Can the Upturn in Deals Endure? The jury’s out on whether the mid-year m&a upturn will last or sputter out.

Dealmakers are trying to determine the staying power of the boomlet of deals that erupted in the summer of 2003. Does Oracle Corp.’s $6.2 billion hostile bid for PeopleSoft Inc.’s, Alcan Inc.’s $3.9 billion run at Pechiney SA, and Liberty Media Corp.’s $7.9 billion purchase of full control of QVC Inc. portend a lasting upswing in deal flow? Or are they and a spate of lower-profile transactions a series of one-off deals that have come to market despite any overt improvement in m&a fundamentals? If it is true that deals create more deals, as CEOs and boards as watch competitors bulk up and figure they too must move, then the 15 or 20 major deals announced in June and July may be a bellwether of stronger m&a numbers for the rest of the year. But wary and sometimes-skeptical dealmakers are questioning why this wave of deals broke when it did. The end of the Iraq war, the 31% increase in the Nasdaq composite index and the nearly 10% uptick in the Dow Jones Industrial Average so far this year, low interest rates, and increased confidence among senior management are key factors that helped spark the June-July m&a fireworks. Observers also take heart from the broad spectrum of companies, from software to metals, issuing deal announcements. But the question recurs as to whether the highlights of the second quarter will continue for the rest of the year or fade like a summer romance. Among the other notable deals out of the gate this summer were IDEC Pharmaceuticals Corp.’s $6.8 billion agreement to buy Biogen Inc., Boise Cascade Corp.’s $1.16 billion purchase of OfficeMax Inc. in a vertical integration, Yellow Corp.’s $1.1 billion bid for Roadway Corp., and ArvinMeritor Inc.’s $2.2 billion hostile offer for auto parts company Dana Corp. Also tucked away in the flurry of deal announcements were smaller transactions like NIKE Inc.’s $300 million purchase of legendary sneaker manufacturer Converse Inc. and the $600 million takeover of clothing maker Nautica Enterprises Inc. by VF Corp., the maker of Lee and Wrangler jeans and other branded apparel. While these deals don’t carry huge price tags they involve recognizable brands that are shifting hands and giving some shareholders and dealmakers further reason to think that the m&a market may be awakening. But cautious bankers and their advisers note that the source of many of the summer’s deal headlines – hostile transactions such as Oracle/PeopleSoft, ArvinMeritor/Dana, and Alcan/Pechiney – may not even get done. One analyst says he is looking to September and beyond to see if the summer’s activity was a blip or the start of an upturn. Fox Pitt Kelton’s financial industry analyst Riley Tierney says, “August will be quiet. While it seems like an outbreak of m&a was overdue, we’ll know if its sustainable by the fourth quarter.” He adds that the lack of bidding wars among the summer’s deals could indicate that the surge is a blip rather than a groundswell. Cautious bulls, cautious bears “The jury is still out on the lasting impact of these deals,” says Jeff Schmidt, a Managing Director in the Chicago office of Towers Perrin. “We’re not ready to declare it a major surge based on the dozen or so deals we’ve seen.” He says that m&a is still risky, that it takes a long time to get deals done, and that the process of doing the deal places a heavy toll on the continuing operations of both companies during the integration process. As a result, he notes that we should only expect to see deal announcements by acquisition-bound companies that have cut costs as deep as they can, and in areas where low growth and low margins are crimping profitability. A similar take comes from D.F. King & Co. Vice President Richard Grubaugh. The proxy firm executive says that he believes the summer outbreak of transactions is the “first mini-wave of a larger wave” of deals that should develop by the end of the year. But he cautions that one indication of the staying power of subsequent deal announcements will be whether the deals are done for stock. Noting that the summer’s deals were primarily cash deals, he says, “The market has yet to prove stock deals will work. Until a company is comfortable using its own stock or accepting the buyer’s stock as viable currency, any deal wave will rest on a shaky foundation.” Bad news could douse mini-wave As dealmakers analyze the summer’s trends, Schmidt says, they should not assume that the negative economic news of the last three years is over. Any return of scandal-like headlines may nix the momentum of the summer mini-wave of m&a. He notes that the “connections between the stinker deals of the last wave and companies’ weak governance have not been fully explored.” The Enron, WorldCom, Tyco, HealthSouth, and numerous other scandals don’t exhaust the distasteful developments, and he adds that more bad news may explode. In particular, he says, shareholder lawsuits against AOL Time Warner Inc. and other frequent acquirers in trouble will continue to bring to light executive compensation abuses that will be linked to mergers during the high-tech bubble of the 1990s. Continued publicity growing out of “bad” m&a deals of the recent past will make it hard for boards to sign on to new m&a deals. “As more litigation surfaces, people are going to say that these deals shouldn’t have been done, the boards were conflicted, and, as a result, it will be hard to sell boards on new deals,” Schmidt says. Analysts who are bullish on the durability of the summer deal wave point to a few changes in the economic climate to justify their “glass is half full” take. After three years of reduced deal flow, Boston Consulting Group Managing Director Chris Nehan thinks that the time has come for companies to balance organic growth with growth by acquisition. “You have three years of pent-up demand, and people are coming to think that acquisitions can be the levers of growth,” he notes. He lists a few advantages for companies willing to move early in an economic recovery cycle: There is more time for executives to do extensive strategic due diligence now. Valuations tend to be lower at the start of a consolidation cycle, while potential sellers have had time to adjust to those lower valuations. It may be easier to consider selling a company for half of its 2000 market cap after three years in which the share price has remained low. Another foundation for the summer deal