Taking the Measure of Merger Mania

What's behind the motherlode of M&As announced during the week of Nov. 20?

by Sam Stovall From Standard & Poor's Equity Research

Thanksgiving week is usually supposed to be a slow one on Wall Street. But market players awoke on Monday, Nov. 20, to a veritable merger maelstrom, including Blackstone's $20 billion proposed purchase of Equity Office Properties (EOP) and Freeport-McMoRan's (FCX) $25.9 billion offer to buy Phelps Dodge (PD). All together, more than $50 billion in deals went down, adding to the $3.1 trillion in transactions posted year to date through Nov. 17, and nearly $7 trillion over the past three years.

S&P's Equity Strategy Group sees the mergers and acquisitions activity driven by a number of factors. First, there is ample global liquidity, with receding inflation risks likely to keep rates low and financing activity strong. Second, private equity has emerged as a potent market force. Kenneth Shea, S&P's managing director of global equity research, thinks private-equity firms "will continue to apply pressure on underperforming companies."

And there is an abundance of cash on corporate and private-equity balance sheets. Diane Vazza, S&P's managing director of fixed-income research, believes "the cash spigot should remain open—the appetite for fixed-income securities tied to M&A will remain strong as historically low credit-default risk rates, combined with the need for yield, create powerful backdrops for continued strong fixed-income issuance."

The Democrats Are Coming

Other factors appear to be playing a part, as well: Dealmakers may believe that equity prices are undervalued, as major indexes, while at multiyear highs, are still below all-time price-earnings ratio levels. And M&A players may see a need for expediency, due to the looming Democratic assumption of power in both houses of Congress, as future deals may see a greater degree of scrutiny in Washington.

What's more, the economic backdrop is favorable. In the U.S., S&P Economics sees a "soft landing" in 2007, with real gross domestic product (adjusted for inflation) slowing to a projected 2.3% growth rate next year from the 3.3% growth anticipated for 2006. In addition, we see global growth at 3.3% in 2007, down from the 3.9% projected advance for 2006.

Future U.S. economic growth is expected to be investment-led, rather than consumer-driven as it was in prior years. Even though S&P sees consumer spending rising a respectable 2.8% in 2007—as a result of only a modest uptick in long-term interest rates and a slight rise in the unemployment rate, to a 4.9% average—we believe the industrial side of the equation will be a key driver, as seen in our projected 6.8% advance in equipment investment and an 8.8% increase in nonresidential construction.

Investment Banking Beneficiaries

The past 12 months have witnessed $3.1 trillion in M&A activity, more than 45% of the three-year total of $6.8 trillion. In the past year, more than 20% occurred in the financial services sector. Cathy Seifert, head of equity analysis for S&P's financial services group, says this is due to midsize and small firms anticipating the lagging effect of the inverted yield curve, "seeking economies of scale or diversification of business mix."

The consumer discretionary and industrials sectors have also been highly active over the past year. The three-year totals were also dominated by the financial services, consumer discretionary, and industrials sectors.