The Real Drivers of M&A

Many investors believe "it's all too easy" at the moment. They are concerned that some left-field development will de-rail the Australian corporate earnings party. These are valid concerns to have at record index highs, yet the annual reporting season is confirming two clear developments. First, there is a rebalancing of the domestic economy occurring. Second, companies who are benefiting from the rebalancing are delivering stronger earnings and dividends than expected.

We are half way through the reporting season for the 12 months to June 2005 (FY05), and almost 80 per cent of companies have met or exceeded expectations. Average reported EPS growth is 25 per cent, while the average dividend growth is 22 per cent. Average reported net/debt to equity ratios have declined by 5 per cent, so you can see better than expected earnings are underpinning an improvement in balance sheets.

EXPORT LED GROWTH

The export sectors and companies that benefit from the health of the export sectors are the main contributor to that 25 per cent EPS (Earnings per Share) growth being delivered, with the resource sector looking like reporting 70 per cent EPS growth on average for FY05.

On the other hand, domestic consumer discretionary and property/ building materials earnings are actually holding the overall reported EPS growth number back, and you can clearly see the rebalancing of Gross Domestic Product (GDP) drivers of the Australian economy from the consumer and property sectors, to the export, capital expenditure, infrastructure, agriculture, regional, and engineering sectors.

We believe this is the biggest strategic point you have to understand - the sectoral drivers of Australian GDP growth are changing. These rebalancings are not short-term; they are 5 to 10 year events (i.e. the property and consumer sector of the previous decade).

The most interesting aspect of all this is that the equity market, as implied by P/Es (Price–Earnings ratios), does not believe in the sustainability of this GDP rebalancing and its effect on corporate export-based earnings. The strongest reported earnings growth companies have the lowest forward P/Es, which basically shows you that the equity market believes this is the peak of the export sector earnings growth.

The market also thought this 12 months ago, and what an error that proved to be. Resource sector earnings for FY05 were forecast 12 months ago to grow by roughly 20 per cent, and we are seeing 70 per cent as the delivered number. The average forecast 12 months ago couldn't have been less accurate.

I remember in the early days of the domestic property cycle that nobody believed in its sustainability, and nobody forecast that median property prices would double over that decade. Building materials companies traded on single digit multiples, while property trusts were considered good solid investments for retirees. As the property cycle extended and extended and extended, other sectors such as banking and consumer discretionary started to benefit heavily from the spill-over effects of the property cycle, and before you knew it any sector that benefited from the underlying property cycle moved into permanently higher P/E bands.

Those property related sectors remain in those higher P/E bands today, despite earnings growth slowing, and in some cases, going negative.

Nobody believed that median property prices could double, just as nobody believed iron ore or oil prices could double, and be sustained. I can buy the three largest iron ore companies in the world (BHP, RIO, CVRD) on single digit forward P/Es.

The market wants to believe that the consumer and property sectors will rebound. We believe the consumer and property sectors will stop seeing negative activity growth, but we don't see any significant rebound in activity until the home equity ATM is refilled, and that will take time.

What is more likely to occur is the market slowly starts believing in the rebalancing of growth drivers, and that will have large P/E ramifications for the beneficiary sectors. We can only see one sector where the market is buying into the rebalancing argument and that is the traditionally low P/E engineering and equipment hire sector.

The market, as implied by the P/Es now applied to United Group Ltd (UGL), Coates Hire Ltd (COA), Transfield Services Ltd (TSE), and WorleyParsons Ltd (WOR), subscribes to the sustainability of the outlook for these export service based companies, yet conversely, as implied by the P/Es of the resource sector, doesn't believe in the sustainability of the commodity cycle.

Well, you can't re-rate one and not the other, and either the pricing of the engineering sector is wrong, or the pricing of the resource sector is wrong.

M&A IGNITES

Mergers and acquisitions (M&A) with a face value of A$10 billion was announced on Monday (Toll Holdings & Patrick Corp., Sigma Company & Arrow Pharmaceuticals), while the only new supply announced was a well-flagged $154m rights issue from Coates Hire. It remains debatable whether T3 (the float of the final tranche of the government's shareholding in Telstra) will happen at current prices or whether investors actually want to buy a growth-less quasi Government Bond with unproven new management.

Investors of all forms are seeking the holy grail of growth plus yield, and they are competing with the forced investment of compulsory superannuants. 40c in every Australian superannuation dollar is looking for a home in Australian equities, while clearly over 50c of every Australian discretionary investment dollar is looking for a home in Australian equities.

Private equity money is also turning up as a buyer of listed equities (Iluka Resources, BayCorp Advantage, etc). Australian equities are clearly the asset class of choice, and returns are outpacing any other asset class's returns exponentially.

Think about it this way. 10,000,000 Australians now have jobs. The average wage is closing in on $50,000pa. The compulsory superannuation guarantee charge is 9%. The average wage earner generates roughly $4,500 in super contributions each year. 10,000,000 x $4,500 = $45,000,000,000, or as we like to call it, $45 billion.

As I said 40c in every dollar at the moment seeks a home in domestic equities, and that equates to $18bn in compulsory super flow into domestic equities per annum alone. A company the size of Woolworths has to be formed each year to meet this legislated demand.

The unprecedented cash generation we are seeing from the corporate sector is being returned to shareholders, and dividends are being reinvested. The market capitalisation of the ASX200 is $750billion, and that ASX200 is yielding 3.5 per cent fully franked. That's another $26.25 billion in dividends that will mostly find their way back into the equity market. In other words, T3 could be absorbed by one year of ASX200 dividend reinvestment alone.

Buybacks are becoming more prevalent, and corporate Australia is finding itself under-geared and with broad excess capital. That's the key point; corporate Australia has excess capital and is competing with investors to buy back their own shares.

Corporate Australia has no real need to raise fresh equity, with the average company having at least 30 per cent room to move on gearing ratios before they become even remotely uncomfortable. Debt is cheap, and equity is becoming more expensive. P/Es are slowly expanding, and most M&A is scrip based and not cash based.

TOO MUCH CASH CHASING TOO FEW SHARES

We have a very big equity supply problem building, and I can't identify a genuine large-scale supply on the horizon that will meet the pent up domestic demand. Either domestic investors start allocating more to off-shore equities, or the P/E of those who genuinely offer the right combination of growth and yield and a quality balance sheet, will rise.

That's why I believe it is unlikely that a large cap sector with clear earnings and dividend growth, that is experiencing a clear de-risking of balance sheets, will continue to command a 50 per cent discount to comparable industrial sectors. This supply/demand imbalance must work in the favour of the resource sector if they can position themselves to capture it.