Friday, August 20, 2010

Will an M&A Boom Lift Sagging Markets?

Anupreeta Das and Gina Chon of the WSJ report, Deals Stage a Comeback:
Global merger activity is sweeping to its highest levels since late 2009, presenting a glimmer of economic confidence while the bond and stock markets continue to price in a weakening U.S. economy.

On a day of bleak jobless news and a 144-point drop in the Dow Jones Industrial Average, Intel Corp. surprised investors by unveiling plans for a $7.7 billion all-cash takeover of Internet security company McAfee Inc. That came just hours before First Niagara Financial Group Inc. in Buffalo announced the biggest bank merger since the peak of the 2008 financial crisis, a $1.5 billion acquisition of NewAlliance Bancshares Inc.

Both deals pale in size next to BHP Billiton's hostile $39 billion offer for Potash Corp. of Saskatchewan, disclosed Tuesday.

U.S. deal activity had been weak through most of 2010, as corporations husbanded cash and waited for more signs of economic revival. Many of the biggest deals have come in Asia, historically a laggard in the merger game.

This week's moves suggest some executives have grown restless waiting for the broader economy to turn. Nearly $85 billion of transactions have been announced since Monday, the highest weekly sum since the week of Dec. 13, 2009, when Exxon Mobil Corp. announced its $40 billion acquisition of XTO Energy Inc., according to Dealogic data.

One factor may be the cash burning in their pockets. U.S. public companies carried $2.03 trillion in cash and short-term investments at the end of the first quarter, according to data from FactSet Research. That's about 57% above the level at the same tome in 2006.

"I wouldn't say that CEO confidence is a 10 for M&A; I would say it's more of a 7," said Jeffrey Kaplan, global head of global mergers and acquisitions at Bank of America Merrill Lynch. "This week's deals are about the ultimate expression of confidence."

The weak overall economy is actually helping one important aspect of deal making: financing. Interest rates on investment-grade and junk bonds have continued to fall by the day. On Thursday, yields for 10-year Treasury notes dropped below 2.6%, helping push corporate borrowing rates to historic lows. Even companies with weaker credit can attract funding at a level that makes deals attractive.

As the stock markets continue to tread water, opportunism is also in the air. When Blackstone Group agreed to buy power generator Dynegy for $550 million last week, Dynegy's stock hovered at its all-time nadir.

Interestingly, BHP tendered a $40 billion all cash offer to acquire Potash Corporation at $130-a-share, a 20% premium, and Intel unveiled a $7.68 billion purchase of antivirus software maker McAfee at $48-a-share offer, a hefty 60% premium.

Earlier this week, Stéfane Marion, Chief Economist & Strategist at the National Bank of Canada wrote a comment, Word: M&A activity levels remain depressed:

Merger & acquisitions (M&A) activity has been unusually muted at this point in the recovery. Uncertainty about financial markets and the sustainability of the economic recovery has led companies to hoard cash rather than spend. Sitting on a pile of cash when many central banks are pledging to keep interest rates low for the foreseeable future does not offer much of a return, particularly if the economy actually continues to grow (albeit at a slower pace). Fortunately, the BHP bid for Potash is a sign that the notion of “animal spirit” is still a concept that needs to be reckoned with.

If this mindset persists, we certainly have a catalyst to drive equity markets higher. As today’s Hot Chart shows (click on chart above), the total value of merger and acquisitions relative to the size of global GDP remains well below its historical average of 3%.
But not everyone is convinced that an M&A boom is on the horizon or that mergers benefit acquirers. Zachary Mider of Bloomberg reports, M&A Losers in $10 Trillion Deal Binge Led by McClatchy, Sprint:
More than half of the 100 biggest takeovers made during the last mergers-and-acquisitions boom have something in common: By one measure, they never should have happened.

The stocks of 53 companies that made the biggest purchases from 2005 to 2008 lagged behind industry peers two years later, according to data compiled by Bloomberg’s ranking group. Among the worst performers were McClatchy Co., Boston Scientific Corp., and Sprint Nextel Corp., all three of which are now valued at less than the price they paid for their acquisitions.

Companies struck $10 trillion of deals during the last merger binge, even after more than a decade of research showing deals often don’t pay off for the buyers. The average stock price of all the top acquirers trailed benchmark indexes by an average of about 3 percentage points.

