By Alexis Xydias
Sept. 21 (Bloomberg) — Never before have U.S. companies piled up cash faster compared with interest costs than they are now, setting the stage for a surge in mergers and acquisitions.
As the economy emerges from the worst recession in 70 years, cash flow may rise from the $1.5 trillion reported by the Commerce Department for the year ended in June, according to data compiled by Credit Suisse Group AG and Bloomberg. The amount reached a record in the past 12 months amid the biggest wave of firings since World War II and central bank interest rates near zero percent.
Cash relative to share prices will climb to the highest in at least two decades next year compared with yields on corporate bonds, the data show. The previous high in 2005 preceded the two busiest years ever for takeovers.
“You’ll see a steady return to growth in the M&A market,” said Michael Boublik, the chairman of mergers and acquisitions for the Americas at New York-based Morgan Stanley. “Investors are wanting and demanding that companies start thinking about M&A to fuel growth, so therefore deals are being well accepted.”
Takeover bids by companies from Walt Disney Co. to Kraft Foods Inc. signal increasing confidence among executives that may extend the 57 percent rallyin the Standard & Poor’s 500 Index from a 12-year low on March 9. A record amount of mergers helped send the benchmark gauge to its October 2007 high.
Dell, Perot Systems
Dell Inc. in Round Rock, Texas, the world’s second-largest maker of personal computers, today agreed to acquire Plano, Texas-based Perot Systems Corp., the computer-services consultant founded by former U.S. presidential candidate H. Ross Perot, for $3.9 billion.
The deal helped limit the decline in the S&P 500, which slipped 0.3 percent today. Perot Systems surged 65 percent, while Dell slipped 4.1 percent in New York trading.
U.S. companies posted annualized cash flow of more than $1.5 trillion in each of the last three quarters, the most on record, Commerce Department data starting in 1947 show.
With expenses shrinking, the money makes U.S. corporations more attractive to buyers who plan to sell bonds to pay for takeovers, Credit Suisse strategists led by London-based Andrew Garthwaite wrote in a report on Sept. 11. Pay to non-government workers has fallen for three straight quarters, dropping 6.6 percent to $5 trillion in the April-to-June period from a year earlier, Commerce Department data show.
Yields on corporate bonds are 0.8 percentage point more than the estimated free-cash-flow yield, or income left over after capital expenses, divided by stock-market value, for U.S. companies in MSCI indexes, data compiled by Zurich-based Credit Suisse and Bloomberg show.
Mergers climbed at least 13 percent in the four years from 1990 until the credit crisis when the gap between rates on corporate bonds and free cash flow was less than 2 percentage points.
Rising cash levels in 2005 preceded the two biggest years in U.S. deals, Bloomberg data show. Takeovers jumped 32 percent in 2006 to $1.74 trillion and 13 percent in 2007 to $1.97 trillion, the data show.
“People are going to realize how resilient cash flows have been in a bad recession,” said Russell Napier, Edinburgh-based strategist at CLSA. “Buyers usually have to finance some kind of debt and cash flow is king. We are not going back to the silly days where anyone could raise billion-dollar deals but we are going to see M&A. For businesses with strong balance sheets, this is a great time to buy.”
Margin of Safety
The cash levels also provide a margin of safety for companies should the highest unemployment rate in 26 years and lower consumer spending drag the economy back into a recession, said Richard Weiss, who oversees about $50 billion as chief investment officer at City National Bank in Beverly Hills, California.
U.S. consumer credit plunged by a record $21.6 billion in July, according to a Federal Reserve report released this month, as banks restricted lending and job losses made Americans reluctant to borrow.
Companies in the gauge have hoarded cash to weather a two- year slump in earnings, the longest since the Great Depression. Share buybacks by U.S. corporations fell to the lowest level in the second quarter since at least 1998, New York-based S&P said last week, as the recession reduced earnings.
Profits for companies in the index will probably fall 22 percent in the current quarter before growing 62 percent in the final three months of the year, according to the average estimate of analysts surveyed by Bloomberg.
‘Makes More Sense’
“Making acquisitions now makes more sense than it would have done six months ago,” said Bo Nordberg, a merger analyst at GFI in London. “But a big caveat is if this rally is not a fundamentally driven rally and we see a pullback, then CEOs don’t want to be seen as having offered too high a price.”
