Markets & Finance

M&A: Where the Action Is


S&P Ratings sizes up the sectors that could see the most deals in the coming year. Among the winners: banks and exchanges

From Standard & Poor's RatingsDirectStandard & Poor's Ratings Services believes that many borrowers, investors, and private equity players are growing increasingly comfortable with aggressive leverage, and the current financial environment is powering a wave of leveraged mergers and acquisitions that will likely again reach record highs. Shareholder-friendly actions, such as large debt-financed stock repurchases and special dividends, also likely will set new records in 2007.

"Still, there will be a downside," says David Wood, managing director for S&P Ratings. S&P expects many of these types of transactions to have a negative effect on credit quality, continuing the trend seen in 2006.

Which U.S. industries are most likely to see medium to high M&A activity this year? Here's S&P Ratings' list:

AIRLINES

Expected M&A level: Medium

While Standard & Poor's expects moderate activity in Aerospace & Defense overall, given the varied degree of consolidation in the industry's sectors, airlines may be a focus of high interest. US Airways Group (LCC; S&P credit rating, B-) increased its acquisition bid for Delta Air Lines (DALRQ; D) to $5.2 billion before withdrawing its offer in January, 2007. Another possible bidder is Northwest Airlines (rated D), which, like Delta, is in Chapter 11 but expected to emerge in the second or third quarter of 2007.

Effects on ratings: With airline ratings already low, the effects of acquisitions will depend on the financing used. In private equity deals, ratings likely would fall into the B category, given expected significant leverage. The consolidation of two airlines in bankruptcy (e.g., Delta and Northwest) would obviously result in a higher rating for the company emerging from Chapter 11.

TELECOMS

Expected M&A level: Medium

Even with a high degree of existing consolidation, deals among regional telecom companies may be likely. Meanwhile, major wireline companies may look to sell properties to either industry players or investment entities. Spin-offs of wireline properties by integrated telecom companies are possible, as they may want to separate higher-growth wireless services from wireline businesses.

Effects on ratings: For possible wireline spin-offs from the regional Bell operating companies, we foresee downgrades, as heightened business risk may be combined with aggressive dividends and other shareholder-friendly activities. Ratings changes regarding regional wireline or wireless deals should be less dramatic.

CONSUMER PRODUCTS

Expected M&A level: Medium-high

Already-significant consolidation has led to increased buying power in some subsectors, and some manufacturers will need to grow to service retailers on a national scale. Some tuck-in acquisitions are likely among packaged-food companies, while apparel retailers' desire for more private-label merchandise and proprietary brands may drive deals.

Effects on ratings: S&P expects additional debt loads and reduced financial flexibility to weigh on ratings. Continued high commodities prices may exacerbate risks in some sectors.

EXCHANGES

Expected M&A level: High

Two very large transactions are already in the works: the merger of Euronext (AA) with NYSE Group (NYX; AA), and the hostile bid by Nasdaq Stock Market (NADQ; BB) to acquire the London Stock Exchange (not rated). Either of these deals could change the competitive dynamics of the sector for years. The Tokyo Stock Exchange (not rated), for example, has said it may be interested in a tie-up with a combined NYSE-Euronext.

Effects on ratings: Any effects depend on the size of the acquisition and existing debt, but pure stock exchanges—those without clearing services—typically generate cash flow sufficient to service debt. Still, significantly leveraged companies (e.g., Nasdaq) may see some downward ratings pressure.

HIGH TECH

Expected M&A level: High

M&A activity in the past several years has been focused on the software and services sectors of the industry, as companies seek to either gain size or broaden their product lines. And while the industry has entered a more mature growth phase, this is likely to continue, as financial characteristics including high recurring revenues, typically strong balance sheets, low capital expenditures, and stable cash flows are attractive to private equity funds. Also, we may see an increase in activity in semiconductors—as in the September leveraged buyout bid for Freescale Semiconductor (BB-).

Effects on ratings: The effects of M&A activity on investment-grade companies will be limited, because many have either the cash on hand or the debt capacity to handle most transactions. Other debt-financed and highly leveraged private equity transactions will fall into the B category. (S&P lowered its corporate credit rating on Freescale from BB+ in December, related to the LBO.)

BANKS

Expected M&A level: High

We expect an increase in cross-industry M&A activity compared with purely bank-to-bank mergers, even as several factors continue to drive the latter. Banks are trying to fend off fierce competition, and acquisitions allow rapid growth of banking offices and retail banking customers. Also, consolidation can help cover increased regulatory and compliance costs, help banks take advantage of advances in information technology, and increase the size and reach of their operations into more attractive growth markets with the decline in geographic restrictions.

Effects on ratings: We don't expect any negative effect for M&A deals with equity and/or cash. That may not be the case if debt is used in a material way or if credit quality weakens notably as the result of a deal. And positive effects, although less likely, may be seen if the resulting organization has an improved franchise or market position and its profit generation increases.

HEALTH CARE

Expected M&A level: Medium-high

We expect medium to high consolidation in the industry overall, with generic-drug makers, life-science, and niche-device companies involved. Broader product offerings and economies of scale are becoming more important competitive features amid sustained overall demand by an aging population supported by third-party coverage under employment arrangements and government programs. Pharmaceutical makers and large, diverse medical-products companies continue to seek innovative players and products to acquire. Also, the field of LBO candidates has broadened—e.g., the $33 billion deal in which HCA (B+) was acquired by a private equity consortium.

Effects on ratings: For larger companies, particular those with significant cash flows, a temporary financial stretch with a reasonable prospect for restoration of more conservative credit measures may limit the effects of heavy debt usage in a transaction. Still, private equity acquisitions may introduce significant leverage and result in ratings in the B category.

ELECTRICITY MERCHANTS

Expected M&A level: medium-high

M&A activity has accelerated in the past few years, and distressed assets from a bubble in gas-plant building are becoming more liquid as markets recover and bid/ask spreads tighten. Banks that took over assets in bankruptcy continue to look to exit with purchases by private equity firms. Meanwhile, larger players may look to achieve critical mass and market diversification, while failed players continue to exit businesses and divest assets to repay debt. Other larger players may make strategic divestitures while valuations remain high.

Effects on ratings: We expect that incremental debt used to finance acquisitions at rising prices driven by lofty commodity prices will have a negative impact on credit quality.


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