Western European stock markets are undergoing a mergers-and-acquisition frenzy, the likes of which hasn’t been seen since the 1998-2000 dot-com boom.
But unlike that frantic period, M&A deals across the continent have ensnared companies of different sizes in many industries. While deregulated industries like banks and utilities have undergone a massive spike in consolidation, M&A transactions have also involved telecom, retail, pharmaceuticals, commodities, and, most recently, infrastructure companies, including stock exchanges, ports and airports.
According to Clive McDonnell, Standard & Poor’s chief European strategist, there were 1,850 M&A deals announced in Europe in the first quarter of 2006, similar to the year-ago period. However, the value of those transactions surged to 380 billion euros from 138 billion euros.
Some of the biggest European mergers include a hostile 22-billion euro bid by Spanish gas distributor Gas Natural for Endesa SA (ELE), the Spanish utility, as well as a concurrent 29.1-billion euro bid for Endesa by Germany’s E.ON AG (EON). In addition, Bayer AG (BAY), Germany’s biggest drugmaker, outbid Merck KGaA for Schering AG (SHR) by offering 16.3 billion euros. There is also the successful takeover of Lucent Technologies (LU) by French telecom giant Alcatel S.A. (ALA) in an 11.1-billion euro deal.
This year may set a record for M&A activity on a global basis, and perhaps in Europe alone, said Howard Horowitz, director of research at Water Island Capital LLC, the investment adviser for the $173-million Arbitrage Fund/R (ARBFX), which specializes in merger arbitrage. Fueling this frenetic buying are two huge pools of cash, he explains. “First, we have the strategic buyers — companies seeking to acquire competitors, either of equal size or in some cases even larger rivals. Since many European companies have delivered strong profit growth recently and cleaned up their balance sheets, they have the resources to purchase new assets, especially after a fallow five-year period of no M&A activity. There is a lot of pent-up demand.” The other major source of cash, he points out, is from private equity funds, which are teaming up to make big multi-billion-dollar transactions.
Low long-term interest rates in Europe are also cited as a driver for M&A activity. Though higher energy and commodity prices and some signs of inflation may compel the European Central Bank (ECB) to tighten later this year, long-term rates in Europe have been stable and at historic lows. “If long-term rates were to dramatically rise, we would probably see more stock-for-stock merger transactions in Europe, thus taking away some of the edge that private equity shops currently have,” Horowitz said. “Or, we could witness some slowdown in M&A deals overall.” Indeed, the ECB raised rates by a quarter point in early March, following a similar rise last December. Long-term rates in the Eurozone are presently at 2.50%, versus 4.75% in the U.S.
Observers point out that the current M&A explosion is occurring amidst an environment of sluggish economic growth throughout Europe. The European Commission recently cut its economic growth forecasts for the Eurozone, citing high oil prices and rising interest rates. Standard & Poor’s expects the Eurozone economies to grow by 1.9% this year, and 1.6% in 2007. For the U.K., these figures come to 2.0% and 2.5%, respectively. In comparison, GDP growth in the U.S. is expected to approximate 3.5% in 2006, and 2.5% next year.
“Economies across the continent are fairly mediocre,” Brugere-Trelat noted. “European companies, particularly large-caps, cannot count only on ‘organic growth’ in order to increase their assets and stay competitive. The only way for them to keep growing is through acquisitions, often by seeking out companies in other countries.” Observers also note that Europe’s tepid economy may actually be driving some M&A deals since stocks trading at cyclical lows make attractive take-over targets.
Many companies simply cannot grow any further in their home countries, due to, among other things, anti-trust laws and the need for market diversification, Horowitz explained. “They have no choice but to seek cross-border transactions. This makes good strategic sense for them.” However, the phenomenon of cross-border mergers, a natural consequence of establishing the EU as a single market force, has faced much opposition from sovereign governments and labor unions worried about job losses, reduced tax revenues, and the dilution of national identity.
While the EU and its purpose of forming a single European economic entity (and single currency) would appear to be in conflict with the protectionist interests of national governments, Horowitz believes the principles of the free-flow of capital and open markets will probably win out in the end. “I think we are on the brink of a five-year period of high M&A activity in Europe,” he says.
As a stock picker, Brugere-Trelat believes that continued M&A activity will help push European equity prices higher. Most Eurozone markets have logged gains of nearly 10% so far this year. “M&A is one of the strongest catalysts one can think of to release value,” he noted.
Investors seeking exposure to European stocks have a wide variety of mutual funds and ETFs to choose from. Single- country Europe portfolios pose specific market risks, while funds and ETFs with a broader geographic mandate offer more stability and a wider net to catch the cross-border M&A activity that’s been supporting European stock markets.
Broad Europe ETFs include iShares S&P Europe 350 Index Trust (IEV), iShares MSCI EMU Index Trust (EZU), streetTRACKS DJ EUROSTOXX Fund (FEZ), BLDRS Europe 100 ADR Index Fund (ADRU), Vanguard European VIPERS (VGK), and Europe 2001 HOLDRs (EKH). Below is a list of the best-performing Europe mutual funds over the past five years. All are ranked 4 or 5 Stars by Standard & Poor’s.
Source: Standard & Poor’s. *Data through April 21, 2006.