Event Driven Investors Receive Their Wish
February 20, 2013
by Chris Maxey, Ryan Davis
Quiet Week Weighed Down By Europe
Equity investors found little reason to move the markets last week, sending the Dow Jones Industrial Average to a slight loss and pushing the S&P 500 Index marginally higher.
Domestic economic data was mediocre last week, while international data disappointed relative to expectations. Specifically, data showed that economies in Europe contracted more than believed during the fourth quarter.
In the US, retail sales were one of the more closely watched indicators as economists were uncertain how consumers would react to tax increases associated with the fiscal cliff deal. Ultimately, retail sales rose 0.1% in January, in line with estimates. That follows two consecutive months of 0.5% gains.
Source: Haver Analytics
Within the underlying components, sales were stronger in department stores, sporting goods and electronics, while weakness surfaced in furniture, apparel stores and in the miscellaneous category. The consensus opinion was that January sales were not terrible given the strength seen in November and December. Gains and losses were spread evenly across components, suggesting no underlying threat from weakening consumer spending.
Along with recent tax increases, consumers are facing a steady uptick in retail gas prices. Since mid-December, the average price for a gallon of gas jumped from $3.22 to $3.71. This is not the first time consumers have seen prices this high, but it will inhibit discretionary purchases at a time when paychecks are already lighter. The direction of gas prices into the spring and summer seasons will be an important driver of consumption growth through the year.
Measures of consumer sentiment offered a similar story. The University of Michigan Consumer Sentiment Index went from 73.8 in January to 76.3 in the mid-February survey. Readings of current and future expectations both increased in the last month, suggesting consumers are adapting to recent shrinkage in their paychecks.
Source: Haver Analytics
The situation overseas was less encouraging, with one news outlet dubbing it the “Valentine’s day GDP massacre.” Euro area GDP declined 0.6% in the fourth quarter, steeper than the 0.4% contraction expected. As expected, Italy and Spain continued contracting, but economists were surprised to learn that German and French growth declined 0.6% and 0.3%, respectively.
Source: FT Alphaville
It is important to remember that the European Central Bank’s (ECB’s) OMT program was formally announced late in the third quarter, mitigating the influence on fourth quarter growth. Economists believe a recent rebound in European manufacturing and better economic prospects globally will act as a positive catalyst for European economies in 2013.
Event Driven Investors Receive Their Wish
For several years, investors have wondered why M&A activity has been so benign. Corporate management teams cited uncertainty about the economic outlook as a primary reason for the depressed activity. With the latest round of tax increases and revenue cuts determined, companies finally appear willing to free their animal spirits and embark on the path of acquisition.
According to data from Dealogic, 2012 represented the first yearly decline in mergers and acquisition activity since the financial crisis. In aggregate, 2012 deal activity remained less than half its 2007 peak.
Source: The Economist
However, the situation has changed dramatically over the past few weeks. US deal activity was $158.7 billion during the first six weeks of the year, double the amount seen during the same period last year. On Thursday alone companies announced $40 billion of M&A deals.
The list of companies receiving bids this year includes several marquee corporations, like Virgin Media, Dell, NBC Universal, US Airways and Heinz.
Source: Wall Street Journal
There implications of this increased activity are mixed. Traditional event driven/merger arbitrageurs are encouraged by the rising pace of deal activity, but also the possibility of topping bids.
Late last year, Sprint-Nextel agreed to sell 70% of its company to Japan’s SoftBank for $20.1 billion. Sprint-Nextel subsequently turned around its proceeds and offered $2.2 billion to purchase spectrum provider Clearwire. Only a few short weeks later, Dish Network offered $2.28 billion to acquire Clearwire.
Activist investors are also starting to become more vocal about their agendas. Website sharkrepellent.com reported 152 cases of corporate activism in 2012, an increase of nearly 33% from the year prior. DLA Piper analyzed the subset of activist situations that began in 2012 with a market cap greater than $1 billion and discovered that 78% ended with a positive outcome. Last year Jana Partners approached Canadian fertilizer company Agrium in an effort to spin off portions of the company’s business. Similarly, activist investor Bill Ackman started a proxy fight with Canadian Pacific Railway in mid-2012 and later won the right to install new management.
Fixed income investors are likely to take a different view of these developments. On Friday, Fitch Ratings downgraded Heinz to junk status, despite Berkshire and 3G Capital paying $23.2 billion in cash for the company and commitments by JP Morgan and Wells Fargo to chip in $8.5 billion through various loan facilities. Fitch is concerned that Heinz’s leverage will jump form 2.5x to potentially more than 5x as a result of the deal.
The fear is that acquirers will actively re-leverage balance sheets to finance deals, resulting in lower credit ratings and more companies dropping from investment grade to high yield status. In 2012, as an example, high yield issuers used 13% of issuance for M&A and another 5% for leveraged buyouts. At the peak in 2007, issuance for the purposes of M&A and leveraged buyouts was approximately 50% of all high yield debt issued.
Although leverage ratios are on a slightly higher path, they are still nowhere near the 2007 peak, suggesting this new buyout boom is still in the beginning phase.
There are plenty of reasons to think corporate activity will remain strong. Companies are holding trillions of dollars worth of cash on their balance sheets, while statistics from Triago show that buyout and private equity firms are holding $193 billion that must be spent by year-end. Before the end of 2015, Preqin estimates that more than 700 buyout firms need to deploy cash.
There are plenty of reasons to suggest a true beginning of a new M&A cycle. However, it is important to remember that confidence can be fickle. There were several false starts in activity during the past few years, only for activity during those periods to derail on concerns about the fragile economic situation in Europe and deterioration in economies such as China. This time feels different given the size and scope of the announced deals, indicating growing confidence among company managements. We are optimistic that this is the start of a new M&A cycle.
The Week Ahead
The holiday-shortened week brings plenty of new data to digest, including inflation trends, housing data and minutes from the last FOMC meeting.
Earnings reports likely to receive the most attention include TNT Express, Barnes & Noble, Danone, Dell, Marriott, BHP Billiton, AIG and Walmart.
This week only brings a handful of central bank meetings, including those in Turkey, Thailand, and Colombia.
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