Mark Lister: Deal making rising anew from the ashes

After a lean few years during which M&A activity fell by almost 60 per cent, deal-making is again alive and well. Photo / Thinkstock

Opinion

Deal-making is alive and well. According to data for the year to date, more than US$700 billion ($882.3 billion) of mergers and acquisitions - or M&A - have happened worldwide.

After a rebound last year from a lean period in corporate activity, the momentum seems to be building.

In the heady days of the economic boom a few years ago, M&A activity was rife.

Takeovers, mergers and hostile debt-fuelled bids for companies by private equity firms were regular reading in the business pages leading up to late 2007.

It was a busy time for markets, and was profitable for investors and investment bankers alike, with many takeovers executed at high prices.

We had our fair share of action in this part of the world with numerous local companies being subject to such activity. Waste Management and Capital Properties, for instance, were taken over, and Pyne Gould Guinness merged with Wrightson. The Warehouse was in the sights of would-be suitors and government intervention was the only thing that stopped Auckland Airport from having a significant foreign shareholder.

The biggest Australasian transaction came when Perth-based conglomerate Wesfarmers (owner of Bunnings in New Zealand, among other things) paid A$22 billion ($29.35 billion) for supermarket chain Coles. The deal was done in the common "cash-and-scrip" way, with Coles shareholders receiving cash and newly-issued Wesfarmers shares.

Whether it was bad timing or bad judgment on Wesfarmers' part is debatable, but the huge, largely debt-funded deal preceded the global financial crisis by just three months. The Australian sharemarket peaked and fell 50 per cent over the next 18 months. Debt funding became harder to get and banks were not nearly as generous when it came to terms and conditions. Wesfarmers found itself in a difficult position, having taken on a lot of debt to buy Coles, and within a year it went back to its shareholders asking for A$7.1 billion of new equity to keep debt levels at bay.

The environment was no longer conducive to M&A activity and deal-making dried up. M&A activity fell by almost 60 per cent from 2007 to 2009. Management teams were all of a sudden more focused on defending existing market positions instead of worrying about growth, and there was so much uncertainty clouding the outlook that companies began to hunker down to try to ride out the storm as best they could.

A balance sheet with a lot of debt was no longer considered optimal or efficient. It had become a threat to corporate survival. Companies went to their shareholders to raise new equity and reduce reliance on debt. A huge amount of capital was raised over 2008 and 2009 and many companies went from a position of high borrowing to having very little debt or even none at all. In addition, costs were reduced, projects delayed and capital expenditure levels carefully looked at.

Today, many companies around the world remain fiscally strong with low levels of borrowing. In Australia, the ratio of debt to equity is about 25 per cent, compared with closer to 50 per cent earlier in the decade. In the United States, the debt levels for companies in the S&P 500 index are less than half of what they were in 2007.

At the same time, economic conditions have improved dramatically. Challenges remain, but banks are willing to lend money to those that can repay it, economic growth is stable and the high levels of uncertainty from the peak of the crisis have reduced. Company profits have risen about 40 per cent in the United States since 2007 and the confidence to invest has returned.

But despite the profit rebound, sales have remained subdued in many cases. The easy gains have been made from cost cutting, as businesses have streamlined operations and emerged from the crisis much leaner. With few costs left to cut and revenue growth for many sectors likely to remain lukewarm, management teams have begun to look for other ways to keep profit growth on the increase. One of the obvious solutions is to use newfound strong financial positions to buy growth. With interest rates also at very low levels, historically low funding costs provide this opportunity.

Shareholder pressure can also be a driver of companies looking to expand and potentially grow by acquisition. Companies that have accumulated high levels of cash over the difficult times are getting a low return on the funds in the bank.

Shareholders expect to see the money they have invested being put to use. If no such opportunities exist, many companies will look to return those unused funds to shareholders, either by increasing dividend payouts, paying special dividends or engaging in on-market share buy-backs.

Most of the large deals so far this year have occurred in the US and Europe, with the biggest being telecommunications company AT&T buying T-Mobile for US$39 billion.

But closer to home, several high-profile companies have also been in the corporate activity spotlight.

In New Zealand, Fletcher Building acquired Australian company Crane Group. PGG Wrightson, and more recently Tourism Holdings, have also attracted corporate interest. Last month, Mainfreight acquired a European logistics provider to expand its global footprint. Mainfreight shares have risen 15 per cent since announcing this acquisition, proving that it is not just the target companies that see benefits from such activity.

In Australia, the resources sector has been one of the most active industries. BHP Billiton, Australia's mining behemoth, unsuccessfully attempted to engage with Canadian company Potash before facing regulatory hurdles. BHP more recently has been widely speculated as a suitor for fellow energy and resources player Woodside Petroleum. With commodity prices remaining high, consolidation in the Australian resources sector could continue, given that these companies are well capitalised with strong cash flows. Global players in industries with high barriers to entry could also be attractive to potential buyers.

There is a long list of companies in New Zealand that have been touted as potential takeover targets. The Warehouse is one, given the strategic stakes held by Woolworths and Foodstuffs. However unlikely, speculation also crops up now and again that Origin Energy could buy out minority holdings in Contact Energy. SkyCity, given likely further consolidation in the Australasian gaming sector, could be an acquirer or a target. Then we have the likes of Fisher & Paykel Healthcare, which has a wide-open share ownership register ripe for an overseas competitor to take advantage of. The list goes on.

The prospect of corporate activity should always be considered, but we should never invest solely on this basis. It is always dangerous to invest in stocks simply in the hope that a takeover bid will emerge, although it can provide a nice windfall when it happens to companies that we want to own anyway for their stand-alone fundamentals.

I certainly don't expect companies to return to levels of indebtedness that were seen a few years ago, as I believe a more conservative slant to capital management will prevail, which is a good thing for investors.

But with confidence improving and plenty of balance sheet capacity, further M&A activity could well continue as the year goes on.

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Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on http://www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice. Craigs Investment Partners may hold the companies mentioned on behalf of its clients.