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Shocking, disruptive and profitable

Where change and disruption lead, merger and acquisitions follow: Prepare for the biggest boom in M&A in modern times.
November 23, 2012

After a lot of huffing and puffing, the £50bn merger between commodities trader Glencore and mining house Xstrata looks as if it will make it to the finishing line. But the £28bn tie-up between European defence and aerospace leaders BAE Systems and EADS failed to get out of the starting blocks. No matter. These two mega deals - one failed, the other (almost) finalised - have one big factor in common: they herald the merger mania that will soon hit London's - and, indeed, much of the developed world's - stock markets.

It will be a time of change, of disruption and of opportunities. Opportunities for company bosses to indulge their favourite and most lucrative pastime - empire building; opportunities for investment bankers to compensate for the lean years that followed the credit crunch; and, most of all, opportunities for the shareholders of target companies to laugh all the way to the bank.

As well as being a time for winners, it will also be a time for losers; perhaps none more than the shareholders of the corporate predators. It is a paradox of takeovers that the winning companies get bigger and their bosses get richer, but the shareholders of these companies often end up being worse off as the value of their investments fade when corporate dreams wake up to hum-drum reality.

But how can we be so confident that a wave of merger and acquisition (M&A) activity is welling up even as we write? Primarily because it was ever thus. Because that's how M&A activity reveals itself - in waves; because each massive wave is generated by a shock to the economic system; and because shocks don't come much greater than the one - complete with its knock-on effects - delivered by the Great Contraction of 2007-12.

 

Light at the end of the tunnel: Ivan Glasenberg, chief executive of Glencore. The £50bn merger of Glencore and Xstrata looks as if it will make it to the finishing line.

 

Proof of waves is in stock market history

■ In the 1920s, when a combination of technological innovation and easy money generated the wave out of which General Motors and General Electric became monstrously big.

■ In the late 1950 and 60s, when - thanks largely to the efforts of Charles Clore and Jack Cotton in the UK - the term 'takeover' was first coined.

■ In the 1980s, when James Hanson and Gordon White were tearing through British industry and, in the US, nearly half of all major corporations received a takeover offer.

■ In the late 1990s and beyond, when the internet delivered the biggest technological shock to industry since the advent of consumer electricals in the 1920s.

Perhaps the next 'bullet' point could read: In the 2010s, when regulatory shocks and the residual effects of technological innovation combined with the healthy state of corporate balance sheets to unleash the dogs of M&A across a variety of sectors (see the table, A shocking experience).

 

A shocking experience: Which sectors will see the M&A action

Looser regulationTougher regulationTechnology-driven
Support servicesBanksMedia
ConstructionFinancial servicesGambling
HousebuildingFood, tobacco & drinksOil & gas
PharmaceuticalsHardware & software
Gambling
Source: Investors Chronicle

 

We'll explain that soon, but meanwhile it is entirely logical that takeovers should be concentrated in bursts of activity. Back in the early 2000s, a team of Harvard University academics, led by Gregor Andrade, an M&A specialist who is now a principal at hedge fund manager AQR Capital Management, found that merger activity in the US was focused on very different industry sectors in the 1970s, 1980s and 1990s. Of the five sectors that saw the most activity in the 70s and 80s, only one sector - oil and gas - figured in both decades, and there was no overlap between the top five sectors in the 80s and 90s.

From this, Mr Andrade's team speculated: "If mergers come in waves, but each wave is different in terms of industry composition, then a significant portion of merger activity might be due to industry-level shocks. These shocks are unexpected, which explains why industry-level takeover activity is concentrated in time." In another paper, Mr Andrade's team found that in the 25 years from 1970 to 1994 on average each industry saw half its M&A activity focused on a single five-year period. Concentration indeed.

Sure, other factors can have an influence. In particular, there is 'q theory' (see box below), though this looks unlikely to play a leading role this time around. Then there is good old-fashioned empire building by company bosses, which tends to prompt its own cascade of copycat bids as rival bosses seek to outdo each other. This factor, however, is more effect than cause. In other words, the bigger factors, to which we'll return to in a moment, instigate the takeover trend, but many bosses need little persuasion to clamber aboard. Much the same can be said about the synergies and cost savings that help to justify deals. Company bosses talk about them more than anything else. And rightly so - the more savings and synergies that can be squeezed out of a deal, then, generally, the better.

