Return of the mega-deal

Corporate America went on a buying spree earlier this year with a flurry of mergers and acquisitions that hearkened back to the heady days of the late 1990s. Alison Arnot reports

Let's consider Procter & Gamble's purchase of The Gillette Company in late January. The marriage of P&G, the maker of many women's personal care products, and Gillette, specialist in men's grooming supplies, was valued at approximately US$57bn, creating the world's largest consumer products company with 21 billion-dollar brands.

Then there was SBC Communications Inc's acquisition of AT&T for $16bn, announced the following day. With the purchase, SBC will now offer AT&T's national and global IP-based network services, as well as its own local exchange, broadband and wireless services.

The creation of the telephone giant had other telecommunications companies scrambling to keep up. Verizon Communications Inc, a New York based telephone service provider, and the smaller Qwest Communications International Inc, based in Denver, Colorado, spent most of February and March competing over who would take over MCI Inc, formerly known as WorldCom. In the end, Verizon won, with an agreement to acquire MCI for $23.40 per common share, or $7.6bn, announced in late March.

These are just three examples of many mergers and acquisitions that took place between November 2004 and March 2005, including the merger of Johnson & Johnson and Guidant Corporation announced in December, the February closure of the Molson/Coors deal previously announced in July 2004, and the March announcement of Kodak Eastman Company's plans to purchase Vancouver based Creo. What's influencing this increased spending? Has corporate America recovered from the dot.com crash and subsequent recession of 2000-2001 and moved on from the fallout of the corporate scandals that plagued 2002?

The answer would appear to be 'yes'. After a period of steady growth and low interest rates over the past couple of years, companies are finding themselves with some extra money. 'Companies within the S&P500 have an awful lot of cash on hand,' says Sam Stoval, chief investment strategist with Standard & Poor's. 'Shareholders are telling management that they want this money to be put to work in the form of dividend increases or special dividend payments, share repurchases, reinvestments in the company, or in M&A activity.' And many corporate executives are choosing the latter, building bigger and, it is to be hoped, more profitable companies.

'Once companies engage in acquisition activity, that forces their competitors to engage in the same practice in order to remain competitive,' Stoval continues. While this merger activity appears to be taking place in a variety of industries - from consumer products to communications, pharmaceuticals, brewing, and high-tech digital imaging - a single business deal can spawn many more within the same industry, as seen in the fight to purchase MCI. 'You have a sort of a cascading effect within industries in order to maintain the level of competitive balance,' says Stoval. Take, for example, the software industry. Oracle Corporation's $10.3bn purchase of PeopleSoft in December was followed a few days later by Symantec's merger with Veritas Software, a deal worth $13.5bn. And more software company mergers are expected. Oracle, for example, has bought the outstanding shares of retail software provider Retek Inc and acquired Oblix Inc - a privately held developer of identity-based security solutions - since the PeopleSoft acquisition.

Another factor may be fear of rising interest rates, which have been creeping up steadily over the past year. The Federal Reserve has raised its target for the federal funds rate by 25 basis points, seven times since May 2004, when the rate had been holding steady at 1%. By March 2005, it was at 2.75%. Companies may be trying to strike before the rates get too high.

'The key [though] is just the amount of money that is on the books of companies right now,' says Stoval. 'Also, monies repatriated according to the American Job Creation Act are allowed to be earmarked towards mergers and acquisitions, whereas they're not allowed to be used for executive compensation or dividend increases.' Besides, being at the helm of a bigger company is an ego boost for management.

But is it good for the company and its shareholders? 'Obviously, on the company being acquired it has a positive impact,' says Stoval. 'But it depends on the company doing the acquiring. If investors believe that either it's not a good fit, or that it could be dilutive in some way, you will find a negative impact. If, however, the benefits appear to be accretive, so it will instantaneously start to benefit the bottom line, then investors would treat it positively.' Share performance can also have a ripple effect across industries. 'If company A is being wooed, then competitor B to company A might also rise in price in sympathy, thinking somebody else will be looking at them,' says Stoval.

Still, research indicates that bigger is not necessarily better. According to a 2001 McKinsey Quarterly report, published by McKinsey & Company, at least half of mergers, acquisitions and alliances fail to create significant shareholder value. The business consulting firm's research indicates that the market prefers deals that are 'expansionist' - those that increase a company's market share by consolidating, moving into new regions, or adding new distribution channels for existing products and services. The market is less tolerant of 'transformative' deals, the report continues - those that move companies into new lines of business or remove a healthy business portfolio.

Most or all of the recent big-ticket acquisitions mentioned here could be viewed as expansionist. And strategy does play a large role in sealing the deal. MCI held Qwest at bay, despite the fact that Qwest's offer was bigger than Verizon's. What mattered was competitive and financial strength and market reach, things the larger company was better able to provide.

The 'merger of equals' between Coors and Montreal based Molson, to create the world's fifth largest brewery, had different effects on the founding companies' financial performance. Coors' profit for the quarter ended 31 December 2004 was up 54.4% from the same period a year earlier, while Molson's was down 59.4%, largely due to merger-related costs.

For its part, Kodak expects Creo's state-of-the-art digital printing technology to add at least five cents to per-share operational earnings and $700m of incremental revenue in 2006. Meanwhile, SBC expects the AT&T transaction to be cash flow positive in 2007 and earnings per share positive in 2008.

Is this optimism well-founded? Time will tell, as shareholders watch their company's financial performance over the coming year.

What is certain is that the merger season hasn't ended. 'Business executives are feeling more confident about the future of the US economy, and that we are on a sustainable up-trend,' says Stoval - and with good reason. The US experienced 4.4% growth in GDP last year, he points out. Forecasts for 2005 indicate continued growth at about 3.8%. So this M&A activity is likely to continue, says Stoval. 'It's money being put to work.'

Alison Arnot is a freelance writer and editor based in Ottawa, Canada.