Summer's Sudden Boom in Mergers and Acquisitions

Mergers and Acquistions Heat Up in SummerTech giants Dell (DELL) and HP (HPQ) have their daggers drawn and are dueling over small data storage firm 3Par (PAR). French drugmaker Sanofi-Aventis (SNY) is trying to catch biotech giant Genzyme (GENZ) in an $18.5 billion bear hug. And in the biggest deal of them all, Australian mining firm BHP Billiton (BHP) aims to snag Potash (POT), a Canadian fertilizer producer, for $33 billion.

After a couple of fairly sleepy years, mergers and acquisition activity has bounced back dramatically, with potential long-term consequences for the stock market. It's a rare ray of hope at a time when other economic indicators are pointing straight toward the floor.

According to data firm Dealogic, there have been $1.78 trillion worth of deals globally in the first eight months of 2010, up 25% from the same period for the year before. M&A's hit $269.5 billion in August, the highest monthly activity so far this year.

"We think it indicates that there is some confidence, at least among the bigger businesses, in the overall economic outlook and in their own business outlook," says Brad Sorenson, director of sector research at the Schwab Center for Investment Research in Denver.

"There is a lot of cash on the sidelines for companies to do things with, things that can boost the stock market like mergers, share buybacks and increased dividend payments," he says.

Price Multiples Have Found Their Level

Greg Peterson, partner for transaction services at PricewaterhouseCoopers, says a number of factors have come into play that are enhancing the urge to merge. Many large firms have large cash piles on their balance sheets, and valuations of target companies have stabilized after two years of high volatility.

"The market has had a significant change," Peterson says. Price multiples, or the amount a company pays for target firm's cash flow, have stabilized within a narrow range. "Sellers have realized this range is the new reality and they are willing to trade at those levels," he says.

After several years of ruthless cost cutting, many companies have decided that if they leave their new cost structures in place, they can boost revenues by acquiring outside firms and achieving economies of scale.

"The buyers are cutting these deals because they're looking to grow, and the sellers are looking to more strategically invest their capital by getting rid of operations that aren't strategic," Peterson says.

How Small Investors Can Get In on the Action

Sorenson cautions small investors against trying to play the M&A game on their own by investing in stocks of sought-after firms. "There's a lot of big money that is chasing those deals out there, and by the time a small investor gets a good read on something, probably a lot of the move has been made," he says.

However, Sorenson does recommend two sectors that he feels will benefit from the latest merger wave.

Schwab has an outperform rating on the tech sector, which has lagged the market over the past few months. A recent study by consultants Ernst & Young showed that the top 25 tech companies have $450 billion in cash sitting idle on their books with which to make acquisitions. The HP-Dell battle for 3Par is just the attest example – HP has $14 billion of cash, while Dell has $7 billion.

Another sector Schwab favors is health care, where Sorenson says that drug overlap, expiring pharmaceutical patents and attractive valuations are driving a lot of merger activity, such as Sanofi's attempt to go over the head of Genzyme's board with an offer so such attractive that shareholders can't pass it up. But Genzyme CEO Henri Termeer has rejected the proposal, saying, "This is not the right time to sell the company."

But Sorenson thinks the recent rash of big deals is a sign of good things to come. "We think we are at the beginning of an M&A wave," he says. "Summer is usually slow, and seeing these deals ramp up now in August bodes relatively well for the fall."
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