 

 

Shock factors

But the pursuit of cost savings won't be the factor that causes the wave to swell. For that, we need to consider these 'industry-level' shocks. Generally, these can be shepherded under two headings: regulatory shocks and technological ones. Regulatory shocks comprise the changes to an industry's rules brought about by a government or its agents. There has been no shortage of them in the UK these past two decades - from the abolition of the so-called 'beer orders', which shook up the pubs industry no end, to the privatisations that created the stock market's 'utilities' sector and the trend to contract out much public sector work, which did wonders for the support services sector.

Those three - plus most regulatory shocks beside - could be fine-tuned as 'de-regulatory shocks'. Deregulation prompts the M&A activity that happens when a regulator liberalises an industry and it has much the same disruptive effect as a technological shock. First, barriers to entry into an industry are lowered. As new, unruly but often imaginative players join the game, then winners and losers soon become apparent. Initially anyway, profits often suffer so it looks as if the new game is a zero-sum affair in which winning is only achieved at a competitor's expense. The winners start to suck up the losers while, simultaneously, losing companies form defensive alliances. That process, via a feedback mechanism, prompts even more deals. Before you know it, a takeover wave is in motion.

 

UK M&A activity

NumberValue (£bn)
200243025.2
200355818.7
200474131.4
200576925.1
200677928.5
200786926.8
200855836.5
200928612.2
201032512.6
20113738.1

By UK companies abroad

NumberValue (£bn)
200226226.6
200324320.8
200430518.7
200536532.7
200640537.4
200744157.8
200829829.7
200911810.1
201019912.4
201128650.2

Source: Office for National Statistics

 

Similar things happen when technological factors prompt a wave of takeovers. Technological shocks are as much about introducing new processes to do familiar things as they are about commercialising inventions. A good example would be the introduction of supermarkets into the UK - a new way to sell groceries. This soon produced scores of new players, quite a few of which graduated to the stock market. Even just 30 years ago among the line up of quoted food retailers were now-forgotten names such as Lennons, Hillards and Bejam. All of those and more were swallowed by corporate predators.

Or recall that 20 years ago pictures of Dolly the sheep were plastered over the tabloids as the UK attempted to transform a pure new technology into a new growth industry - biotechnology. That prompted the creation - and rapid listing on London's stock market - of a score of biotech companies. Where are the likes of PPL Therapeutics, Cambridge Antibody Technology and Vanguard Medica now? True, quite a few went bust, but others became the prey of major pharmaceuticals companies, while still more grouped together vainly in search of the economies of scale that could make them viable.

The next wave

So how are the forces gathering that will power the next great phase of takeovers? The background is certainly right. By that, we mean that company finances are in decent shape, so company bosses can realistically contemplate big moves. As the table, The State of UK plc, shows, corporate debt has only crept up since before the crunch yet, simultaneously, financial assets - cash, investments and debtors – has risen, meaning that net liabilities have drifted downwards.

Another background driver is in place - the imperative to promote economic growth. As a means of repairing the developed world’s economies, austerity won’t go far. What's really needed - though it's a long-term fix – is a re-build of the structural things that power an economy. 'Structural' means both the bricks and mortar but also the rules and regulations on which an economy thrives (or chokes). In other words, governments need to stimulate the forces that will disrupt, shake up but ultimately improve industries, whether that means building better roads or removing restrictive barriers.

Some industries are easier to tackle than others. In the UK, construction and housebuilding can always respond to the government's touch. Hence, for example, the government's current enthusiasm - not matched at the local level - to hack away at planning regulations. And when construction and housebuilding do revive meaningfully, then there are enough quoted companies in these sectors to stimulate brisk takeover activity.

Ditto various parts of the support services sector, where companies doing work funded from the public purse proliferate. How much more efficient some of them might be – how much better the value of money they might provide – if more were to merge, generating lots of lovely economies of scale?