breakout is an attitude change among buyers. “Our clients are having conversations with counterparties and we’re expecting to see a high percentage of completions out of our backlog of deals,” says Mark Brady, head of m&a at William Blair & Co. He says that until recently buyers weren’t willing to pay the price sellers needed to get deals down. But starting this summer, that changed. “We’re seeing a renewed willingness to go ahead and complete things,” he says. Brady says he sees evidence of the improved m&a climate from the fact that until recently, large, corporate strategic buyers haven’t been active. “When you see Kodak becoming willing to pay for growth, something’s changed.” In late July Eastman Kodak Co. bought PracticeWorks Inc., a provider of dental imaging systems and dental practice management software, for $500 million in cash to enlarge its imaging business. While acknowledging the existence of pent-up demand for m&a opportunities, CIBC head of m&a Bruce McCarthy says it is a little early to celebrate the return of a flourishing m&a market. “We still need to see the economy pick up more, an increase in capital spending, and improvement in earnings.” But he says that for some buyers, today’s environment can be seen as a buying opportunity. In an echo of Grubaugh’s point about the paucity of stock deals, Gregory Benning, head of m&a at Adams, Harkness & Hill, says that cash remains the most popular way to pay for deals this year. “Financial contingency deals, those that have a stock- or bank-financed section, have not been looked at positively by target boards.” He says there are still concerns among sellers about valuation and closing issues, which tend to give the upper hand to buyers who can simply write a check. In general, targets remain risk-averse and have not lost the acute sense of concern about risk and liability that characterized corporate actions across the board in the last three years, he says. Another sign of potential weakness in the boomlet follows on from Tierney’s observation that no one is throwing wads of cash at targets. Bidders, such as Oracle, are only making modest improvements in their offers in response to targets’ statements about being undervalued, he points out. The Fox Pitt Kelton analyst also points out that despite a fairly high percentage of hostile deals this summer, few, if any, white knights have entered the fray. Summer of the hostiles Deal pros have noted that the prominence of hostile deals such as Oracle’s bid for PeopleSoft, Alcan’s bid for Pechiney, and ArvinMeritor’s run at Dana. “The appearance of these hostiles is definitely new. And although they’re tricky, you like to see them because they indicate an increased level of risk taking,” Tierney says. One reason for the increase in hostile deals is that buyers have more confidence than sellers. “There is a mismatch between buyers and sellers right now. Sometimes people decide this is the time to go to the shareholders,” Nehan says. For Blackstone Group Vice Chairman Hamilton “Tony” James, the appearance of hostiles is caused by the combination of low stock prices and available financing. Another banker, Steve Koch, Co-Chair of M&A at Credit Suisse First Boston, says that the outbreak of hostiles could be a sign that the boomlet has legs. “We saw a disproportionate number of hostiles early on in the beginning of the early 90s cycle of m&a,” Koch notes. He adds that people tend to get interested in buying before selling. Executives worry that things will get more expensive if they wait. For the bulls, the ArvinMeritor bid for Dana will be an especially closely watched barometer because it features a smaller company – ArvinMeritor has a $1.25 billion market cap – trying to swallow a larger competitor with a market cap of $2.29 billion. “If an upstart player like ArvinMeritor can get its bid financed and can carry it out, then you have another positive indicator for the m&a market,” Tierney says. But bankers and advisers who don’t think the summer surge is going to continue say that before companies get excited about a lasting upturn in the m&a cycle, they should wait to see how many of the hostiles get completed. Effect of marquee deals on the mid-market Just as dealmakers are divided on the sustainability of the summer m&a boomlet, they are split on whether there is a trickle-down effect on the middle market ($500 million and up). “In the middle market, and in private equity, you have pent-up demand on the part of sellers,” Nehan says. He notes that would-be sellers, and some buyers, are starting to feel that the market is stable enough to offer them a price closer to what they’re looking for. Certainly, middle-market dealmakers are looking at a better environment that they’ve seen for the last two years, he adds. One trend in the mid-cap market, according to Benning, is the emergence of what he calls “value-driven” deals. These involve targets that, when measured by cash on hand or hard assets, offer a buyer an alternative to going out and raising money. He thinks that the large-cap activity affects mid-market players in value-driven and other types of deals considerably. CIBC’s McCarthy says that while there isn’t a direct correlation between large-cap and mid-cap deals, they are impacted by similar factors. He thinks there has been an increase in strategic dialogue in both sectors. Not a boom, not a bust “M&a is like an iceberg. What you see is 10% or 20% of what’s going on,” says Koch. He says that if there is an increase in announcements, there is also an increase in deal discussions in general going on. Some of these will eventually surface and become visible. He adds that the summer’s increase in deal flow isn’t the beginning of a boom but is merely a return to normal levels of activity. For Blackstone’s James, the summer deals outburst is an indication that the m&a market has returned to reasonable levels of activity. “Deals had dried up to almost nothing. The business was clearly at an unsustainable low.” Koch expects to see a return to a steady level of deal activity as corporate planners mull strategic transaction as a way to increase growth. But he cautions that this gradual recovery is dependent on the absence of shock waves in the market. Only the most pessimistic dealmakers totally discount the summer of 2003 mini-wave of deals. For the rest, the summer deals mark the beginning of the end of the post-bubble trough in activity. 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