M&A Sector Arbitrage

Louis Capital Markets M&A Scenario Model

Originally published in the June 2007 issue

Global M&A activity is running 63% ahead of 2006 so far this year. Since the start of 2007 $2 trillion of deals have been announced and April has been the busiest month in history. The driving forces that continue to fuel M&A activity are well known, and include the low cost of debt financing, the unintended consequences of Sarbanes-Oxley and the leniency of the FTC and the Department of Justice to approve deals.

The latter may perhaps motivate companies to rush the completion of any deal companies are considering before the 2008 presidential elections, as they speculate that the winner could be less M&A friendly than the Bush administration.

“Global M&A activity is running 63% ahead of 2006 so far this year. Since the start of 2007 $2 trillion of deals have been announced”

Surprisingly, the sectors in the S&P 500 where conditions have been most conducive to M&A activity do not trade at a premium to the market. In fact, the opposite is true, several sectors that our M&A scenario model ranks at the top in terms of potential M&A activity trade at a discount to the market.

The Louis Capital M&A Scenario Model screens all the constituents of every sub-index in the S&P 500 (and the Bloomberg Europe 500) and ranks every conceivable combination in each and every sector by potential EPS accretion (or dilution) that a merger would deliver for the acquirer. For the S&P 500 alone the model generates almost 1300 possible combinations. The model does not take into consideration factors such as anti-trust barriers, management/workforce compatibility, cost and revenue synergies et al. For the S&P 500, the top ranked sectors are integrated oil & gas, electric utilities, multi-utilities and power merchants (think TXU) and integrated telecom. For the Bloomberg Europe 500 the top ranked sectors are mining, building materials, utilities and telecom.

Clearly, the commonality among most of these sectors is that profitability is at historically unprecedented levels. The sustainability of such profitability may be called into question, but the executives of these companies are rarely the ones to be cynical on the outlook of their company or the sector in which they operate.

Such sentiment, supported by soaring profits, often leads to a frenzy ofM&A activity at the top of the cycle for a specific sector. The tech and telecom M&A boom of the late nineties is a point in case. The technology and telecom sectors traded at a 43% and 14% premium respectively to the S&P 500 by the end of 1999.

Currently the highest ranked sectors in the S&P 500 as selected by the model ie the ones which are most conducive to further consolidation, do not. This leads us to make several conclusions;

a) US acquirers will continue to prefer primarily debt financing over equity financing, since costs of debt are low and the acquirers’ equity is not (yet) overpriced, and thus a more expensive form of financing

b) M&A activity in these sectors still has legs, since there are enough sceptical investors that remain underweight these sectors (as reflected by the valuation discount to the market). This means that their assets are relatively cheap and consolidators in these sectors will choose to buy an asset rather than build from scratch because it’s cheaper to buy than to build

c) There is a disagreement between the investment community and the corporate executives. Fund managers for example expect copper prices to decline, as reflected by the 30% discount the sector has to the S&P 500. Freeport McMoran however foresees lasting copper supply shortages and was willing to spent $23 billion to buy its nearest competitor Phelps Dodge.

Fund managers see current oil prices as unsustainable long term and as a result the oil sector P/E is almost half that of the S&P 500. Conversely, Exxon is bullish enough on oil prices to spend $8 billion per year buying its own stock. We don’t know which side will prevail, but what we do know is that conditions in aforementioned sectors strongly encourage more M&A activity.

Not only because of the potential for EPS accretion but also because the men and women running the companies are the most fervent optimists about the prospects of their specific sectors. As an investor, to benefit from further consolidation we recommend a hedged strategy that offsets a long position in the integrated oil sector (exchange traded fund: XLE), long utilities (ETF: UTH) and telecom (TTH) with a short position on the S&P 500 (ETF: SPX).

Stock specifically, the most accretive acquisitions the model has selected among all S&P 500 constituents were Exxon-Mobil acquires Murphy Oil or Hess Corp, Dominion Resources acquires Integrys, Excelon buys Pinnacle West and Verizon acquires Windstream.