Cautious Optimism for More M&A Activity in 2013

Bridget Freas: Good to be here.

Glaser: At the end of last year, we saw an acceleration in M&A deals. Is that start of a trend? Is 2013 going to be a real blockbuster year for mergers?

Freas: Well, if you look at just the end of the year, you might think that, but I think you need to take it in the context of the whole year. Deal activity was down 3% from 2011 for all deals announced. But if you look deal sizes, they really picked up in the fourth quarter, particularly in December. So the dollar volume of all deals announced last year actually increased a tiny bit, but if you take out the fourth quarter, it would've been down by a lot. So, it's really hard to make a trend out of the last fourth quarter, but we are cautiously optimistic that 2013 is going to be better than 2012.

Glaser: What are some of the factors that are pushing management teams to look at more deals?

Freas: We are expecting a pick-up particularly in strategic acquisitions. We do think that the leveraged buyout market is open. We do see opportunity for financial transactions, but I think particularly, if you look at management teams, they are sitting on stockpiles of cash. That's the number-one thing. There is only so long that executive teams can wait on pulling the trigger and actually deploying that capital. The other thing, I would say is, for a lot of sectors, corporate profit margins are at a cyclical peak. So, it's going to be hard to continue to grow the bottom line without new sources of earnings, and we think one of the easiest ways to achieve that is through acquisitions--definitely new sources of growth and just a way to continue to drive the bottom line.

Glaser: On the flip side, what's holding the deal flow back?

Freas: I think the number-one thing is just the economic environment as a whole. We are cautiously optimistic that economic indicators are starting to look better in 2013 in the United States. Europe is starting to stabilise. We're starting to see a little bit of a turnaround in China. But I think there is still a lot of uncertainty. I think that's the number-one factor, and we're seeing that probably across all sectors.

Glaser: How about financing? There might be some firms that can do this with cash, but others are going to need to borrow. Is that open? Is there a possibility to finance these deals, or are we going to see mostly cash- or stock-type transactions?

Freas: Absolutely. I think in the two years that we have been publishing this report, this is the first time where we've really seen an open financing market on all fronts. I mentioned before the stockpiles of cash, that's been a phenomenon that's been ongoing, but now we've also seen a major comeback in the equity markets, so equity financing is readily available. The S&P 500 is only a few points below its 2007 peak, and then the credit markets have really improved. High-yield debt, investment-grade debt, and even bank debt is widely available and for pretty cheap.

Glaser: We've talked a little bit about the acquisition targets, but what about the acquirers themselves. How do you think about those companies, and how should investors think about them?

Freas: Well, in the last couple of years, we have always included a section on acquirers, but our focus has always been so much more on the targets. So we've really tried to expand that in this edition. And we have a new section that focuses specifically on what happens after the deal, what is the rationale for the acquirer, and what does this mean for investors in the acquirer shares? Because a lot of times, you see them acquire a deal for an attractive price and the shareholders in the target get their premium, and then that's the end of the story. But have they been able to actually use their acquisition to build shareholder value? We revamped our stewardship rating in the last year to really focus on allocation of capital. We noticed that one of the number-one indicators of exemplary stewardship were companies that used M&A activity to drive returns on capital, and that kind of ties into our economic moat framework.

We've seen companies in health care and industrials really focus on using M&A activity to build their moats, which we think is indicative of a successful acquisition driving returns for shareholders. And this also gives a chance for investors to not only focus on trying to profit from investing in targets, but the acquirers, as well.

Glaser: But certainly a lot of deals don't end up producing value, instead ending up in a big write-off. What are some red flags that a deal may not go well?

Freas: This is another thing that we talk about in the report because companies are always happy to discuss all their successful acquisitions, and so when a deal is announced, of course they are highlighting the valuation and the strategic rationale and the synergies. But it's hard to figure out some of the questions that shareholders should be thinking about and whether to vote in favour of the deal, or if it's a deal that's already happened, whether they should buy shares in the newly combined company or shares of companies that tend to be highly acquisitive.

So, I think some of the red flags that you might think about are more obvious like high valuation, was it a competitive bidding process that might have bid up the final deal price? But we talk a little bit more on some other things such as, has the management team done a lot of due diligence? How much leverage did they take on in order to close the acquisition? Has there been management change around the time of the acquisition? So there are some things that we think commonly reflect deals that end up in, as you say, a big write-down a few years later.

Glaser: Now looking across industries do you think there are certain areas that are going to see more activity this year and some that are going to see less?

Freas: Sure. Well, we've seen health care and consumer being very active. That's been the case for a couple of years now, but recently we've seen a pick-up in industrials and technology. There's some talk right now of a $15 billion deal going on with Dell. Now, who knows if that will actually reach the finish line, but we have seen greater interest in the tech sector. So there are early signs of a better 2013.

And then in energy, we think that the conditions for M&A have improved. We aren't necessarily seeing better traction on deals yet, but we think the pieces are coming into place, so our outlook has improved there. Also energy is one of the sectors that we think is more attractively valued. Energy and financial services, in particular, are two areas where we think the valuations are the most attractive, which tends to indicate more M&A activity because there's a greater margin of safety to being able to drive returns off of those kinds of deals.

Glaser: You mentioned that you've had a few of these reports already. What's the track record of these ideas of companies that could potentially be acquired?

Freas: The number of companies that we've had on our list changes from time to time. This is our second year in doing the reports, so this is the sixth edition that we've put out. But overall we've had 14 companies that we had named as potential targets accept a bid, four just recently in the last few months. That's on our total list of potential targets.

Now what we try to do in every edition is narrow that list to maybe 12 or 15 top investment ideas. So these are potential targets that we think offer an attractive valuation for investors either because of their M&A potential or other factors, and four on that narrow list of investible ideas have been acquired in the last two years. So, that's a track record that we're very proud of.

Glaser: Bridget, thank you so much for your thoughts today.

Freas: Thank you.

Glaser: For Morningstar. I'm Jeremy Glaser.