Con­fi­dence drives merg­ers

Faster US growth may pull merger ac­tiv­ity higher, float­ing all eco­nomic boats, writes Sikonathi Mantshantsha

Financial Mail - Investors Monthly - - Front Page -

That the US Fed­eral Re­serve is now talk­ing about the pos­si­bil­ity of rais­ing in­ter­est rates from the mid­dle of 2015, in the face of almost full em­ploy­ment in an econ­omy that no longer needs the ar­ti­fi­cial support of quan­ti­ta­tive eas­ing, must shift the fo­cus to how much more growth the world’s big­gest econ­omy will achieve next year.

Along­side the GDP growth spurt, merg­ers and ac­qui­si­tions have topped seven-year highs in value, with the ac­quir­ers of com­pa­nies pay­ing pre­mi­ums of about 25% to gain con­trol of their tar­get firms. Those deals, and buoy­ant share mar­kets, are re­flected in the US econ­omy’s an­nual 3.5% growth in the third quar­ter of 2014.

That helped lower un­em­ploy­ment to 5.8% in Oc­to­ber, bring­ing the US econ­omy to what of­fi­cials call “near full em­ploy­ment”.

In­vestors are pin­ning their hopes on the prospect that the mar­kets will main­tain the mo­men­tum into 2015, and that some of the mooted megadeals will in­deed fi­nally emerge.

There has been an in­crease in ma­jor gen­eral merger ac­tiv­ity this year, with trans­ac­tions of $30bn and above fit­ting the cat­e­gory of megadeals. Among the big­gest deals this year were Gen­eral Elec­tric’s $17bn takeover of Al­stom’s en­ergy as­sets and Or­a­cle’s $5bn ac­qui­si­tion of Mi­cros Sys­tems. But a few other pro­posed large merg­ers never ma­te­ri­alised, and there is prom­ise of more yet to come.

This year’s merger spree was driven by com­pa­nies rich in cash and that have strong bal­ance sheets, which is un­like con­di­tions in the hey­day of deal-mak­ing back in 2007, says Reuters in a June 2014 ar­ti­cle.

That was when pri­vate eq­uity

in­vestors used cheap money to sad­dle com­pa­nies with debt in the hope that it would be ser­viced from the rapidly in­creas­ing sales fu­elled by almost free money com­ing from the mort­gage sub-prime cri­sis and the pe­tro­leum economies of Asia and the Mid­dle East.

China held a prom­ise of su­per growth, which had been sus­tained for at least three decades.

The Reuters story came just months be­fore even big­ger deals be­came ap­par­ent.

Lo­cally, SABMiller’s mar­ket cap­i­tal­i­sa­tion was in­flated by about R100bn on the JSE, to more than R1-tril­lion, after its failed takeover at­tempt of Heineken was spec­u­lated to leave the brewer vul­ner­a­ble to its own takeover by An­heuser-Busch InBev. The fam­ily that con­trols the Dutch brewer Heineken re­jected SABMiller’s un­so­licited ap­proach in Septem­ber, opt­ing in­stead to re­main in­de­pen­dent.

While it has gone slightly quiet again, the ru­mour mill con­tin­ues, and there is spec­u­la­tion that AB-InBev is en­gaged in con­sult­ing fund­ing in­sti­tu­tions about a pos­si­ble takeover of the London-based brewer with South African roots.

With the ma­jor eq­uity in­dices hov­er­ing at around record val­u­a­tions, the buzz­word is con­fi­dence, and that is ex­actly what the mar­kets want, says Sasha Naryshkine, a port­fo­lio man­ager at Ves­tact in Jo­han­nes­burg.

The S&P 500 is lead­ing the pack, hit­ting a record 2,000 points late in Novem­ber. “It’s a good thing for eq­uity mar­kets; more and more peo­ple are con­fi­dent of the fu­ture,” says Naryshkine.

While it is pos­i­tive to have the con­fi­dence that is fu­elling the merger waves, Naryshkine also cau­tions that the worst pos­si­ble merg­ers can be con­sum­mated dur­ing times of such height­ened ex­pec­ta­tions. “It was dur­ing the re­sources boom be­fore 2007 that the worst merg­ers were done.”

But things have since changed for the worse in re­sources.

