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Where to look for M&A activity in 2013
By Elsa Buchanan | Tue, 5th March 2013 - 17:53
While global economic uncertainty had hindered merger and acquisition (M&A) activity over the past few years, market conditions are now ripe for a year of increased deals.
"We are barely into the new year and M&A activity is 70% of what it was for the whole of the first quarter last year," says James Butterfill, global head of equity strategy at Coutts.
"Super deals" making the headlines at the beginning of 2013 have indeed made up for the lack of M&A activity in 2012, with Dell (DELL) and private equity firm Silver Lake Partners announcing a $24.4 billion (£16.1 billion) leveraged buyout to take the IT colossus private.
Virgin Media (VMED) followed suit, agreeing a $23.3 billion takeover by US-based Liberty Global, while NBC Universal took over Comcast for $16.7 billion. Heinz (HNZ) is also in the process of being acquired in a $23 billion bid by Warren Buffett's Berkshire Hathaway and Brazilian G Capital.
James Butterfill, global head of equity strategy at Coutts, describes this sudden revival in M&A activity as being the fruit of the volatility index, or VIX.
The VIX is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices, and a reflection of the US market volume, the VSTOXX. Triggers for volatility are mostly linked to political and market instability, as expressed in February 2007 when the index rose more than 64% and hit a high of 80.86.
M&A has a negative, lagging relationship with the VIX - when the VIX is high, M&A falls and vice versa, but with a six- to nine-month lag. The delay is explained by the fact that M&A deals are often a long time in the making, with lengthy negotiations having taken place.
Butterfill stresses the M&A activity seen so far is not a "false start", as he expects volatility to remain lower than in previous years.
He explains: "Post the Italian elections and the US sequestration there are few market-moving events.
"As political uncertainty has subsided and the macroeconomic backdrop has improved, it makes [optimistic] projections more believable."
The second reason behind this surge in M&A, according to Butterfill, is an increase in the number of cash-rich corporates.
Corporates are now facing the "use it or lose it" dilemma, he says, as investors have been pressuring money-hoarding companies to either use the funds to make acquisitions and increase capital expenditure or give it away to shareholders, either in the form of share buybacks or dividends.
Andrew Garthwaite, global equity strategist at Crédit Suisse, is of the view that corporates' most preferred option for the use of cash "is to fund M&A activity, with the second most preferred option being to add to existing cash reserves." Capital expenditure and discretionary spending are the "least preferred options," he adds.
And for those turning to M&A, cash-rich corporates can "cherry pick from under-leveraged companies at attractive prices," explains Butterfill.
Garthwaite notes a further three factors contributing to the M&A surge.
Firstly, he explains, M&A activity typically lags the stockmarket by 12 months and chief executive officers' (CEO) confidence by 18 months.
And over the past few months business confidence has been improving, as worries about debt crisis in the eurozone and China's potential slowdown ease. Stockmarkets have continued to rally, with the Dow Jones share index hitting a record high of 14268.
"The recent rise in both drivers suggests M&A activity should rebound," Garthwaite says (see graph).
M&A tends to lag stockmarket returns by 12 months
Source: Thomson Reuters, Crédit Suisse research.
Secondly, Garthwaite says M&A has never been this "earnings accretive". Indeed, he explains, there is "close to a record gap" between the free cash flow (FCF) and the earnings yield, and the corporate bond yield, "making debt-financed bid activity particularly attractive."
Lastly, Garthwaite says buying is "abnormally cheap compared to building", especially in Europe.
He explains the proportion of market capitalisation trading below replacement value is above the historical average, with 28% of European market trading below replacement value, "well above the post-1995 average of 14%".
Garthwaite says this implies "equity market valuations are sufficiently attractive to encourage further bid activity".
Risks to an M&A pick-up
The only headwind to M&A activity in 2013 will be regulatory, says Coutts' Butterfill, as M&A will be highly scrutinised. This has already been the case, after US regulators alleged insider trading had taken place ahead of Heinz's "super deal".
Claudia Panseri, equity strategist at Societe Generale Private Banking, echoes this view, saying M&A could be marred by governmental meddling, especially if the M&A implies job cuts.
"I think problems could come from state intervention when you have cross-border M&A activities... but this issue will be reserved for sectors such as aerospace and other highly-regulated sectors," she explains.
According to data from Dealogic, US companies have spent $219 billion on mergers and acquisitions so far in 2013, a sharp rise from 2012, when firms spent just $85 billion during the same period. "US firms are on pace to have the biggest year in M&A activity since 2000," Dealogic states.
But Europe paints a different picture. "There is a discrepancy between the M&A in the US, where banks have resumed lending, and the euro area, where banks are not lending," notes Panseri.
She explains M&A activity remains slower for UK-listed companies "based on the fact economic growth is still weak", while lowering the already-very-low interest rates would not necessarily help a pick-up in M&A.
So where should investors be looking in 2013?
"In terms of [M&A]... I think you still have opportunities in the pharmaceutical sector, which has been lacking visibility in the US, the airline sector, for sure, and the media sector as well," confirms Panseri.
She explains: "Euro companies are still relatively attractive to US companies", because of their low valuation and higher US exposure.
In the media sector, Crédit Suisse analyst Joseph Barnet-Lamb prefers Perform Group (PER) because "a major media group could see this as a unique asset [due to its] strong ownership of digital rights to sporting leagues."
Those with growing exposure to emerging markets should also be added to investors' basket. "Take the examples of Lafarge with its South East Asia exposure deals, or Danone with its dairy products in China," Panseri says. "Growing exposure to those markets is a rationale that has not been talked about, but it is an element of focus... that we observe in a lot of deals."
She cites SABMiller (SAB), which has over 50% of its sales coming from emerging markets: 23% of its 2012 sales came from Latin America, 20% from South Africa and 11% from Asia.
Brisith American Tobacco (BATS) also stands out, with 28% of its sales emanating from Asia; and 27% from Europe, the Middle East and Africa (EMEA) - mostly Russia; followed by Associated British Foods (ABF), with 24% of sales coming from EMEA, 21% from Asia and 11% from Latin America.
Also in the consumer sector, Crédit Suisse analyst Rogerio Fujimor prefers Burberry (BRBY), as the "large free float without any family involvement would make it attractive to aquisitive cash-rich companies such as PPR Holdings or LVMH", while analyst Patrick Jobin opines that Lindt & Sprüngli's "premium portfolio could be very attractive to the likes of Nestlé or Lotte."
Butterfill says investors might want to place their tokens on his favourites, "which have all had a growing share in revenues from growth markets which we define as emerging markets plus Asia." These include oil and gas exploration and production group Tullow Oil (TLW), mining and petroleum company BHP Billiton (BLT) and metals and mining corporation Rio Tinto (RIO).
According to Crédit Suisse analyst Thomas Adolff, Afren's (AFR) "good African producing portfolio and play on Kurdistan oil presents a strategic attraction."
Another M&A sweet spot could be "sectors in which it is difficult to enter", Panseri says, citing aerospace and defence as examples. She hints at "some European aerospace companies... those which are exposed to the US."
Butterfill shares her views, preferring companies such as Rolls-Royce (RR.).
Finally, Butterfill lists Vodafone (VOD) as a favourite, as an acquirer in the telecoms sector. "As the industry is undergoing such a change related to consumer habits and computer or smartphone usage, it is likely that the sector will have strong, continued M&A," he explains.