S&P Analyzes Anticipated M&A Activity

Standard & Poor’s Ratings Services announced that it has conducted a review of the corporate industrial and insurance sectors where its analysts see noteworthy M&A activity this year, with a special focus on how such activity could affect sector credit quality.

“Corporate and financial market concerns about accounting, economic, and credit issues appear to have constrained M&A activity in the first quarter of 2005,” noted S&P. “But because companies continue to generate healthy cash flow, this suggests that better-positioned companies are still building sizable cash war chests, which, coupled with rising competition in many sectors, augers well for those who make their livings from M&A fees.”

S&P said that its credit analysts “project that the sectors in which M&A activity will likely be beneficial to credit quality will be oil & gas, pharmaceuticals, and steel. The findings of this review also suggest, however, that the credit quality effect of mergers, acquisitions, and divestitures in most sectors is likely to be neutral or negative, despite the often trumpeted benefits of M&As by managements.”

S&P’s report concludes that the likelihood of M&A activity in the insurance sector, in both North American and Europe is “medium.” The “expected effect on credit quality” is neutral for North America, but negative for Europe.

S&P’s generally less than enthusiastic outlook stems from some of the conclusions reached after examining past mergers. The report notes: “M&A activity tends to occur in waves in industries where competition cuts into revenue and profit growth–factors that spur consolidation. A growing body of academic research indicates that more than 75 percent of large-company M&A results in the loss of shareholder value–often driven by business risk considerations and often separate from any negative effects of additional or excessive leverage undertaken to fund the M&A.” It also notes that, “although a drop in shareholder value does not necessarily lead to an immediate deterioration in credit quality and ratings, but there is a marked tendency for material declines in stock value, as well as in credit and bond quality, to correspond with rating downgrades over the long term.”

S&P lists five factors that can detract from the expected benefits of M&A activity, which are summarized as follows:
— Difficulties in realizing cost savings from integrating operations.
— The acquirer’s management resources and energy being finite. A need to concentrate heavily on integrating the acquired entity may cause a loss of focus in running day-to-day operations
— Cultural integration and morale issues, both in the acquired and the acquiring operations.
— The challenges and costs commonly associated with mergers can be exacerbated by falling margins in the acquirer’s operations.
— Excessive leverage and interest costs.

Discussing the insurance industry, S&P said: “Expectations are that activity will center on life insurers, as consolidation is well under way in the health insurance sector, and few significant transactions are expected there. Unlike health insurers, life insurers face no legacy issues and fewer regulatory hurdles to consummate deals. At the same time, the importance of achieving economies of scale is increasing. The biggest impetus for consolidation among life insurance companies is to expand distribution channels, one of the purposes of MetLife’s $11.5 billion bid for Citicorp’s Traveler’s life insurance unit.”

S&P said that in general, “the outlook for the industry as a whole is stable. Credit quality should remain unimpaired as long as the acquiring entity is the partner with the stronger rating. However, these deals can raise questions about creditworthiness until the implications of a merger are fully resolved. MetLife, for example, has been on CreditWatch with negative implications since the announcement of its deal in January.”