Takeover activity back with a vengeance

American companies are paying the biggest premiums on record in takeovers, a sign executives are growing more bullish about profits and stocks even after the biggest rally for the Standard & Poor's 500 Index in 73 years.

When Dell agreed to buy Perot Systems for US$3.9 billion ($5.5 billion) in September, it offered 77 per cent more than the stock price during the 20 days before the deal was announced.

Xerox paid 38 per cent more than market value when it purchased Affiliated Computer Services for US$5.8 billion.

The average premium in mergers and acquisitions in which US companies were the buyer and seller rose to 56 per cent this year from 47 per cent last year.

Chief executive officers are so sure the economy will keep recovering they're agreeing to prices that are 37 per cent higher than the average since 2001.

While stocks in the S&P 500 are trading at the most expensive valuations in seven years compared with profits in the past 12 months, buyers are looking out to 2011, when analysts say earnings will have risen 52 per cent.

"M&A activity is a sign of confidence in the future of the country," said Bill Gerber, chief financial officer at an Omaha brokerage.

"Companies have to look two, three, four, five years ahead."

TD Ameritrade acquired Thinkorswim Group, a New York options brokerage, in January for US$606 million, paying a 48 per cent premium. The company will add 3 per cent to 7 per cent to profits during the fiscal year ending in September, Gerber said.

The price-earnings ratio on US equities climbed as the S&P 500 surged 65 per cent from a 12-year low on March 9, pushing its annual return in 2009 to 23 per cent, the biggest since 2003.

The index slipped 0.4 per cent last week after New York-based bank Citigroup sold shares at a discount and investors speculated Federal Reserve Chairman Ben S. Bernanke was preparing to raise interest rates next year.

Higher takeover premiums may help drive gains in the stock market. A Deutsche Bank AG index of potential US targets has advanced almost seven times more than the S&P 500 since Dubai's debt crisis roiled global markets last month.

The total value of deals involving US buyers and sellers has plunged 57 per cent from its all-time high three years ago to US$306.9 billion this year.

Record M&A in 2006 helped drive the S&P 500 up 17 per cent between mid-June and mid-December, part of a five-year rally in which the index doubled to a record 1565.15 in October 2007.

The measure has rebounded to 1114.05 from 676.53 in March.

Takeovers picked up this year after the price of corporate assets fell to the lowest level since at least 1994 in March and the financial crisis eased.

S&P 500 companies traded for 1.52 times book value, or assets minus liabilities, on March 9 and now cost 2.24 times, still cheaper than the day before New York-based Lehman Brothers collapsed in September 2008.

Executives say they're finding bargains based on projected earnings.

Analysts predict per-share income for companies in the S&P 500 will jump to US$94.98 a share in 2011 from US$62.52 this year.

While the S&P 500 trades for 22.4 times its companies' profits over the last 12 months, the price-earnings ratio falls to 11.7 when measured against analysts' 2011 forecast.

The multiple using reported profit has fallen to that level once since 1990, in March on concern $1.7 trillion in bank losses and writedowns would spur a global depression.

Dell acquired Perot to expand in the market for health-care information technology.

The takeover gave Dell a partner to boost sales of computer services as companies reduce PC purchases.

The second-largest personal-computer maker agreed to pay US$30 a share in cash for Perot, whose stock had already jumped 31 per cent this year.

It valued the company at 29 times the average analyst projection for 2010 profit.

Dell, whose shares have dropped 15 per cent since the deal was announced, paid twice as much relative to sales as Hewlett-Packard Co gave shareholders of Electronic Data Systems in its takeover last year.

The US$13 billion price Hewlett-Packard agreed to was about half EDS's annual revenue, compared with the 1.4 times sales that Dell offered.

Hewlett-Packard has gained 11 per cent since the takeover was announced in May 2008, compared with a 5.4 per cent retreat for computer companies in the S&P 500.

"Given historical acquisitions we've seen in terms of HP, what they paid for EDS based on revenues, it just seems like you're paying a little more," said JPMorgan Chase analyst Mark Moskowitz.

The transaction will start adding to earnings in the fiscal year that begins in February 2011, the company projects.

"Our investors have to trust that we'll manage those decisions effectively," said Dell chief financial officer Brian Gladden.

"There may be other cases where we have to pay what would be considered above-market premiums for special assets.

"I would put Perot in that bucket."

Xerox agreed to pay US$63.11 a share in cash and stock for Affiliated Computer in September to shift to technology services as sales of printing equipment drop.

Affiliated Computer trades at 13 times projected 2010 earnings.

Shares of Xerox, the largest maker of high-speed colour printers, have fallen 6 per cent since the purchase announcement.

Xerox is paying 0.96 times ACS's annual sales.

When International Business Machines bought PricewaterhouseCoopers LLP's business-consulting unit for US$3.5 billion in 2002, it paid 0.7 times revenue.

IBM has advanced 79 per cent since the takeover was announced in July 2002, compared with a 62 per cent gain for a gauge of technology companies in the S&P 500.

"We don't overpay for any properties," said Larry Zimmerman, chief financial officer at Xerox. "The discussion you have with shareholders is that not only are you more competitive, not only do you have a stronger business model, the returns for the longer-term shareholder are going to be better than if you didn't do it."

Cheap valuations aren't enough to spur mergers and acquisitions, says Brad Hintz, a New York-based securities-industry analyst who was chief financial officer at Lehman Brothers a decade ago. Gross domestic product growth and confidence in the economy are also necessary, he said.

"What's the easiest way for a CEO to lose his job?" he said. "He does a bad M&A deal. You see M&A activity picking up when the markets become more attractive with the likelihood that if I buy a company today, an improving economic environment will help that acquisition."

Economists say US GDP will rise 2.6 per cent in 2010 after shrinking 2.5 per cent this year.

Confidence in the world economy held near a record high this month as reports showed the US recovery is gaining momentum and more banks repaid government bailout funds, according to a Bloomberg survey.

Berkshire Hathaways Warren Buffett is so confident about US growth prospects that he agreed last month to pay US$26 billion for the 77.4 per cent of Burlington Northern Santa Fe his company didn't already own.

Buffett, the world's most successful investor, paid 23 per cent more than the railroad's stock price during the preceding 20 days in an "all-in wager on the economic future of the United States".

Takeovers increase the value of shareholders' stakes 30 per cent to 55 per cent of the time, according to a 2003 review by Paul Pautler of the US Federal Trade Commission's Bureau of Economics.

Although deals may cut costs for the combined company, they erase value when buyers pay too much, he said.

Mergers may rise 35 per cent next year and 23 per cent in 2011, according to Sanford Bernstein.

The forecast is based on an analysis using data since 1980 that incorporates growth in GDP, corporate earnings and commercial loan volume, which it said are about 72 per cent correlated to takeovers.

"M&A is back," said James Paulsen, who helps oversee about US$375 billion as chief investment strategist at Wells Capital Management in Minneapolis.

"It shows improving confidence as companies are willing to pay up to get those deals done.

"It also reflects the strong liquidity position in corporate America right now, which is a positive for future growth in equity values."

- BLOOMBERG