"The current financial crisis is the most serious since the second world war, and perhaps since the Great Depression."–The London Observer, March 23, 2008
Many investors find it hard to believe that some of the largest companies in the country could be taken over and cease to be independent public corporations. In a very deep recession, which the economy may be facing, huge firms with vulnerable businesses, competitive pressures, and weak balance sheets may end up being takeover targets.
In an extremely difficult economy, regulators are more likely to countenance combinations which might be considered anti-competitive in a period of robust growth. Better to allow an M&A event to save a company and its work force than to ask the government for funds as Chrysler did in 1979. The government is likely to say "no".
Creditors and lending institutions are also more likely to be liberal with covenants than to see the money they are owned disappear due to an insolvent company’s troubles.
The M&A list here includes companies which might be bought and their likely buyers. It is not a list which would make sense unless the US falls into the kind of recession that it did from November 1973 to March 1975. GDP dropped by almost 5% and unemployment moved above 9%. By the end of that 21-month bear market, the S&P 500 had lost 42.6% in value, according to Ibbotson Associates and BusinessWeek. It may have been the toughest period since WWW II.. A number of the top 200 companies on the Fortune 500 in 1972 quickly disappeared or were bought. That list included American Motors, White Motor, Lykes, and Otis Elevator
There is a school of thought that the the US may face a downturn of that magnitude beginning in the first quarter of this year and that it will extend through most of 2009. The housing market may be that bad. Pressure on large financial institutions may cause a run on some money center banks not unlike the run which ruined Bear Stearns.Increases in the prices of key commodities including oil, wheat, and metals could make it almost impossible for consumers to afford some basic goods and could also damage margins at companies which rely on these as part of their cost of goods. If so, the M&A world will change from business as usual.
1. One of the most vulnerable large US companies is Ford (NYSE: F). Its current share of the domestic car market is about 15%. It does have some successful operations overseas, but it is not particularly well position in critical markets like China. Ford has made tremendous cost cuts, but the prices for metals used in its vehicles adds about $350 per unit compared to 2007, according to Lehman Brothers. Rising gas prices will hurt sales of its most successful products, SUVs and pick-ups. Ford’s stock trades at $5.60 and was recently as low as $4.95, well below where it traded two years ago when there was concern that that the company might have to file for Chapter 11.
VW has recently said that it expects to sell eight million cars by 2011. That is up from 6.2 million last year, The European company says it can triple sales in the US over the next decade. VW’s one huge weakness as a global car company is its tiny market share in the world’s largest car market. A takeover by VW would give Ford products access to markets like China.It would also give VW the sales it wants in the US. Putting the two large car companies together would allow for significant cost savings and would create the largest auto company is the world with global revenue of over $260 billion.
2. Qwest (NYSE: Q) is by far the weakest of the independent phone companies created by the break-up of AT&T in 1974. Its stock has fallen from over $10 in June 2007 to under $5. Shares in AT&T (NYSE: T) and Verizon (NYSE: VZ) are off only about 10% over the same period. Qwest has no cellular operation of its own and cannot afford to upgrade its systems to fiber for delivery of high-speed internet and TV services. This makes the company more vulnerable to competition from cable and satellite TV companies. Qwest has over $14.3 billion in debt. Its wireline services are shrinking.
Verizon (NYSE: VZ) is probably the most logical buyer for Qwest. The deal would give the New York-based company a huge pool of customers for cross-selling cellular with land-line products . If the Verizon fiber-to-the-home project continues to be successful, it might move the build-out into the Qwest service area to compete with cable and satellite there. Verizon has a market cap of $105 billion. Qwest’s is $8.5 billion. The savings in putting the two together could be significant.