Even if the rhetoric turns out to be better than the reality it's sufficient to justify many a takeover - and similar arguments can be made for the pharmaceuticals industry, where the need to get more bang per – mostly taxpayer funded – buck is clear. If, simultaneously, that meant less time and money were needed to get new drugs to market, that would be a great help. That implies less regulation and more disruption. Sure, pharmaceuticals companies are thinner on the ground in the UK than they used to be, but this is a global industry where there are probably still too many players and weaker ones in need of defensive alliances.

Yet the forthcoming regulation-driven shake-out will also be unusual. We have spoken of the need for less regulation. This time round, however, there is also a demand - though perhaps not actually the need - for more regulation. The takeover activity stimulated by tougher regulation will be focused on the finance industry and is a consequence of – or a punishment for – the bad things that industry did to get us in the mess we're trying to get out of.

 

The State of UK plc

Financial assets..Financial liabilities.Net liabilities.
.Totalof which, cashTotalshort-term loanslong-term loans.
20061,6935443,5373971,0661,844
20071,8846413,6914771,1121,807
20082,2256913,4235381,3161,198
20091,9426193,6104791,1771,668
20102,0916703,8454401,2091,754
20112,1407223,7914081,1651,651
Source: Office for National Statistics

 

Extra financial regulation is already coming thick and fast. Most of all it means that each company - be it a bank, an insurer, whatever - will need more capital for each piece of business it does. More capital equals bigger companies. That means fewer of them, which requires takeover activity. Sure, within the banking industry there are also forces afoot that will compel the players to become smaller - separating retail and investment banking; restricting proprietary trading - but that will drive break-ups and M&A activity of its own.

Then always - but always - there is technology fuelling M&A. Our table mentions four sectors where technology's effect is easiest to spot because deals will be driven by factors already in motion. So, for example, the disruptive effects of the internet and the convergence of computers, telephones and television has not run its course. It will cause further fun and games in various sectors as weakened media companies merge with one another; and as newly dominant technologies seek to widen their areas of application (think of all the M&A that Google has been doing and where Facebook will surely follow).

Play the victim card

To be prepared for this wave of M&A investors need to grasp one big thing - takeovers are one of the few areas of human activity where it pays to be a victim. When Gregor Andrade and his team studied the results of all 3,688 M&A deals in the US from 1973 to 1998, they found that, on average, the share price of target companies rose almost 24 per cent in the period from 20 days before the deal was announced to its closure. Over the same period, the average price of shares in acquiring companies fell almost 4 per cent.

And it's easy to see why shareholders in corporate prey should win while the predators lose. For starters, M&A activity gains momentum as stock market levels rise, so not many acquirers get first-mover advantage, most have to join the bandwagon. On top of that, they have to add a bid premium, which, as we see, has averaged 24 per cent, but is often much higher.

In Mr Andrade's extensive trawl, the combined returns of shares in both target and acquiring companies showed an average gain of almost 2 per cent. In other words, the market generally thought that value would be created by each deal, but only minimally. It's small enough to make you wonder why so many bosses are so keen to indulge in M&A. Then again, you might ask why are so many people so keen to indulge in so many pointless sports? It's fun and it's human nature - all you need is that disruptive kick to get the ball rolling.

TAKEOVER CANDIDATES:

AZ Electronic Materials

Until recently, few outside the research labs of the big electronics companies had heard of AZ Electronic Materials (AZEM). Yet for decades its chemicals have played a crucial role in the drive towards smaller, faster, more powerful and cheaper gadgets. It’s become a highly profitable business, too, with huge exposure to fast-growing Asian markets and enviable market share, the kind that rivals would struggle to emulate.

Almost 80 per cent of AZ's products are sold in Asia where it has strong relationships, particularly with LG, Toshiba and Samsung, and most of its products are either number one or two in the market. That's where it spends much of its $54m (£34m) research and development budget, too. Given that investment in new products, AZ historically beats the market and should continue to outperform as computer chips keep shrinking and the public continues its love affair with smartphones, tablet devices and huge TVs.

