Serious Money: One of the best buys in the UK equity market last year turned out to be a troubled bank, Abbey National. Having replaced its senior management team in an effort to try and restore financial health - and investor confidence - the bank quickly succumbed to a bid from a Spanish bank, Santander. In 2004, Abbey National's share price rose by 21.2 per cent while Santander's fell by 4.6 per cent. We will return to the obvious moral of this story a little later.
The merger and acquisition business is booming. One of the reasons the financial press is full of stories about the return of the mega-bonus to Wall Street and the City of London is the return of the deal. From huge mergers involving large telecommunication companies - like Nextel and Sprint in the US - to smaller deals in less well known companies, we see an almost daily announcement of M&A activity.
M&A activity has always been highly correlated with the economic cycle: as the global economy boomed throughout 2004, the volume of M&A deals picked up. The fuel for the M&A surge was cash - companies everywhere have lots of it - and the catalyst was surging confidence.
Companies are cash rich largely because of restructuring: as the economy has picked up, firms have boosted productivity rather than hire extra people. Not all firms are choosing to engage in M&A: dividends and share buy-backs have also received a boost from growing piles of cash. Indeed, some people are surprised that so much of the cash has been used to fund deals, rather than all of it being returned to shareholders. Part of the dotcom bubble was inspired by spectacularly inappropriate M&A deals (funded more by share issuance than cash) and, more generally, there is a growing mountain of evidence that, on average, mergers do not produce long-term gains for shareholders, particularly for those who own the company doing the acquiring.
The idea that M&A destroys shareholder value is now mainstream, but needs to be treated with caution. It is a proposition about the average deal. This implies that some deals will work and some won't. Because we now know all about M&A's poor history, we might be tempted, naively perhaps, to think that the bar has now been raised and companies and their investment bankers might be slower to bring dodgy deals to market.
The global telecommunications sector looks ripe for more deals. Companies are cash-rich, often operating in a high-margin business without the need, right now, for huge amounts of capital expenditure (all that over investment in telecom capacity in the 1990s means that capex is low today). In the fixed line businesses, margins are under inexorable pressure and growth is non-existent as customers are steadily being lost to cheaper fixed line competitors, mobile operators and VOIP (internet telephone operators such as Skype and Vonage).
The mobile businesses are looking more and more like quasi utilities - mature businesses with stable cash flows. Any senior executive running any of these firms risks being bored to death. Hence the temptation to do deals.
Guessing which companies are likely to be involved in M&A activity can be a profitable game. There are people who do this for a living and are called, amongst other things, arbitrageurs. If history is any guide, the sectors most likely to be involved are banks, telecommunications, oil and pharmaceuticals. Of the top 20 largest US deals of all time, for example, only two have not been involved these sectors (the exceptions were AOL-Time Warner and Daimler-Chrysler).
Apart from phone companies, the sector that is ripe for further consolidation, particularly in Europe, is banks. Of course, this statement could have been made at any time in the last decade. Compared to their US counterparts, European banks (with one or two honourable exceptions) are small, fragmented, badly run and not particularly profitable. US banks keep consolidating and European banks run the risk of simply being marginalised in the years ahead as the banking business goes global. Santander's purchase of Abbey National can be seen in this light: management recognition that European banks must either consolidate or die.
Cynics have also argued that such mergers are just a reprise of the bad old days. Cross-border banking deals are notoriously difficult to pull off in Europe since costs (labour) cannot be cut in the way that they can in the US. Indeed, successful cost-cutting can only take place in the UK, with its relatively relaxed labour laws, hence the interest being shown in UK banks by their continental counterparts.
The chance of being bought at a premium is probably the only reason to own UK banks right now. The great boom in British banking shares was driven mostly by a surge in consumer borrowing which is now coming to an end.
You don't have to forecast a crash in the property market to believe that the glory days for UK banks are now over. Indeed, the parallels between banks and phone companies are uncanny: both are throwing off lots of cash at a time when both top-line revenues and profit margins are coming under pressure.
Under such circumstances, the urge to merge can be irresistible. Simply giving money back to shareholders is both dull and smacks of managerial defeatism. But domestic mergers are out of the question, thanks to regulation, so the only hope is a cross-border saviour.
At least one prominent market pundit believes that the French bank BNP is going to bid for Lloyds TSB in 2005. If BNP is that silly, then Lloyds shares are a buy.
As a sector, on the usual fundamentals, I think UK banks are a big sell, but the M&A story is a wild card that is worth keeping an eye on.