3. Sears Holdings (NASDAQ: SHLD) is one of the worst consolidations in recent US corporate history, the combination of the businesses of Sears and K-Mart. The deal has ruined the reputaion of hedge-fund manager Eddie Lampert. The new company was created in 2005 and has a total of about 3,800 retail outlets among all of its brands. After peaking above $195 in April 2007, the stock has fallen as low as $85 earlier this year. It now trades at about $100. In the most recent quarter, earnings fell to $426 million from $811 million a year earlier. Over the course of that one year, cash on hand fell $2.2 billion to $1.6 billion, some of it due to share buy-backs. There is much evidence that supports the view that retail customers do not have the money to buy non-essential items. This change in consumer behavior will damage retail revenue over the next several quarters. Gas prices are too high, consumers are maxed out on credit cards and are feeling pinched due to loss of jobs and falling home prices. The battle for the retail buyer is going to increase and Sears is poorly positioned to compete with Wal-Mart (NYSE: WMT), Target (NYSE:TGT), and CostCo (NASDAQ: COST)
Sears has very modest long-term obligations, but poor performance has taken its market cap under $14 billion. Its price to sales ratio is down to .25x. Wal-Mart’s market cap is $212 billion and has a price to sales of .53. A buy-out by Wal-Mart would probably mean the closing of hundreds of Sears and K-Mart locations. But, Wal-Mart could cut significant administrative, supply chain, and purchasing costs. If Sears shares are pushed down to the $50 range by more bad news there is a deal to be done. Target is another possible buyer.
4. Advanced Micro Devices (NYSE: AMD) is not in as bad a spot as some investors think, at least not in terns of strategic positioning. It is the No.2 company in a two company race. The market cannot be without a challenger to Intel (NASDAQ: INTC) in the server and PC chip markets. AMD is very badly run. The decision to buy graphics chip company ATI was a significant mistake and contributed to the $5 billion in debt on AMD’s balance sheet as well as a huge write-off last year. AMD also got into a price war with its larger rival compressing its gross margins.
There has already been speculation about an AMD merger with graphics chip company Nvidia (NASDAQ: NVDA). The most recent comments about this came from research firm Amtech. Intel has been moving into Nvidia’s markets. While Nvidia is much smaller than Intel, with a revenue run rate of $6 billion, adding AMD would bring that up to about $13 billion. AMD is at an operating break-even. Nvidia could probably take out several hundred million in administrative, marketing, and R&D costs. Last year, research costs at AMD were over $1.8 billion. By adding ATI, Nvidia would be a graphics chip powerhouse. Nvidia has a market cap of $10 billion to AMD’s $3.7 billion. For the deal to make sense, AMD’s shares, currently at just above $6, would probably have to drop closer to $3.
Most of AMD’s debt is due in 2012 and beyond. The majority carries interest of 5.75% and 6%. If the company got into real trouble, lenders might be willing to bring down those rates, if Nvidia would put the obligations onto its balance sheet.
5. Washington Mutual ((NYSE: WM) may have to be sold for the same reason Countrywide (NYSE: CFC) was. Moody’s recently cut Washington Mutual debt rating to one notch above junk. S&P recently wrote that the mortgage crisis may hit the financial firm harder than the ratings agency had expected. WM’s market cap is down about 75% this year. If mortgage defaults spike up sharply because of a deep downturn in the economy, Washington Mutual could get into more trouble.
Washington Mutual may be forced to find a buyer. In many ways, the strongest of the large banks in the US is Wells Fargo (NYSE: WFC). According to Barron’s "unlike most of its peers that have been badly dinged, the San Francisco-based bank doesn’t have a big capital-markets operation exposed to credit derivatives, structured-investment vehicles, or mortgage-backed securities. Shares of Well Fargo have done better than Bank of America over the last six months and nearly as well as JP Morgan.
WFC currently has a market cap of $107 billion to WM’s $13.7 billion. Washington Mutual’s market cap was recently as low as $10 billion. Wells Fargo is already in the home loan business so Washington Mutual’s operations are not foreign to the bank. If housing prices continue to move down sharply, it may become clear to the Fed that WM will not be able to remain independent. The agency might even be willing to help finance a deal for a capable buyer. Washington Mutual could go to one or two of the large money center banks. Right now Wells Fargo would seem to have the fewest problems and the most time to give to turning around a troubled thrift company.
6. A number of pundits think that Citigroup (NYSE: C) is too big to fail. That observation is probably correct, but it is not too big to be bailed out and sold to another, better-managed money center. That could be Bank of America (NYSE: BAC), but JP Morgan Chase (NYSE: JPM) is a more likely dark knight. If the deal were to go through, the government would have to provide waivers of certain banking regulations about retail market share caps.
