FYI | May 08 2014
-Upturn in M&A to persist
-Equity value/activity disconnecting
By Eva Brocklehurst
Consolidation is the word. Standard Life has examined some of the aspects driving the recent increase in global merger and acquisition activity. Generally, this M&A activity takes the path of either a takeover or a merger of equals, as well as building stakes in companies or spinning off subsidiaries. Standard Life observes the waves of activity usually come at the end of a business cycle, when confidence and financial conditions are improving. Deals usually track equity valuations closely, albeit with a lag up to a year. It remains a way for companies to boost market share or gain an advantage in a fast-growing sector. Standard Life believes, so far, investors seem to be willing to give companies the benefit of the doubt in that M&A will create the necessary synergies.
Activity is usually spearheaded by the US but recently Asia has become more important. Asia Pacific M&A now accounts for about one third of the total, up from 15-20% a decade ago. M&A is being financed by cash in about two third of deals with a mix of stock and debt in the rest, as Standard Life observes. In the last activity wave in 2012 stock was comparatively low as a percentage but this year it has become more common, used in around 18% of deals and moving back towards the peak of 20% seen in 2005. As dividend-paying companies lag the overall market then market turns to favouring leveraged stocks, and companies that make acquisitions witness their share prices rise. The analysts do not think, at this stage, companies are overpaying for their targets.
What's ahead? It's a low growth global economic recovery and companies often need to stabilise margins and find new ways to grow if they want to deliver profits expected by the market. Constraints on bank finance are slowly starting to fade and in some cases, high cash levels are providing the firepower for M&A activity. This is the dominant situation in the US, where the ratio of cash to short-term debt has broadly doubled to three times. Such cash can help finance acquisitions outside the US. This cash ratio compares to 1.2-1.4 times in Europe and Japan, where it hasn't even doubled since 2008. The other aspect driving M&A is debt de-leveraging. Stocks which are highly leveraged and have servicing pressure may consider selling assets to reduce the debt burden. European utilities divested more than US$30 billion in assets last year and this is expected to continue.
At present cash and stock are funding over 90% of M&A. More companies are taking advantage of low yields in the corporate bond markets to access capital. There are more cross-border approaches too. Deal size is rising as companies look for cost cutting opportunities too. The analysts note that market valuations rose in 2013 and hence companies engaging in significant share buy-backs began to underperform. Investors are moving towards companies with better growth prospects rather than just income and yield. They are looking for sales and earnings growth to justify a future rise in share prices.
There are headwinds. Political or economic uncertainty can dampen appetite as well as change in regulation or constraints on finance. An acquirer will not be keen on a company with a rich valuation that has constrained sales growth and political risk. Still, the analysts note, after the major European monetary crisis in 2011-12 it is apparent that formal measure of policy uncertainty have declined dramatically in the past year.
Standard Life notes investors have rightly asked whether these M&As add value. There are risks if the company moves away from its core business or takes on too much debt and the analysts cite studies in the 1990s that concluded a majority of such transactions destroyed value. The analysts observe more recent evidence suggesting the deals do create value in most sectors. After examining the top 500 deals across 13 sectors between 2002-09, the analysts cite an Accenture survey which concluded positive value was achieved in 10 sectors, especially banking, consumer goods, resources and insurance. Value destruction occurred in energy, infrastructure and retail. Bolt-on acquisitions create the highest total returns for shareholders, according to a study by McKinsey cited by Standard Life.
The analysts believe the rest of the world will follow the upturn in M&A in the US and this should broaden away from media, vehicles, internet, heath care and beverages towards finance, real estate, software and telecoms. In the first quarter Standard Life finds signs that the volume of large-cap M&A is now reaching levels seen before the global financial crisis. One aspect that differs since 2012 is a disconnect that's growing between equity valuations and deal activity: the lag of a year referred to at the start of this piece. The analysts suspect the unconventional monetary policies in train in recent years have driven up the price/earnings ratios for share markets, requiring stronger earnings growth to justify further progress on price.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
