“An optimist is a guy that never has much experience and a pessimist is a person who has had to listen to too many optimists.” — Don Marquis, U.S. Journalist
Stock market participants are certainly optimistic. Mergers and acquisition (M&A) participants, especially private equity (PE) pools are especially optimistic! M&A activity dominated the news in the second quarter. The prices paid for for acquisition targets have been astounding. Driven by cheap money allowing buyers to lever purchases, both the private and public markets are awash in liquidity.
The second quarter started out with some major transactions. Kirk Kerkorian’s measly $US4.5 billion bid for Chrysler was outdone by Cerberus Capital’s $US7.4 billion. Daimler had paid over $US30 billion about ten years ago and suffered multi-billion dollar losses in the interim. A flurry of noteworthy transactions followed:
• Imperial Tobacco (UK) teamed up with two PE firms to purchase a French/Spanish company Altadis for $US16 billion.
• Nestle (Swiss) backed a subsidiary, Novartis, in the purchase of Gerber for $US5.5 billion.
• Cemex (Mexico) purchased Rinker for $US14 billion.
• The battle for ABN AMRO, a dutch bank, began with a bid from RBS, Royal Bank of Scotland, of $US90 billion. The bid was soon raised to $US96 billion as Barclays (UK) entered the fray. Atticus, a PE firm with a stake in Barclays urges that Barclays withdraw. This saga continues.
• Alltel, the fifth largest wireless operator is purchased for $US27 billion from a PE consortium.
• Microsoft makes its first major purchase in an Internet company, Quantive, for $US6 billion.
• Unicredit purchased Capitalia for $US29 billion to form Europe’s second largest bank.
• Warner Music was left in the dust by Tera Firma Capital Partners (PE) which purchased the coveted EMI for $US6.4 billion.
• Closer to home, Alcoa launched a hostile $US27 billion bid for Alcan.
• Also close to home, Thomson agreed to purchase Reuters for $US17.2 billion.
• Rupert Murdock’s News Corp. made a hostile $US5 billion bid for Dow Jones & Co. that own the Wall Street Journal.
• More consolidation in the cement industry as Hanson, which recently offered to privatize St. Lawrence Cement in Canada, purchased Heidelberg Cement for $US15.8 billion.
• Warbug Pincus bought Bausch & Lomb, the unfortunate victim of a major product recall, for $US4.5 billion.
• The NASDAQ exchange purchased the OMX exchanges in Sweden, Denmark, Iceland and Finland.
• Two PE firms teamed up to buy Avaya, a telecom equipment firm, for $US8.2 billion.
• Colony Capital (PE) purchased an oil and gas firm, Tamoil, in Lybia, for $US5.4 billion.
• Elevation Partners (PE), purchased 25 percent of PALM, a cell phone/organizer manufacturer.
• Chicago Mercantile Exchange received approval to purchase the Chicago Board of Trade for $US10.1 billion.
• British Imperial Chemical Industries purchased a Dutch rival, Akzo Nobel, for $US74.3 billion.
Although this list is just a snapshot of some of the activity in the quarter, several themes emerge. Large, basic industries are consolidating on a global basis. This consolidation is rapid and is occurring where synergies can be maximized and structured so that taxes can be minimized. Many of the acquisitions cited above were for firms that have been experiencing difficulties in competitive markets, resulting in poor earnings. Despite those difficulties, the acquirer was often a financial purchaser, not a strategic purchaser. Traditionally, financial buyers would be more constrained in the price they would pay due to the fact that many of the synergies afforded to a strategic buyer would not be present. In some industries, freedom from regulatory restrictions and the ability to effect change out of the publics’ vision will counter this deficiency. Cheap access to capital has allowed these financial buyers to out-bid strategic buyers in many cases.
Other activities of note included Ford’s confirmation that they were examining options for their troubled Land Rover and Jaguar brands. This announcement follows their sale of the Aston Martin brand to a PE firm earlier this year. Toyota surpassed GM as the largest automotive manufacturer in the world!