Over the last six months, shares of Citi are down 53% while shares in JP Morgan are flat which speaks volumes about what the market thinks of the prospects and managements of the two companies. It is only a few days since Citi traded below $18, so the market clearly thinks the financial conglomerate is in big trouble. A combination of problems with LBO debt and mortgage-backed securities led a Merrill Lynch analyst to say Citi may have to write-down another $18 billion for the first quarter. The head of government-owned investment firm Dubai International Capital said that it will take more than the combined efforts of the Gulf’s wealthiest investors — the Abu Dhabi Investment Authority, the Kuwait Investment Authority and Saudi Prince Alwaleed bin Talal–to save Citigroup, according to the AP.
The Fed would have to be involved in any bail-out of Citi. It is unlikely that the company would stay intact even if it was merged into JP Morgan. The sale of some assets would probably be necessary to help fund a takeover. The bank may be too big to fail, but it is not too big to be liquidated with the majority of the pieces going to JPM.
7. Of all the companies in the telecom and cable sector, Charter Communications (NASDAQ: CHTR) is undoubtedly the most damaged financially. The firm is controlled by billionaire Paul Allen. It has $19 billion in debt and recently took on another $1 billion in junk paper. Over the course of the last year, Charter’s shares have dropped from $4.93 to $.91 and recently traded as low as $.61. The company has a market cap of a mere $362 million and trades at .06x sales compared to Comcast (NASDAQ: CMCSA), the largest company in the industry, which trades at 1.9x even though its stock is off sharply in the last two quarters.
Charter has virtually no cash or operating income which can help it compete against the aggressive encroachment of the new telecom fiber initiatives and satellite TV. These new threats are difficult enough for well-funded companies like Comcast and Time Warner Cable (NYSE: TWC). If the economy continues to worsen, the yield that cable companies get from extra services like VOD and VoIP is likely to fall and some subscribers may leave all together.
The FCC has already stated that Comcast is at or near the size beyond which the agency will allow it to expand and may try to block additional acquisitions by the firm. If Charter fails, and it may well, the most logical buyer is Time Warner Cable. Time Warner is considering spinning the cable company out to shareholders. TWX currently owns 86% of TWC. In the process of becoming independent, Time Warner Cable may have the opportunity to raise more capital.
The largest hurdle to a buy-out of Charter is its mountain of debt. The company’s lenders, and Paul Allen, would have to be convinced that they are better off owning a piece of a larger company than clinging to one that will almost certainly fail financially, even in a good market. If Charter is sold, common shareholders may get nothing. Lenders may get a fraction of the dollar which they are owed. The alternative is probably worse.
8. E*Trade (NASDAQ: ETFC) retains a significant value in its discount brokerage business, but that is almost completely overwhelmed by its mortgage-related holdings which have caused such great losses that the company’s shares have fallen from a 52-week high of almost $26 to under $4. The stock has recently been as low as $2.08, which would put the firm’s market cap at only $1 billion.
E*Trade recently reported that daily average revenue trades fell 17% in February when compared to the month before. In a sharp market sell-off, E*Trade would likely lose customer assets and trading volume, both of which would do further damage to the company. The head of ETFC recently said that he did not believe that his firm would be sold. Market forces may make him eat those words. E*Trade says it expects losses of $1 billion to $1.5 billion over the next three years in its home equity portfolio. E*Trade believes that it can set aside money to cover about half of that loss. But, what happens if the housing market turns sharply lower as the year goes on and the plan has underestimated the potential losses?
E*Trade could be sold to either Schwab (NASDAQ: SCHW) or TDAmeritrade (NASAQ: AMTD). The Fed may have to underwrite the purchase of the company’s mortgage portfolio. probably by an entity different than one of the discount brokers. Schwab is the larger of the two discount houses, with a market cap over twice the size of AMTD’s. In a big market downturn, ETFC will almost certainly be forced to find a buyer. Schwab can take substantial costs for marketing, administration, technology, and customer service out of a combined company.
9. Wendy’s (NYSE: WEN) is a perfectly fine company which is likely to be hit by the rising costs of food commodities and a fall-off in customers in a rough economy. The firm is certainly in one of the most competitive segments of the market, fast foods. It has about 5,300 outlets. Profits are very modest. Last year, the company made $88 million on $2.45 billion in revenue. The top line has been flat since 2004.
