M&A Market Awaits Clearer Economic Signals
The means and motives for deals are in place, but macroeconomic fears will likely keep the M&A market in waiting.
Global merger and acquisition activity continued to decline through the latter months of 2012, bringing total deals announced down 3.1% for the year. However, a number of sizable transactions were announced in the fourth quarter, particularly in December, more than offsetting the plummeting deal sizes for the first nine months of the year and bringing total dollar value 0.6% higher in 2012. Might this be a sign of further megadeals around the corner? We are skeptical. Some resolution of fiscal policy matters in the United States should help, but we expect to see greater signs of global economic strength before the M&A market heats up again.
The means to do a deal are widely prevalent. We believe banks have an increased appetite for funding leveraged buyouts, and the corporate bond market is open and active, making it easier to finance large-scale acquisitions, particularly as companies continue to stockpile cash. Higher market valuations have supported equity raises as well, so there is little question that capital is available for M&A, but CEOs continue to delay pulling the trigger. The S&P 500 is only some 5% off its 2007 peak, yet total deal value is down nearly 50% from five years ago. So while the number of deals completed looks more encouraging (down about 8% compared to 2007) the M&A market is still sluggish relative to the size of the market and how stocks have performed. We believe this could create more acquisition activity in sectors with cheap valuations, such as energy and financial services, given the wider margin of safety to create shareholder value.
With corporate profit margins likely past their peak in the current cycle for many industries, there are fewer organic-growth opportunities to enhance earnings. CEOs can play defense for only so long before needing to make capital-allocation decisions. We see this in the banking sector, for example, where well-capitalized banks face muted credit demand and regulatory headwinds limiting the ability to lend and increase fee income, prompting them to turn to the M&A market with their excess capital, in our view. Large technology firms also have few organic revenue-growth avenues and may seek acquisitions to deploy cash and combat a rapidly evolving competitive environment.
However, in some sectors, a stubborn gap persists between the expectations of sellers and buyers regarding the underlying value of a company. This is particularly true in industries facing high uncertainty where market valuations remain below prerecession levels, such as metals and mining. Many of these companies have recently divested noncore assets, such as Europe's ArcelorMittal (MT) and
ThyssenKrupp (TKA). Investing internally to cut costs and improve synergies within existing businesses is becoming a priority over expanding the top line. To consummate a large acquisition at this stage would suggest conflicting priorities, and shareholders have lost patience with companies that aggressively pay for growth with little attention given to returns on capital.
In preparing this report, each industry team of Morningstar analysts has developed a unique scoring system by assigning different weightings to specific investment criteria to identify the most compelling takeover candidates in each sector. We recognize there are still several barriers when it comes to M&A activity, and don't expect every name we've featured in this report to be a takeover candidate. However, we believe the names on our lists generally exhibit characteristics of a typical takeover target for each industry group.
Morningstar's M&A Methodology and Performance
In developing the criteria to select our potential acquisition targets, each sector team considers current industry conditions and M&A trends within the sector, as well as the prevailing objectives in seeking a transaction and hurdles to completion. While certain aspects such as a target's size, capital structure, and cash flow profile are recurrent themes in identifying attractive takeover candidates across different industry teams, other industry-specific considerations also come into play. After screening each industry's coverage universe for companies that meet the characteristics usually found in takeover candidates, analysts then assign each a rating for every criterion based on a proprietary scoring system. Industry teams also determined specific weightings for their industry-specific criteria, and combined this analysis with other company-specific factors that influence the likelihood of an M&A transaction to determine the final ranking. The current criteria selected by each team are outlined in each industry section featured in this report. As M&A trends and industry fundamentals change over time, the criteria used are likely to evolve, as well.
Each sector team also develops a list of potential acquirers from their coverage universes, which feature a combination of companies specifically targeting names on our takeover lists or just generally looking to make a deal to fill out their product portfolio or expand their geographic presence. While industry teams don't formally assign criteria in identifying potential acquirers from their respective industries, many of the names on these lists share common qualities such as large cash stockpiles, a successful track record of integrating acquired business, or simply needing an acquisition to fill a glaring business need or stay competitive with peers. These names also tend to be wide- or narrow-moat companies whose competitive positioning provides them with greater access to capital when contemplating an acquisition.
In the six months since publishing our July 2012 M&A piece, "Green Shoots in a Still Bleak M&A Landscape," we've had further success in identifying both takeover targets and acquirers. Four of the names featured in the report accepted bids in the back half of 2012. Kenexa was acquired by International Business Machines (IBM) at a 42% premium, and SprintNextel (S) settled on a deal to acquire Clearwire (CLWR) in December (though DISH Network (DISH) has since joined the bidding). Deutsche Telekom (DTEGY) subsidiary T-Mobile and
MetroPCS (PCS) announced a merger in October 2012, and the
PVH (PVH)- Warnaco (WRC) deal also announced in October is one of our best examples of not only identifying a likely target, but predicting the specific acquirer, as well. In the two years we have published this report, 14 identified takeover targets have accepted bids and four of these were also on our narrow list of best investable ideas, all taken out at substantial premiums. In our view, the steady stream of M&A activity we've seen from our potential takeover and acquirer lists validates our methodology.
