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Jul 31, 2010

M&A focus: Activity may yet live up to forecasts

Morgan Stanley predicts an uptick in activity

Yet another report predicting M&A activity has hit desks. This one is from Morgan Stanley, which believes the ‘prognosis for M&A over the next 12 months is good.’

Morgan Stanley’s dispatch is the latest in a long line of studies, reports, notes and conversations, all predicting an M&A revival going back well over 12 months now. But deal activity remains stubbornly low. Indeed, in Morgan Stanley’s report, author Graham Secker points out that M&A activity is at its lowest levels since the early-to-mid 1990s. 

According to analysis by Secker, deal volumes and values in Europe for 2010 are on course for their lowest levels since 1996. What’s more, if you take into account market capitalization, deal values relative to market cap are due to plumb depths this year not seen since 1990.

So why might activity occur? Secker says if we experience a ‘reasonable degree of macro stability’, which must be considered a big IF, given the sovereign debt tremors that continue to roll across the continent, the following three factors offer encouragement that deal making could be ready for a comeback:

One: M&A volumes tend to follow a rise in corporate earnings and return on equity metrics, both of which are now on the way up, explains Secker. He notes that, according to Morgan Stanley’s analysis, European profits will grow by more than 50 percent on a year-on-year basis to May 2011.

Two: the free cash flows (FCF) of companies – which investors often use to analyze the returns they can expect from their investments – are looking cheap to buy, because market consensus dictates that the FCF yield should hit around 8 percent in 2011, up from around 6 percent on the 2010 estimate.

Three: the balance sheets of companies across Europe are, generally, in a good condition. Morgan Stanley notes that even medium-sized companies have lots of cash, not just the bigger firms.

Notwithstanding the macro picture, it all sounds pretty positive. In the report, Secker goes on to pick out some sectors he believes are ripe for consolidation, given the large number of firms operating in them. ‘Our analysis of sector fragmentation shows industries such as capital goods, diversified financials, media, telecoms and transportation are more fragmented in Europe than in the US and therefore do have relatively more scope for consolidation,’ he says.

He adds that ‘we would expect European stocks (and particularly those with high international exposure) to be attractive to overseas acquirers’ given the weak performance of sterling and the euro over the last two years.

Whether Secker is proved right, or suffers the fate of the many other M&A false prophets we have seen of late, we will find out over the next 12 months or so. The first clues probably won’t arrive until the autumn, however, as bankers, company executives and fund managers wind down for the sleepy summer months.