Caveat emptor prevailed as the US courts threw out the anti-trust case against the investment banks that brought the dot-com firms public during the late 1990’s. Investors got somewhat of a reprieve as Tyco, a case of corporate malfeasance, settled a class action suit for $US3 billion. In other corporate news, the CEO of Siemens, one of the world’s largest engineering firms, was forced to step down over allegations of bribes in foreign countries to gain contracts.
At the start of the quarter, Citigroup, announced that it was eliminating 17,000 jobs, or 5 percent of its global workforce. Not entirely related, other bad news in the financial sector continued to pervade market sentiment as troubles continued from the sub-prime lending debacle discovered in the first quarter. Bear Stearns, a large investment firm, announced the failure of two large hedge funds directly involved in the sub-prime sector. The fallout continues as other financial institutions examine related-party exposures to these failures. No-one is certain how far the damage may permeate throughout the financial sector.
Problems in the US housing sector continue as the number of building permits plunge. Builder confidence, as measured by the US Association of Home Builders, is at its lowest level since February 1991.
Stoking these concerns; Interest rates! Rates in the US have risen producing a positively-sloped yield curve (i.e. Rates go higher as the maturity gets longer) for the first time in over a year. Canadian rates have been moving in sympathy with those south of the border but at a lagging pace due to the unprecedented strength of the Canadian dollar. During the second quarter, the Canadian dollar appreciated 8.4 percent to $US0.94! The rapid rise of the Canadian dollar is exacerbating the productivity deficit that exists versus that of US manufacturers. Underlying inflationary concerns appear to be the culprit causing interest rate increases, but we see little reason for this to change given high energy and increasing agriculture prices.
As we head into the third quarter’s summer months, market participants continue to shun these headwinds. Blackstone, a very large PE firm, went public for a valuation in excess of $US35 billion. The Chinese government participated purchasing a 10 percent stake. In Canada, the battle for BCE appears to favour Ontario Teachers’ in a consortium with private equity over Telus, a strategic buyer. An abundance of consumer confidence is evident by the number of consumers that have lined up for days to purchase their new iPhones for $US600.
We are content to let the market continue in its folly while we bide our time and pounce on opportunities selectively. Over the last six months, we have allowed cash positions to rise and remain short term in our fixed income exposure. Our position is that the market will remain quite volatile over the next period, swinging dramatically with interest rates and commodity prices.
FIXED INCOME NOTES – SECOND QUARTER 2007
Over the course of the second quarter, expectations of an interest rate cut by the Federal Reserve evaporated in face of concerns regarding stronger than expected inflation numbers. At the same time, the feared impact of mounting losses in the sub-prime mortgage lending arena did not materialize.
While the U.S. appears to be in a holding pattern regarding central bank action, in Canada, low unemployment, rising wages and higher inflation measures have resulted in an interest rate hike, at the time of writing this report, with a possibility of a further hike in the fall.
In light of expected higher rates in Canada, an inverted yield curve (where shorter maturity instruments yield higher than longer term ones) and the continued modest risk premiums, we maintained our strategy of investing in shorter term investments, including money market securities and bonds up to two years in term. In line with this strategy, we acquired certain provincial, municipal and bank securities when markets sold off, and expect to continue this pattern of short term bond purchases at times of market weakness.
What we haven’t seen as yet in a meaningful manner is the widening of interest rate spreads of issues carrying a default risk against those of the benchmark, riskless, Government of Canada securities. This would imply that risk premiums are still too low, despite the fact that fundamentally higher rates increase the risk for corporate borrowers. Consequently, most of our purchases of corporate instruments, with the exception of the above noted bank instruments, have been limited to money market instruments with a term of one month or less.
The total return performance of the bond market for the quarter, as measured by the Universe Bond Index (formerly Scotia Capital Universe Bond Index), was -1.67 percent. Yields on a representative ten year Government of Canada bond increased by 44 basis points over the course of the quarter to yield 4.55 percent. At the same time, spreads between Federal and Provincial issues remained largely unchanged.