M&A Off to Slow Start But Poised for 'Perfect Storm' Ahead
MHKSCKPVIamp;A Activity is Down 33% year-over-year
High Cash Balances, Attractive Valuations and Low Borrowing Costs Could Key Rebound
Despite a dismal quarter for deal-making to start the year, signs continue to point toward a positive climate ahead for mergers and acquisitions.
The core elements needed for M&A — hefty cash balances, low costs of borrowing and increased confidence — are in place even though it would be hard tell by corporate behavior to start 2012.
With $184 billion in the books, M&A volume in the U.S. has dropped by fully one-third over the same period in 2011, marking the worst start to a year since 2003, according to Dealogic. This has occurred as stock marketvaluations remain attractive even as they continue to rise off the October lows, and business optimism is growing, at least among CEOs.
"You see evidence of renewed confidence most everywhere you look, both from businesses and consumers and investors for that matter," says James Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "You'd think that would show up in M&A."
Most likely holding back the confidence it takes to get deal-making rolling has been a series of geopolitical headaches, from the sovereign debt crisis in Europe to the political gridlock in Washington.
But companies remain rife with cash, building up a $3.7 trillion stockpile — $1.2 trillion for nonfinancials — after the financial crisis thanks to accommodative monetary policy and a hesitation to put money to work in such a fragile economic environment.
Other factors, including a low cost of borrowing, are adding up to generate enthusiasm about the M&A picture.
"The perfect storm sits right offshore," Goldman Sachs analysts said in a recent research note. "A combination of high cash balances, improving confidence, low rates and slowing top-line growth augurs an uptick in M&A activity in 2012."
Goldman sees tax uncertaintyfiguring into the mix as well. With tax rates likely to rise across the board in 2013, the firm believes that could "pull forward" activity that otherwise might occur further down the road.
"While we acknowledge that many companies may prefer to engage investors in a social contract via capital returns though buybacks and dividends, we see several drivers that can support the appetite for the right consolidation opportunities," the firm said.
Finally, Goldman asserted that reasonable valuations and a likely slowdown in earningsahead will force companies to find other ways to grow, as M&A "can act as a means of bolstering growth profiles, diversifying revenue streams, and creating margin efficiencies."
There have been some signs lately of thawing in the M&A picture.
Coty's $12.2 billion hostile bidfor door-to-door cosmetics giant Avon Products could make a signpost, as unwelcome offers are seen as a key indicator of M&A trends. The Coty-Avon deal would represent, if successful, the biggest hostile deal since the $24.5 billion Sanofi-Aventis takeover of Genzyme in August 2010.
It also would put 2012 hostile dealmaking nearly on par with activity in 2011, itself a fairly lackluster year.
"There's been a period where firms have been holding off making big expansions given the uncertainty, especially from Europe," said Jeffrey Greenberg, economist at Nomura Securities in New York. "Given that we have some clarity, the market is certainly calmer and more accommodating for reasonable M&A activity."
Corporations have been active at a near-record pace in terms of raising money as well. High-yield bonds have been coming to market rapidly, leading to expectations that some of that money will have to be put to work.
"One straightforward thing that firms could be doing with that cash is going out and picking up potentially underpriced assets," Greenberg said. "The general outlook at the end of last year was overwhelmingly pessimistic. Considering that M&A plans take a while to get from inception to completion, you'd only start seeing new seeds of that activity sprouting up once there's more certainty."
Paulsen, at Wells Capital, said the resistance toward M&A matches retail investor reluctance to commit money to stocks.
Despite the aggressive bull-market rise since October, far more cash has flowed to bond fundsthan stock-based mutual funds, indicating continued caution in the financial markets.
"You don't see hedge funds going after this, you don't see the fund flows, and you don't see real aggressive M&A," Paulsen said. "Maybe they'll all come together. Maybe we'll get a period where we're going to decide the water's looking better, they're missing out, and they have the wherewithal."