Time for a New Corporate Buying Spree?

As earnings take a nosedive, analysts expect to see more companies turn to M&A to pick up the slack. They certainly have the cash

by Steve Rosenbush

The slowdown in U.S. corporate profits has been swift and stunning. While earnings for companies in the Standard & Poor's 500-stock index grew a robust 14.7% in 2006, profit growth has screeched to a halt amid the troubled financial climate of 2007. With the income-reporting season kicking off the week of Oct. 8, average earnings for the S&P 500 companies are on track to grow just 1.9% during the third quarter, the slowest pace in more than five years, according to senior S&P index analyst Howard Silverblatt. That's down from 7.9% for the first quarter and 9.6% in the second. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

The slowdown creates a dilemma for corporations, which face an imperative to "grow or die," Silverblatt says. How will they address their profit-growth problem? Many experts believe they will increasingly turn to mergers and acquisitions. "I don't think there's any question that growth will be harder to come by and that many companies will attempt to compensate for that by using M&A," says Hal Ritch, the former co-head of M&A at Citi (C); Donaldson, Lufkin & Jenrette; and Credit Suisse (CS), which acquired DLJ. He's now co-CEO of Sagent Advisors, an M&A advisory shop.

Ritch and other M&A advisers say they have detected a shift in their business during the last few months. The private equity firms that dominated M&A last year and during the first half of 2007 have been doing fewer deals of late. They are having a tougher time securing funding (BusinessWeek.com, 9/17/07).

"We have seen a shift toward corporate buyers during the last 90 days," Ritch says. One senior M&A lawyer agrees with that observation. "Our private equity pipeline has slowed. All of a sudden we're seeing strategic buyers who want to look at deals," says Bob Profusek, head of the M&A practice at global law firm Jones Day. U.S. private equity buyouts totaled $33.3 billion in September (BusinessWeek.com, 9/27/07), down 27% from $45.6 billion in August, according to researcher Dealogic.

Flush With Cash

The corporate world has the resources to support a big boom in M&A, should management choose that route. Earnings growth may be weak, and consumers may be drowning in debt, but corporate balance sheets are in stellar shape. Companies are flush with cash and operating at historically low levels of long-term debt. Excluding the financial and utilities sectors, companies in the S&P 500 had $622 billion in cash on their books at the end of September. That's near the all-time quarterly high of $640 million recorded in March, 2006, and nearly twice as much as the $328 billion on hand at the end of 2000. Cash as a percentage of long-term debt is 40%, well above the average of 31.2%, according to S&P's research. Debt as a percentage of market value is 14.8%, well below the long-term average of 21.7%.

Companies also can use their stocks as a currency to make acquisitions. Corporate executives have been under intense pressure from activist investors such as Carl Icahn to buy back shares. Stock buybacks in the second quarter of this year rose to a record $157 billion—$39 billion above the previous record set in the previous quarter. "We're in uncharted territory when it comes to buybacks. We've never seen anything like this," Silverblatt says.

If those shares aren't used for M&A, the alternatives aren't too appealing. Letting the stock sit in the corporate treasury is unproductive, and retiring shares reduces a company's size and market value, which is generally viewed as undesirable. The remaining choice is to put the shares back on the public market, which would dilute earnings—another grim option.