“As a CEO, you are forced to think about growth, think about outperforming others, building the biggest and most dominant corporation in your sector, and you will do deals,” said Alexander Roos, a partner at Boston Consulting Group. “Everyone is always very convinced of being the first to know how to do it right.”

Worse at Peak

Deals executed during a financial boom tend to turn out worse than those done in a slump, according to research by Roos. Even so, a lack of access to cash and credit can lead companies to shelve purchases at the most opportune time. The global economic slowdown that began at the end of 2007 coincided with a collapse in the M&A market, with annual takeover volume falling by more than half from the peak, to $1.8 trillion last year.

“If you can get things at low prices, you’re going to make money,” said Donna Hitscherich, a senior lecturer in finance at Columbia University and a former M&A banker. “But you have to have the courage of your convictions.”

Warren Buffett had one of the top-performing deals in the Bloomberg ranking after his Berkshire Hathaway Inc. bought PacifiCorp for $5.1 billion in 2006. Berkshire’s stock outperformed a benchmark index by 35 percentage points, making PacifiCorp the ninth-best deal in the ranking.

That doesn’t mean the billionaire investor hasn’t had deals turn sour. In 2008, Buffett applied the lyrics of a country music song by Bobby Bare to missteps in M&A: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”

Best, Worst

Suez SA, the best-performing acquirer in Bloomberg’s ranking, was boosted when it also became a takeover target. Paris-based Suez purchased shares in Belgium’s Electrabel SA that it didn’t already own for about 12.6 billion euros ($16.2 billion). Suez was itself later bought by Gaz de France SA, helping the shares beat a benchmark index by 83 percentage points.

McClatchy’s purchase of the Knight Ridder Inc. newspaper chain, for $4.1 billion in 2006, ranked the worst of the 100 on Bloomberg’s list, with McClatchy shares underperforming the Bloomberg Advertising Age AdMarket 50 Index by 93 percentage points. Sacramento, California-based McClatchy borrowed cash to buy the chain as newspaper real-estate advertising plunged. Elaine Lintecum, McClatchy’s treasurer, declined to comment.

Boston Scientific outbid Johnson & Johnson to buy Guidant Corp. for $27.5 billion in 2006. The takeover diversified Boston Scientific’s product line while leaving it to deal with tens of thousands of safety recalls linked to Guidant defibrillators. The stock traded 64 percentage points below the Standard & Poor’s 500 Health Care Equipment Index two years after the purchase. Paul Donovan, a spokesman for Boston Scientific, declined to comment.

Sprint Nextel

Sprint’s $36 billion combination with Nextel in 2005 led hundreds of thousands of customers to defect to competitors and pushed the stock 47 percentage points lower than industry peers. The company is now valued at about $30 billion including debt.

Sprint has made “great strides” in the past 2 1/2 years in improving its customer experience, strengthening its brand and generating cash, said Scott Sloat, a spokesman for the Overland Park, Kansas-based company, in an e-mail. The combination with Nextel also allowed Sprint to bring the first fourth-generation mobile-broadband network to customers, he said.

Shareholders of buyers may be growing less tolerant. The biggest transaction announced this year, Prudential Plc’s $35.5 billion offer for an Asian insurance unit owned by American International Group Inc., fell apart when Prudential’s investors refused to support it, calling the price too rich.

Among smaller purchases, stockholders of Charles River Laboratories International Inc. last month scuttled a planned $1.6 billion acquisition of WuXi PharmaTech (Cayman) Inc.

During the past decade, large institutional investors have grown more willing to speak out against an acquisition, a strategy the activist hedge funds pioneered, said Christopher Young, head of takeover defense at Credit Suisse Group AG.

That “rambunctiousness,” Young said, has only grown since the depths of the financial crisis in 2008. “Shareholders are saying capital is a scarce asset, you should use it wisely.”

Despite these missteps, I see an M&A boom on the horizon. Cash rich companies will look to grow through acquisition. What does this mean for large pension funds? They should already be invested with Merger Arbitrage hedge funds (beware of betas in merger arb funds), and more importantly, they should be overweight the top companies that are being acquired and underweight the top acquirers.

As for the overall market, an M&A boom couldn't come at a better time. Sagging markets need a lift, and big acquisitions will help bolster confidence. Will it be enough to propel markets higher? If you couple this with the Fed sponsored liquidity tsunami, it might spark things up again, but if the economy keeps weakening, a lot of merger plans might be placed on hold or permanently shelved.

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