Big Mergers For A Recession Economy
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 companies. 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 it job force than to turn it over to the government as the Chrysler problems were in 1979.
Creditors and lending institutions are also more likely to be liberal with covenants than to see the money they are owned whittled down by an insolvent company’s troubles.
The M&A list here with both companies which might be bought and their likely buyers is not a list which would make sense unless the US fell into the kind of recession that it did from November 1973 to March 1975. GDP fell 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 where bought. That includes 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 stretching through most of 2009. The housing situation may be that bad. Pressure on large financial institutions may cause a run on some money center banks not unlike the run which ruining Bear Stearns. 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. The Observer recently wrote “the current financial crisis is the most serious since the second world war, and perhaps since the Great Depression.” 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). It 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 it vehicles adds about $350 per unit compared with 2007. Rising gas prices may 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 filed 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. 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 sales 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. It 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 not cellular operation of its own and cannot afford to upgrade is systems to fiber for delivery of high-speed internet and TV services. That make the company more vulnerable to 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 pull of customers for cross-selling cellular and land-line products. If the Verizon fiber-to-the-home project continues, 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 should 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 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, or $3.17 a diluted share, in the fourth quarter ended on February 2, from $811 million, or $5.27 a share, a year earlier. Over the course of that one year period, cash on hand fell $2.2 billion to $1.6 billion, some of it due to share buy-backs. All of the evidence points to a drop in the number of customers who will go to most retailers over the next few quarter. Gas prices are too high, consumers are maxed out on credit cards and are feeling pinched do to falling home prices. The competition for the retail buyer is going to increase and Sears has very little to rational to give shareholders about how it can be effective competing against the likes of 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 cuts 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.
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 has 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 speculation 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. If AMD’s market cap comes down to $1.5 billion, there may well be a deal.
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 write 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, and, in may 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 American over the last six months and nearly as well as JP Morgan.
WFC currently has a market cap of $107 billion to WB’s $13.7 billion. And Washington Mutual’s was recently as low as $10 billion. Wells Fargo is already in the home loan business so its dynamics 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 worth 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 trouble 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 target. If the deal were to go through, the government would have to provide waivers of certain banking regulations about 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 big financial conglomerate is in big trouble. A combination of trouble with LBO debt and mortgage-backed securities problems lead a Merrill Lynch analysts to say Citi could have to write-down another $18 billion for the first quarter. The head of government-owned investment firm Dubai International Capital 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 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 worst 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 are 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 company out to shareholders. TWX currently owns 86% of TWX. In the process of a spin-out, 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 it almost completely overwhelmed by in mortgage-related holding 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 shares have 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 loss 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 its expects losses of $1 billion to $1.5 billion in its home equity portfolio. It believes that it can set aside money to cover about half of that. But, what happens if the housing market turns sharply lower as the year goes on and the plan has underestimated 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, 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 it 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 move up and customer flow falls that Wendy’s could begin to loss money. Over the last six months, Wall St. have voted for the company’s prospects by selling off the stock. Over that period, the shares are off almost 30% while McDonald’s (NYSE: MCD) and Burger King (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 at 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. Their 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 reserach 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 buy-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 result 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 bringing the company’s market cap down to $5.1 billion. 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