Merger Mania: Drivers & Destinations

Standard & Poor's says the current deal frenzy is not over yet

Market participants woke Monday, November 20, to a veritable merger maelstrom.

This included Blackstone's $20 billion proposed purchase of Equity Office Properties (EOP) and a $25.9 billion offer by Freeport-McMoRan (FCX) to buy Phelps Dodge (PD). Taken together, more than $50 billion in deals went down, adding to the $3.1 trillion in transactions posted in the 12 months ended November 17, and nearly $7 trillion over the past three years.

What does it all mean? What is driving this activity? Who are the beneficiaries? Which sectors are likely to see the most activity, and what are the prime takeover candidates?

S&P Equity Strategy sees the M&A activity fueled in part by ample global liquidity, with receding inflation risks likely to keep rates low, and by the emergence of private equity as a potent market force. Kenneth Shea, S&P's managing director of global equity research, thinks private equity firms "will continue to apply pressure to underperforming companies."

Another factor is the abundance of cash on corporate and private equity balance sheets. Diane Vazza, S&P's managing director of fixed-income research, says, "The cash spigot should remain open. The appetite for fixed-income securities tied to M&A will remain strong, as historically low credit default risk rates, combined with the need for yield, create powerful backdrops for continued strong fixed-income issuance."

We also believe that there is an underlying faith in future worldwide economic growth and the health of individual sectors, and that equity prices are undervalued. In addition, we think companies may feel the need for expediency in making deals before the Democrats take control of both houses of Congress. What's more, the economic backdrop looks favorable, as S&P Economics does not foresee a recession in the United States in 2007. S&P is forecasting real GDP (gross domestic product) growth slowing to 2.3% next year from the 3.3% expected for 2006. In addition, we see global growth at 3.3% in 2007, down from the 3.9% estimated for 2006.

We think future U.S. economic growth will be investment led, rather than consumer driven, as it was in prior years. Even though S&P sees consumer spending up a respectable 2.8% in 2007 - a result of only a modest uptick in long-term interest rates and a slight rise in the unemployment rate to an average 4.9% - we believe the industrial side of the equation will be significant, as evidenced by our projected 6.8% advance in equipment investment and 8.8% increase in non-residential construction.

The past 12 months have witnessed $3.1 trillion in M&A activity, more than 45% of the three-year total of $6.8 trillion. In the past year, more than 20% occurred in the financial services sector. Cathy Seifert, head of equity analysis for S&P's financial services group, says that going forward a number of midsize and small firms, anticipating the lagging effect of the inverted yield curve, "may seek economies of scale or diversification of business mix." The consumer discretionary and industrials sectors have also been highly active over the past year. The financial services, consumer discretionary, and industrials sectors also dominated the three-year totals.

The two primary beneficiaries of the merger trend are the investment banks doing the advising and the companies being acquired. According to S&P's Capital IQ, over the past two years, Citigroup (C) has advised on about $800 billion in M&A transactions, followed by Morgan Stanley (MS), with $754 billion in deals, and Goldman Sachs (GS), with $671 billion in deals.

Merger World: Global M&A Transactions
  Past 12 Months   Past 3 Years
Sector Size ($ Mil.) % of Total Size ($ Mil.) % of Total
Consumer Discretionary 433,405 14.0 1,026,470 15.1
Consumer Staples 112,287 3.6 322,292 4.8
Energy 277,293 9.0 518,601 7.7
Financials 638,451 20.7 1,506,486 22.2
Health Care 264,178 8.6 545,284 8.1
Industrials 343,226 11.1 699,303 10.3
Information Technology 220,724 7.1 518,506 7.7
Materials 270,914 8.8 551,996 8.2
Telecom Services 273,488 8.9 605,495 8.9
Utilities 253,185 8.2 477,353 7.0
Totals 3,087,151 100.0 6,771,786 100.0

Source: S&P’s Capital IQ.