Europe's Urge to Merge

S&P European strategist Clive McDonnell explains what's behind the M&A boom -- and what could derail it

European companies appear to be caught up in merger fever. According to a report released last week by Standard & Poor's European equity strategist Clive McDonnell and his team, 1,100 deals were announced in the first two months of 2006. While that's about the same number as in the comparable period of 2005, there's one eye-popping difference: Their total value is €231 billion -- 360% higher than a year earlier.

And the trend shows no sign of slowing. Bayer (BAY) had its cash offer accepted by Schering (SHR) on Mar. 24. And on Mar. 23, press reports indicated that Alcatel (ALA) is in talks to buy U.S. rival Lucent Technologies (LU). Big cross-border merger deals are also in the works in the utilities and finance sectors.


  What's behind the cacaphony of corporate wedding bells? BusinessWeek Online reporter Alex Halperin recently spoke with McDonnell about the spate of big mergers, the "split-personality" companies looking for deals -- and the implications for investors. Edited excerpts of their conversation follow.

What do you think all the M&A activity is reflecting?

I think it reflects a couple of different factors. One of the most important is a change in perception among investors. In the past the focus was on paying down debt and restructuring balance sheets. Now that that is completed, we've passed a natural inflection point where people are looking at new growth opportunities.

However, ordinarily there'd be a mix of organic growth and M&A. But this time around there's been much more a focus on M&A and returning cash to shareholders. It's a recurring issue that many management teams are highlighting that there are insufficient organic growth opportunities.

Anglo American, (AAUK) a big mining company, reported that they are planning to double their share buybacks to $2 billion, from $1 billion, as well as [pay] a special dividend of $500 million. So the opportunities that are there are by acquiring companies both by incumbents and private equity groups.

So this is companies looking for growth wherever it can be found?


How long do you think this can last?

As long as a piece of string. Inevitably there'll be some form of a crisis that derails the M&A activity. That could come in the form of higher-than-expected interest rates. It could be action by the credit-rating agencies, being more aggressive in downgrading because of increased use of leverage to maybe unsustainable proportions.

It'll be some sort of financial mini-crisis, not something with global implications but a fairly normal situation where rates overshoot or we see some problems with overseeing the debt that leaves people a little more risk-averse. And arguably we're already seeing that. If we look at emerging markets, people are already pulling out.

Are you seeing investors wary of the end of this streak, or are they enjoying themselves?

I don't think it's that the end of the M&A activity is in sight. It's that investors' appetite for risk fell to very, very low levels, however we want to measure it, quantitatively or qualitatively.

We've seen a bit of a flight to quality, and, in part, that's helping the M&A activity in mature markets as money is flowing back home. This part of the cycle is where people's risk appetite is reduced and they look for higher-quality returns going forward. How long this part will last is very, very difficult to say at this point.

In your March report, you talk a bit about "split-personality" companies [as a major source of mergers]. What do you mean by that?

A split-personality company is one that tends to have a substantial low-growth business and also a rapidly growing new business area, which may be totally unrelated to the core part of the business. Typically [they are] a conglomerate or a company that's been around for a long time, and its business cycle has matured with low growth, low returns, and intense competition.

Company managers would be aware that they have to diversify into new areas and they would be branching out. And these new areas may become increasingly significant going forward. So they have a split personality.

Does the recent M&A activity change your outlook, which has been relatively bearish so far on the year?

Our overall strategic view is unchanged. Earnings-per-share growth is slowing, and the longer-term growth opportunities are not so good. There is a mismatch between analysts' forecasts for long-term growth and what we're seeing in other countries.

So they're basically too optimistic about long-term growth, that's for sure. But that can continue for a prolonged period of time. Their overoptimism is more reflected in their models than in their EPS number for next year.

From a short-term tactical view this market has a head of steam. We're not assessing the sustainability of the M&A activity, we're highlighting what we see as the drivers of it. We're trying to distance ourselves from the debate about how sustainable this is. We're saying, "This is happening, so let's try and figure out where the winners are going to be."

Where are they going to be?

We've identified a number of different sectors: telecom, materials, specifically metals and mining, health care, utilities, and the media. They're the areas that share these key traits we've identified.

Do you think that's where small investors should hop aboard?

Investors should certainly look in those sectors if they're trying to pick up on M&A candidates.

I think the issue of leverage is key when assessing any company at the moment. [Underleverage] is an important attribute of a company that may see a change going forward. That change may not be an acquisition or a merger or it being the focus of an acquisition or a merger. Rather, the pressure to gear up balance sheets is in place. You could see management look at new growth opportunities themselves and gear up their balance sheets and increase leverage as a way to pursue those.