AZ is no stranger to merger and acquisition, either. Swiss chemicals giant Clariant bought AZ from Germany's Hoechst in 1997, then sold it to private equity group Carlyle seven years later. Fellow buyout firm Vestar took a stake a few years later. Any improvement in economic conditions might get private equity interest again, or trade buyers such as Air Liquide, Akzo Nobel, or Dow Chemical might decide it's much simpler acquiring AZ's technology, rather than attempting to replicate it. Everything went to plan during the third quarter and a highly cyclical AZ will get even busier when economic conditions improve. A buyer may want to strike before then and won't be put off by a relatively modest forward PE ratio of 15. Lee Wild

 

Investors Chronicle's five M&A targets

NamePrice (p)Market value (£m)1-yr change (%)Forecast PE ratio (x)Dividend yield (%)
AZ Electronic Materials 354.51,350.3444.815.32.23
Plexus206170.46171.10.43
Hyder Consulting3801475.68.42.37
ITV923,598.5137.310.82.17
Gulf Keystone Petroleum 172.251,509.25-4.7na
Source: Thomson Datastream

 

Plexus

In the aftermath of BP's Macondo disaster in the Gulf of Mexico, there has been a sea change in the way governments look at and regulate safety requirements for offshore drilling. And Plexus (POS), an Aberdeen-based oil and gas engineering business focused on subsea wellhead equipment, is perfectly placed to capitalise on this. Plexus has developed and patented a 'friction grip technology' that is fast becoming a best-practice product for shallow-water wellheads, and indeed has already been used in more than 150 wells by dozens of multinational oil companies.

Yet with exploration increasingly targeting deeper, higher-pressure prospects offshore, the risk of a blow-out is greater than ever and the arguments for not using engineering solutions, where they exist, will be difficult to defend both commercially and legally.

So Plexus is partnering and collaborating with a slew of the biggest and best industry players to develop a similar product for deepwater drilling. At the moment, high-pressure/high-temperature deepwater exploration wells (costing up to $200m (£126m) to drill) have to be permanently abandoned after drilling whether the reservoir is commercially viable or not, as there is no technical solution available to tie back these wells to production platforms. Should it be successfully commercialised, the technology would transform the industry. It would shave several years off the field development lifecycle and potentially save operators hundreds of millions of dollars in drilling costs.

True, it will likely take a few years to test, prove and permit the new wellhead. But if it can do so, Plexus's technology will be sought after by every large oil company in the world, not to mention the energy and engineering arm of General Electric. Matthew Allan

Hyder Consulting

Hyder Consulting (HYC) makes a strong case as a takeover target. The consultant engineer has spent years successfully building a Middle East business and it is strong relationships with the spending decision-makers in the region that make it a tantalising prospect to any US group struggling with sluggish home growth and the prospect of national budget sequestration - a far cry from the bulging wallets of oil-rich nations in Middle East and budget surplus in fast-growing Asian economies.

Hyder has kept the wolf from the door by tripling the dividend over the last five years, maintaining a strong balance sheet and delivering on overseas growth, but any slip ups or further weakness in sterling could leave it wide open.

North American raiders have a strong track record with UK consultant engineers – most recently Canadian company Genivar shocked the market by taking out WSP at a 65 per cent premium. This was only the latest deal after Halcrow, Scott Wilson and Davis Langdon were taken over by large US groups in the last two years. The one factor that separates Hyder from this group is its strong balance sheet - while rivals suffered from excessive debt built up during the go-go years and paid for it, Hyder has been more prudent and currently holds net cash. In Hyder's latest update, trading was strong in Australia and earlier in the year it won the largest design contract ever awarded in Qatar. But with a market capitalisation of £147m, and shares at 380p trading on a lowly 8.3 times forecast earnings of 45.8p, its valuation still doesn't reflect its fair value, a fact that surely won't go unnoticed for too much longer. John Ficenec

 

ITV

ITV (ITV) was the subject of a barrage of takeover speculation throughout the summer. So far it hasn't come to anything, but there are plenty of reasons why the UK's number one commercial broadcaster could still attract the attentions of a suitor.