Top Investment Ideas Among Morningstar's Potential Takeover Candidates
As usual, we have examined our list of potential takeover candidates for compelling investment ideas. These are the M&A takeover candidates that meet the typical takeover criteria for their respective industries, but also trade at a discount to our fair value estimates either because their stock prices don't reflect their takeover potential or because the market is underestimating their long-term cash flow potential due to technical or short-term considerations.
Although we believe the market is more conducive to M&A activity in 2013 compared with this time a year ago, the strong market rally during the past six months has left us with a smaller pool of attractively priced potential takeover candidates. The average price/fair value ratio of the takeover candidates we've identified in this report is 1.03, ahead of the acquisition-candidate valuations from our July 2012 (average price/fair value of 0.95), January 2012 (0.86), and September 2011 (0.84) reports, and more consistent with trends in our January 2011 (1.06) and May 2011 (1.03) reports. Still, we do find intriguing opportunities in several categories where deal activity appears to be heating up, including technology/telecom and energy.
We've removed a number of the names from our previous M&A investment ideas list, either because they (or their industries) were involved in announced or speculated M&A activity, experienced significant share price appreciation during the past six months, or no longer meet the criteria of a takeover candidate based on Morningstar's industry-specific criteria. This list includes Charles River (CRL),
Chico's FAS (CHS), Myriad Genetics (MYGN), NASDAQ OMX Group (NDAQ),
Range Resources (RRC), Riverbed Technology (RVBD), and Ultra Petroleum (UPL). Nonetheless, a number of holdover names from our last report remain on our updated list of 11 M&A investment ideas, including Guess (GES),
Icon (ICLR), Leap Wireless (LEAP), Mosaic (MOS), NII Holdings (NIHD), and SandRidge Energy (SD).
There are five new additions to our top investment ideas: Abiomed (ABMD),
BG Group (BG.), Chesapeake Energy (CHK), City National (CYN), and
Kohl's (KSS). Abiomed is a name we've featured on our top investment ideas in previous iterations of the report, and we continue to believe the company's status as a takeover target is secure given that its Impella ventricular assist device (VAD) appears to be changing the paradigm for treating acute heart failure events. Shares plummeted following its Nov. 1 update as a result of regulatory concerns, namely a HIPAA subpoena on its marketing practices and a change in Impella's regulatory pathway, which will likely increase the cost of doing business for Abiomed going forward. However, after analyzing the likely negative consequences of these issues, we do not believe those uncertainties warrant such a sell-off, making Abiomed attractive to investors, including potential acquirers (such as Johnson & Johnson (JNJ)).
The two additions from our energy coverage universe--BG Group and Chesapeake Energy--hold multiyear, concentrated inventory positions in key unconventional plays, are reasonably sized for an acquirer, and have expert knowledge of how to successfully exploit North American tight oil and gas that could be valuable for a national oil company or a major seeking to develop similar plays overseas. Additionally, given that two activist investors now hold 20% of the common stock and a newly installed board no longer answers to embattled CEO Aubrey McClendon, Chesapeake makes our short list of potential takeout targets.
While Kohl's strong cash flow qualities and solid balance sheet screen well as a possible takeover target, we believe the depressed valuation (trading at about 10 times our 2013 earnings per share forecast) will make the board prefer to wait for operational initiatives and some macroeconomic improvement to play out before they would consider a standard buyout premium, Still, Kohl's is one of the few department store retailers that still has growth opportunities, which could draw interest from potential private equity sponsors. Additionally, while Kohl's has not been considered a real estate takeover play similar to Sears Holdings (SHLD) or
J.C. Penney (JCP), partly due, in our view, to the store base being younger and often in strip centers that might be less unique and sought after, we'd point out that the store portfolio might also be more homogenous and require less investment, thus making it easier for a third party to value. The company owns just over 400 stores out of over 1,100 total units, without considering ground leases and corporate facilities such as its headquarters.
Morningstar's complete M&A research offering is available to Morningstar Select subscribers at select.morningstar.com. For additional information about Morningstar's institutional equity and credit services, please follow this link, contact your Morningstar Institutional Equity Research sales representative, call 1-312-696-6869 (Monday-Friday 8 a.m. to 6 p.m. CST) or email: firstname.lastname@example.org.
R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.