Executives will have to rely less on cutting costs to make acquisitions work. The U.S. unemployment rate climbed to 9.7 percent last month, bringing the number of Americans thrown out of work since the recession began in December 2007 to 6.9 million, the most in any post-World War II contraction, data compiled by Bloomberg show.
From the start of the decade until the onset of the contraction, the jobless rate averaged 5 percent.
The cheapest valuations in 15 years for the S&P 500 helped spur the 2006 to 2007 takeover boom. While the S&P 500 is now trading close to the lowest level relative to profit since 1989 based on next year’s earnings projections from analysts, growth forecasts by economists from Goldman Sachs Group Inc.’s Jan Hatzius to Morgan Stanley’s Richard Berner in New York indicate equities aren’t currently a bargain.
Profits for companies in the S&P 500 will rise 25 percent next year, according to the average estimate of more than 1,500 equity analysts compiled by Bloomberg this month. That was 10.9 times faster than the expansion in gross domestic product forecast by 53 economists in a separate survey.
The ratio of income to GDP growth is the highest on record and compares with an average of 6.1, based on data compiled by Bloomberg going back 60 years.
Private-equity firms that spent a record $1.4 trillion on announced deals in 2006 and 2007 have less access to loans after the seizure in credit markets. Leveraged buyouts dropped more than 70 percent this year through last week, data compiled by Bloomberg show.
U.S. banks tightened standards on loans in the second quarter and expect to restrict lending until at least the second half of 2010, the Fed’s quarterly Senior Loan Officer survey showed last month. Most banks cited reduced risk tolerance and “a more uncertain economic outlook” as the main reasons for restricting credit to businesses.
Mergers and acquisitions dropped by about half in the U.S. to $492.5 billion this year through last week, the slowest pace since 2003, Bloomberg data show.
The pace of deals slowed after the collapse of subprime mortgages froze credit markets, leading to $1.62 trillion of writedowns and losses at the world’s biggest financial firms and the bankruptcy of New York-based Lehman Brothers Holdings Inc.
“The M&A cycle is so early right now,” said Jim McDonald, chief investment strategist at Northern Trust Corp., which manages $558 billion in Chicago. “The deals that are being done today are more bite-sized and strategic. They’re not franchise- changing.”
The MSCI World Index of 23 developed nations had added 4.2 percent in September as Burbank, California-based Disney’s $4 billion purchase of Marvel Entertainment Inc. in New York and Kraft’s $16 billion bid for Cadbury Plc revived takeovers. Marvel rose 28 percent since Disney, the world’s biggest media company, announced the deal on Aug. 31.
Media companies are loading up on debt that may be spent on M&A, according to Barclays Capital. News Corp., the New York- based owner of the Fox broadcast network, and Discovery Communications Inc., a Silver Spring, Maryland-based television producer, led almost $4 billion in media debt sales last month, according to data compiled by Bloomberg.
Cadbury, the London-based maker of Creme Eggs and Trident gum, has climbed 39 percent since Northfield, Illinois-based Kraft, the second-largest foodmaker, proposed buying it.
“The driver of the next M&A boom is going to be globalization,” said Ralph Schlosstein, chief executive officer of New York-based Evercore Partners Inc., the ninth-ranked adviser on announced takeovers this year, according to Bloomberg data. “The Kraft-Cadbury deal was a great example of that.Cadbury has a great exposure in emerging markets and that’s part of whatKraft is trying to get.”
Of 118 non-financial S&P 500 stocks worth less than $5 billion, 52 had a higher free-cash-flow yield than the corporate-bond yield through last week, along with net debt less than three times their annual earnings before interest, taxes, depreciation and amortization, Bloomberg data show.
Hasbro Inc. in Pawtucket, Rhode Island, the world’s second- largest toymaker, had a free-cash-flow yield of 11.6 percent. Watson Pharmaceuticals Inc., the Corona, California-based maker of generic drugs, had net debt that was less than half of its EBITDA. Its free-cash-flow yield stands at 12.9 percent.
Nathalie Pelras, who helps oversee the equivalent of $2.4 billion as a fund manager at KBL Richelieu Gestion in Paris, owns shares of Cadbury and bought Windsor, England-based InterContinental Hotels Group Plc on speculation the chain may get a bid.
“If the real, offensive M&A begins again, obviously this means there will be a premium on stocks and the market will play the theme and add those premiums to all the stocks that may be a target,” she said. “The risk is that this may lead to a bubble of valuations, but in principle M&A is a good thing.”
Last Updated: September 21, 2009 17:22 EDT