Fatal Attraction

Why has there been a sudden burst of global takeover activity? It’s simple: fund managers are more bearish than the corporate world, and the corporate world is exploiting that caution.
The global mergers and acquisitions cycle is accelerating, not so much in the number of deals we are seeing but in their size. The predators are getting more audacious. Consider this: on Monday night we saw the old British Telecom (now O2) bid for by Spain's Telefonica; Barrick Gold made an unsolicited bid for Placer Dome; and Dubai Ports bid for P&O.

In just one night, the total value of bids announced globally was north of $US50 billion!

The Barrick bid for Placer Dome will inevitably trigger a new round of consolidation in the global gold industry, and is indicative of the problems facing big mining companies as they seek to expand operations.

We have already witnessed the cost blowouts from Newcrest Mining, BHP Billiton, Rio Tinto and Woodside Petroleum after they committed to major brownfield expansions. Despite high commodity prices, mining companies are facing rising input costs and chronic shortages of skilled labour, which is making it increasingly difficult to replace reserves. It is now easier to take over another miner than to develop a new project.

I believe takeover activity will remain a feature of the Australian mining industry as the big mining houses continue to leverage Chinese demand for raw materials.

This cycle has been going for two years now, and it's all based on low interest rates and investor scepticism. Just about every company I go to see, or whose releases I read, is more upbeat about the future than the fund managers I speak to.

I know the role of a fund manager is one of risk management and capital protection, but I hate to think just how much medium-term money will be left on the table by this continued scepticism.

I remain strongly of the view that it is contrarian to be positive on the medium-term prospects for global economic growth, and therefore contrarian to be positive on the medium-term prospects for corporate earnings.

This simply can't be the top of the equity earnings or equity price cycle because there's too much bearishness around, and that bearishness seems out of whack with the strong economic data we are seeing. It's also out of whack with the strong equity earnings we are seeing, the upbeat AGM season we are also seeing, and the solid domestic bank reporting season we are seeing.

The over-riding bearishness is also out of whack with price/earnings (P/E) multiples, which simply aren't stretched. If anything, we are seeing a degree of p/e compression occurring as investors become too worried about inflationary pressures. We are also seeing prospective equity dividend yields rising.

The corporate world is rubbing its hands with glee, with equity market investors basically providing a smorgasbord of takeover targets due to their continued scepticism. The cost of funding these deals via debt is starting to rise, and the corporate is moving to lock in generational low-interest rates via acquisition.

The US Federal Reserve did raise interest rates by another quarter point on Tuesday night, but we believe it only has another 50 basis points to go before it reaches its "neutral" target.

But this isn't all about locking in cheap debt funding; it's also about the excellent state of corporate balance sheets and the amount of free cash generation. The paybacks on merger deals are shorter than ever due to the amount of free cash that can be bought inside these reasonable P/Es, and that's why I continue to believe highly cash-generative companies are extremely vulnerable through these periods.

Corporate Australia continues to be highly cash generative, and lowly geared, and that is making many of our largest companies global targets. Make no mistake: Australia will not remain immune as corporate predators chase bigger prey. Some time in the next 12 months, we will wake up to find a top 50 Australian company has received a takeover bid from a foreigner.

We have wide open registers in Australia, and a market that is populated by sceptical investors obsessed with short-term earnings. If ever there's a chance of a successful large-cap takeover, it's in Australian equities.

But remember: it's never the "pretty girls" who get taken over; it's always large-cap laggards such as Southcorp, WMC Resources, ALH, and in recent times, Patrick Corporation, who receive bids.

In today's market, I think it's companies such as Harvey Norman (HVN), John Fairfax Holdings (FXJ), APN News & Media (APN), Ten Network (TEN), Lend Lease (LLC), Multiplex (MXG), PaperlinX (PPX), Amcor (AMC), AMP (AMP), IAG (IAG), National Australia Bank (NAB), BlueScope Steel (BSL), Foster’s Group (FGL), and Alumina (AWC) that are vulnerable to takeover in the next 12 months. Almost all are "self-funding" in terms of dividend yield, and almost all are "under-geared".

Why are they vulnerable? Because we operate in a very short-termist market, where the market de-rates any company with even the slightest negative earnings revision. They throw the "brand" baby out with the short-term earnings "bathwater", and that's the catalyst for takeover activity. It's like corporate "burley", and it attracts "predators".

I would recommend looking through the list of major broker quant team "negative earnings and price momentum" lists, as at the bottom of those lists, you will find the next large-cap takeover targets in Australian equities.

If you think like a predator '” focusing on brands, cash flow, and synergies/cost savings '” then there's some serious medium-term money to be made in large-cap Australian "laggards". You need patience, and you need to be able to tolerate months of under-performance before the big payday comes. The "self-funding" nature makes the holding cost less painful. But when the "payday" does come, it can make your performance for the whole year.

We had to be patient in Southcorp, WMC Resources, and Patrick Corporation, but the bids came and the premiums always stun the short-term obsessed analysts. The bids stun them because they don't understand "strategic value", and they don't think like corporates.