Since taking over as chief executive, former FA and Royal Mail boss Adam Crozier has made great strides to turn the group around, not least in reducing its dependence on advertising revenues by investing in its content production capability. Studio revenues grew 34 per cent in the first half of the year, and were revealed to be stronger than expected again in its third-quarter trading update last week.

ITV itself has been snapping up smaller production companies to boost its international footprint, and a large content group such as RTL or NBC might in turn buy ITV for the same reasons. Technology may be shaking up the world of broadcasting, but the old-fashioned business of making popular programmes is key to ITV's revival.

Although ITV is successfully diversifying its revenue streams, so called 'spot' advertising still accounts for around 70 per cent of its revenues, but net advertising revenues should be flat this year, a decent outcome that’s ahead of an unpredictable market. That's underpinned very strong cash generation this year - an attribute always in demand among private equity buyers, which have circled targeted the group before.

While the improving performance and takeover speculation has lifted ITV's shares to a five-year high of 93p, on a forecast PE ratio of 11 there's still plenty of room left for a bid premium. Broker Panmure Gordon this week lifted its price target from 125p to 140p, 50 per cent above today's share price. A quick look at the board beyond Mr Crozier also supports the idea that a takeover could be his end-game - chairman is long-time cohort Archie Norman, who after reviving the fortunes of Asda sold the supermarket chain to Walmart. Nomura has included ITV in its recently published list of 16 European companies that could attract a bid (see table below). John Hughman

Gulf Keystone Petroleum

One of the most talked-about oil and gas frontiers in the world is located in the Kurdistan region of Northern Iraq. Fearful of alienating officials in Baghdad, the oil majors were initially reluctant to commit to the region, but the continued success of smaller operators such as Afren (AFR) and Gulf Keystone Petroleum (GKP) eventually prompted a change of tack. The Kurdistan Regional Government consequently expanded exploration deals with foreign oil majors and boosted a growing crude-for-products trade with Turkish interests, including the development of a gas/oil pipeline. Now the likes of ExxonMobil, Gazprom and Total are active in Kurdistan, and looking at ways in which to expand their footprint in the region. However, gaining acreage in Kurdistan has become progressively more difficult, so growth through acquisition is the way forward.

Gulf Keystone, through the scale of estimated production at its Shaikan oil field - 150,000 barrels of oil a day by 2015 - is a prime candidate for the majors, although any approach would be contingent upon the outcome of a legal dispute with Excalibur Ventures, which is claiming a 30 per cent stake in Gulf Keystone's Kurdistan assets.

Admittedly, the group has been subject to takeover speculation in the past, to no avail. But given the increased clamour for Kurdish assets, together with the fact that Gulf Keystone's share price is now 57 per cent adrift of its 12-month high, you could make a reasonable case that the group will end up in the majors' cross-hairs once the Excalibur affair is resolved. Mark Robinson

 

Nomura's 16 takeover targets

NameTickerPriceMarket value (m)1-year change (%)Forecast PE ratio (x)Dividend yield (%)
African Barrick GoldABG384.9p£1,578.42-29.512.92.84
BeiersdorfD:BEI€58.26€14,681.5241.427.81.2
C&CGCC€3.77€1,274.5726.713.22.25
1st Quantum Minerals (Lon)FQM1,310p£6,239.666.318.80.92
Imperial TobaccoIMT2,395p£23,645.091.711.24.41
InformaINF380.5p£2,293.303.39.64.68
InvensysISYS219.5p£1,789.416.410.72.05
ItvITV92p£3,598.5137.310.82.17
Kloeckner & CoD:KCO€7.69€766.78-17.40
Schweizerische Nat.Bk.S:SNBCH1,000CH1006.91.5
Rhoen-KlinikumD:RHK€14.87€2,055.513.219.23.03
Severn TrentSVT1,524p£3,632.14-4.1164.6
Swiss Life HoldingS:SLHNCH113.9CH3,654.0318.96.13.95
Sky DeutschlandD:SKYD€3.66€2,848.4795.70
UbmUBM703.5p£1,726.5945.112.23.8
Wolters KluwerH:WSG€13.92€4,202.409.58.94.89
Source: Nomura