’m leery of an industry that’s consolidating. The forces driving the mergers probably outweigh any perceived bargains.

Posted by on July 10th, 2014 at 10:57 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.