The oil price has de­clined 30% from the $111/bar­rel high in Au­gust last year, to the cur­rent $78/bar­rel, while the prices of both plat­inum and gold have de­clined by 23% and 17% re­spec­tively over the same pe­riod. The drop in the prices of th­ese ma­jor com­modi­ties may help

The JSE all share in­dex has stayed just above the 50,000 mark since Oc­to­ber … This record-break­ing per­for­mance comes in the face of seem­ingly in­sur­mount­able prob­lems in the do­mes­tic econ­omy

drive con­sol­i­da­tion in their fields, says Naryshkine. “Com­mod­ity prices have moved sig­nif­i­cantly lower now, and [there­fore] you’d ex­pect some merger ac­tiv­ity in that space,” says Naryshkine.

Un­like the pre-global re­ces­sion re­sources merg­ers, which was for growth, a new wave of trans­ac­tions would be fu­elled by the need to sur­vive, Naryshkine says. Sur­vival-driven merg­ers come about when the cost of pro­duc­tion sur­passes the sell­ing price and rev­enue. Pro­duc­ers then merge to ex­ploit scale and gain con­trol over vol­umes sup­plied to the mar­kets.

“A lower-price en­vi­ron­ment is when the best merger deals are done,” says Naryshkine, point­ing out that at the height of the re­sources boom be­fore 2007, “peo­ple didn’t think prices could fall; they were too con­fi­dent”.

This low point in the com­modi­ties cy­cle, to­gether with the de­pressed global eco­nomic out­look, does not bode well for ex­pan­sion op­por­tu­ni­ties, says Wayne McCur­rie, a port­fo­lio man­ager at Mo­men­tum As­set Man­age­ment.

“There is an over­sup­ply of re­sources, and gen­er­ally over­sup­ply sit­u­a­tions take time to work them­selves out of the sys­tem,” he says. It is not good for ei­ther ex­pan­sion­ary merg­ers or new projects.

In the face of de­pressed re­sources mar­kets, com­pa­nies will have to think about ways in which they can cut costs in or­der to cope with lower com­mod­ity prices, says McCur­rie.

At $80 a bar­rel of oil, cer­tain

pro­duc­ers in the Mid­dle East and the US are not prof­itable.

Some of the ways they could ar­rest the sit­u­a­tion is to merge with ri­vals in or­der to ex­ploit economies of scale, or to ar­rest the pro­duc­tion glut that is threat­en­ing to put a sus­tained down­ward pres­sure on prices.

In con­trast with the de­pressed re­sources prices, mar­kets in other in­dus­tries are do­ing rather well, cour­tesy of th­ese same lower oil prices.

The JSE all share in­dex has been stay­ing just above the 50,000 mark since Oc­to­ber. That’s due to the com­bi­na­tion of a weak­en­ing lo­cal cur­rency, re­duced do­mes­tic out­put and higher global eco­nomic out­put.

This record-break­ing per­for­mance comes even in the face of seem­ingly in­sur­mount­able prob­lems in the do­mes­tic econ­omy. SA’s an­nual GDP growth has stut­tered to about 1% a year from 3% three years ago, and the rand has weak­ened sig­nif­i­cantly to R11 against the dol­lar now, from R7/$ in 2011.

It is there­fore clear that most of this per­for­mance is not an­chored on the lo­cal eco­nomic re­al­ity, but rather on a gen­er­ally warmer global sen­ti­ment.

It’s not about to get bet­ter any time soon.

SA’s sig­nif­i­cant struc­tural prob­lems, the big­gest of which is the dire short­age of en­ergy to power up eco­nomic ac­tiv­ity, will not be solved in the short term, says McCur­rie.

“And that en­vi­ron­ment does not bode well for ex­pan­sion. It doesn’t help the in­vest­ment cli­mate,” he says.

It is in the US that things have im­proved sig­nif­i­cantly, says Naryshkine. Earn­ings growth of about 9%/year, while they seem pedes­trian in the emerg­ing mar­kets con­text, have lit a fire un­der share prices in the world’s num­ber one econ­omy.

“This ris­ing tide of merg­ers does float all boats, but there are risks that have to be care­fully weighed up,” says Naryshkine.



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