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Will corporate take-overs drive the next phase of the rally?

The recent bid by Kraft Foods for Cadbury may signal the start of a new period of Mergers & Acquisitions (M&A). After all, funding has become cheap again and many more companies may be looking for “sweet deals” in the near future.
Media reports have been suggesting that the current string of M&A deals signals an increased optimism of managements about the economic future. We have doubts about that interpretation. It is more likely that managements are simply good at math! They see that their funding costs have fallen below the free cash flow yields of potential targets and that is that. M&A is just making good business sense again!

This is a story of a famine turning into a feast, of distressed financial markets opening up in record time. Global M&A is still down 60% from the record level of $4,400 million in 2007, but this is changing fast. That is not because banks have become so generous all at once, but because equity and corporate bond markets have become very willing to provide new capital. Corporate bond issuance has broken all records in the first quarter of 2009 and has remained strong ever since. New bond issues are generally heavily oversubscribed and the same is true for equity issues.

With yields on money markets and longer dated government bonds close to historical lows, investors are now scrambling for higher yields. Buying of corporate bonds has therefore been unusually aggressive and they cannot be called cheap anymore. One can even argue that equities are now slightly more attractively valued than corporate bonds, a complete reversion of the situation of late 2008.

This development has been very favourable for quoted companies; they can fund themselves cheaply now, in the bond- as well as the equity-market. As said before, this environment is perfectly suited for M&A, even without an inherent conviction among managements that the future looks bright. As long as they can buy competitors with a stable business model and with a free cash flow yield that is higher than the corporate bond yield which they have to pay themselves, it makes sense. In these cases the acquisitions virtually pay for themselves! With companies generally having behaved very prudently during the past recession, there is no lack of viable, cash generative targets out there!

As long as corporate bond yields remain low, which may be for quite a while, M&A activity is likely to boom again. And not a moment too soon, as financial markets will need a new positive impulse to drive them even higher. After all, upside surprises on earnings and economic data are likely to become scarcer, given the higher expectations and potential lack of upside in consumer demand. Valuations have normalised and have therefore lost some of their appeal. So M&A may provide the icing on the cake in this mature phase of the recovery-play.

How can investors play this theme? Not easily. After all, if the M&A targets were known in advance they would not get an average 22% premium on announcement of the deal! However, there are some rough guidelines. Each deal will generally be good for the equity holders and potentially bad for the bond holders. Targets will tend to have good free cash flow generation. They can be found in all sectors, but tend to be overrepresented in the more defensive parts of the investment universe. This is also where our preferences lie.