The greatest cost problem for a company like Wendy’s is that it must maintain a huge marketing budget to protect its brand and bring in customers. Over the last three years, the average annual cost for doing this was roughly $115 million.
It is not hard to imagine that as food prices increase and customer flow falls, that Wendy’s could begin to lose money. Over the last six months, Wall St. has voted against the company’s prospects by selling off the stock. During that period, the shares are down almost 30% while McDonald’s (NYSE: MCD) and Burger King’s (NYSE: BKC) are flat to slightly up. Wendy’s market cap is only $2 billion or .8x sales. The figure for McDonald’s is 2.7x and for BKC it is 1.6x..
If Wendy’s struggles, and it will if the economy gets worse, McDonald’s and Burger King could both be possible buyers. There are substantial opportunities to save tens of millions of dollars in marketing costs on top of administration, purchasing and logistics expenses.
10. Boston Scientific (NYSE: BSX) ruined itself when it bought medical device company Guidant. In January 2006, BSX got into a bidding war with Johnson & Johnson in an attempt to take over the medical device maker. Eventually Boston Scientific won by paying a price over $27 billion. The results were a disaster. In 2005, Boston Scientific made $891 million on revenue of $6.3 billion. For 2007, the company lost $569 million on revenue of $8.6 billion. The company’s long-term and short-term debt balloned from $2 billion to $8.2 billion between the two years. At the same time, medical research began to indicate that drug-coated stents, one of BSX’s most profitable products, might cause clotting in heart arterties. Doctors began to reject using the devices in favor of by-pass surgery.
In mid-2004, Boston Scientific traded for over $44 a share. Now it sits at under $13 and has recently been as low as $10.76. The company is cutting personel and selling divisions, but that may not solve its debt service problems especially if the economy takes a sharp drop. The company’s market cap has fallen to $18.6 billion and its price-to-sales ratio is 2.2x.
Johnson & Johnson may still be able to get Guidant, and at a sharp discount. It could pick-up the rest of Boston Scientific as a bonus. JNJ has a $185 billion market cap and trades at over 3x sales. The company is already a big player in medical devices and the stent market. JNJ has cash and marketable securities of about $9 billion and long-term debt of $7.1 billion. In 2007 the company had net earnings of $10.6 billion on revenue of $61.1 billion.
If Boston Scientific gets into more trouble, the investment bankers know where to go.
11. Level 3 (NASDAQ: LVLT) has one of the best broadband networks in the world with 48,000 miles of IP network. The company has been put together through M&A activity which has built up a huge debt-load and made the company overly complex. The firm’s long-time No.2 executive was sacked recently as operating results make it difficult to handle Level 3’s debt service. In 2007, the company had a net loss of $1.1 billion on $4.3 billion in revenue. Long-term debt was over $6.8 billion. Taking out debt service and loss on extinguishment of debt and the operating loss for the year was $241 million.
The company cannot go on with its current financial problems and in a deep recession, these troubles will almost certainly become worse. Level 3’s share price has dropped from a 52-week high of $6.42 to $1.86. Level 3 is probably not a viable standalone company even in a good economy.
Level 3 has a $2.9 billion market cap. The most logical buyer for LVLT is large content delivery network Akamai (NASDAQ: AKAM). Akamai has a market cap of $5.1 billion. It is much smaller than LVLT but highly profitable. In 2007, the company made $145 million on $636 million in revenue. Revenue was up 45% from 2006. Akamai has cash and short-term investments of $545 million and long-term debt of $200 million.
Level 3 will not change hands with its current debt structure, so lenders are going to have to decide whether they would prefer to get a very modest amount in a liquidation or bankruptcy or take more favorable arrangement with a negotiated reduction of debt backed by the Akamai balance sheet. Under these circumstances, common shareholder in LVLT would almost certainly get nothing.
Level 3 is already in the CDN busines competing against Akamai. Akamai could take the asset of Level 3’s network and use it to take advantage of the boom in video, voice, and data over the internet. In the process, several billion in equity and debt in Level 3 would have to go away.
Douglas A. McIntyre
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