How to Make the Most of a Resurgent M&A Market in 2010

Unlike this time last year, prospects for U.S. corporate mergers and acquisitions (M&A) appear robust heading into the new year. And that bodes well for investors astute enough to identify the sectors where action will likely be hottest.

As an indication of the improving outlook, nine deals with a total value of $19.9 billion were announced from the start of December through Christmas Eve. That came on top of November's 14 M&A announcements, which were valued at $63.175 billion - although that number was distorted somewhat by Warren Buffett's $26.52 billion bid for the 78% of Burlington Northern Santa Fe Corp. (NYSE: BNI) he didn't already own.
By contrast, archives of merger-tracking Web site The Online Investor,  show 15 deals involving publicly traded U.S. stocks in December 2008, but the total value was a meager $3.986 billion. (That's not counting the $8.8 billion merger of Japanese electronics giants Panasonic Corp. (NYSE ADR: PC) and Sanyo Electric Co. (OTC: SANYY), which brightened the global picture somewhat.) November 2008 had 14 deals valued at just $4.898 billion.

As a rule, an increase in M&A activity is a bullish sign for both the economy and the stock market, says Money Morning Contributing Editor Shah Gilani, who tracks deals for his own advisory service - the Trigger Event Strategist. However, he cautions that the positive impact can be mitigated, depending on the reasons underlying the transactions.

"Deals getting done is indicative of a positive outlook for the economy in that acquiring companies are looking to expand their businesses," Gilani explained. "In the current environment, most deal-making is centered on extending the acquirer's market share and reach with regard to existing business lines - and that's healthy."

"It signals that companies are focusing on consolidation and concentration, which will ultimately yield larger economies of scale, greater business efficiencies and lower product prices. That typically translates into higher net margins and increased profits."

An example of this kind of synergistic combination is the merger of The Black & Decker Corp. (NYSE: BDK) and The Stanley Works (NYSE: SWK) - a $4.5 billion all-cash deal that will unite two of the world's largest and best-known toolmakers.

What we don't want to see, Gilani notes, are acquirers looking to "conglomeratize" or radically diversify away from their current business spheres.

"The market won't view takeover actions of that kind as a good move, but rather as a sign of weakness, reflecting a negative outlook for the company's core business lines," he said.

The market also frowns on companies taking on excess debt to finance acquisitions.

"If too much debt is used, it's a killer," said Gilani. "You only have to look at the vintage leveraged buyout (LBO) deals of 2006-2007 to see disaster in action because of deals too laden with debt."

With respect to the impact on the stock market in general, the increase in M&A activity could restore a "level of comfort" regarding share valuations, while also providing a sense that things are getting back to normal. It could also help create a floor under the prices of stocks in the industry groups seeing the most play, helping them resist all but a really strong overall correction.

Of course, the continued resurgence in M&A action isn't guaranteed. It depends primarily on three financial factors:

  • The credit situation must continue to loosen up so that new deals can be financed.
  • Stock prices of target companies must remain low enough that all-cash deals make sense.
  • The stocks of acquiring companies must be strong enough to be considered "good capital" - i.e., attractive for use in all-stock deals.

Right now, the probability of those conditions persisting looks good, meaning investors hoping to profit from renewed takeover activity should look to take speculative positions in stocks of companies in sectors where M&A deals are likely to percolate.

Industries where business is already strong are the best starting points. Technology, the medical sector, pharmaceuticals, mining companies and entertainment top that list. Examples already announced in these sectors include:

Investors who pick out potential target companies like those just mentioned can reap large windfalls if they get in early enough - or, even better, if there are multiple suitors for a company. For example, several pharmaceutical companies took an interest in Medarex and the firm's shareholders eventually netted a 100% premium when Bristol-Myers cut the final deal.

But rather than trying to guess which companies might get bought out, it's often easier to first identify potential targets.

"Investors need to have a large perspective and an in-depth understanding of the sectors where M&A is likely in order to speculate on what makes sense as a strategic acquisition for expanding companies," says Gilani. "Forward-looking statements by management and an analysis of quarterly and annual reports often provide an insight into a company's growth strategies, though that requires some reading between the lines. It's also important to examine the financial resources to see if or how an intended acquisition or merger might actually be completed."

Another clue that a company might be looking for an acquisition would be if it's financially healthy but has limited growth potential in its existing business.

"When established and seemingly tired companies need to grow, they often look to extend their business lines by acquiring additional business lines that make sense in terms of where other larger or more nimble players are heading," Gilani explained. One example of that, he says, is either AT&T Inc. (NYSE: ATT) or Verizon Communications (NYSE: VZ) possibly acquiring DirecTV (Nasdaq: DTV) to add streaming video to their mobile-phone businesses. "That would instantly add customers from DirecTV's subscriber base, and also let them better compete against [Apple Inc. Nasdaq: AAPL]. I think it will be acquired."

A similar situation exists in the mining sector. BHP Billiton Ltd. (NYSE ADR: BHP), one of Australia's leading resources companies, has built up a cash pool in excess of $18 billion thanks to the run-up in gold and oil prices. That has a number of analysts and takeover specialists citing Freeport-McMoRan Copper and Gold, Inc. (NYSE: FCX), Potash Corporation of Saskatchewan Inc. (NYSE: POT), or Anglo-American PLC (OTC ADR: AAUKY) as potential acquisition targets by BHP in 2010.

Recognizing special situations can also be helpful in identifying potential M&A transactions. For example, many U.S. companies are looking to expand their overseas operations, and acquisitions of complementary foreign firms with established products or territories are one way to do that. That was reflected by the recent $932 million stock-and-assumed-debt offer by New York-based agribusiness Bunge Ltd. (NYSE: BG) for Usina Moema Participacoes SA, a leading Brazilian sugar company with strong ethanol-production operations.

The gradually improving housing market has also prompted speculation that merger discussions could be in the works among some of the leading home-construction companies such as Pulte Homes Inc. (NYSE: PHM) that are looking to expand out of distressed markets and increase economies of scale.

Always keep in mind, however, that an announcement of takeover talks could actually have a depressing effect on the price of the acquirer's stock as investors worry about a possible shortage of cash or other resources to complete the deal.

And don't assume that a proposed merger or acquisition is really a good idea, warns Gilani.

"There's going to be a lot of M&A activity in the next couple of years," he said. "Some of it will be productive, some will be disastrous. There will be blood because greedy bankers need to ramp up fees to fuel new business and M&A"

And if the analytical stresses and risks involved with picking individual takeover targets seem too daunting, there are several mutual funds that specialize in playing M&A activity.

A few you could look at include Franklin Group's Mutual Global Discovery Fund (TEDIX), the Arbitrage Fund (ARBFX) and the AQR Diversified Arbitrage Fund (ADANX). There's also a new exchange-traded fund (ETF), the IQ ARB Merger Arbitrage ETF (NYSE: MNA), which started trading in mid-November.

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