Equity Markets Look Good As M&A Picks Up

The value of global mergers and acquisitions activity hit a six-year low this year, but Kraft’s $19 billion bid for Cadbury, Xerox’s $6.4 billion offer for Affiliated Computer Services and Abbott Laboratories €5.2 billion ($7.64 billion) bid for Solvay could be an indication of a recovery in deal-making in 2010. That’s going to help drive stocks higher overall as traders speculate on the next takeover target, of which there likely are many.

Most of the M&A activity is driven by the ability to finance a deal and on that measure, conditions haven’t been better since around 1992. The way to measure this is by looking at the spread (or difference) between free cash flow yields and corporate bond yields. The wider the spread, the better that buyers are able to finance acquisitions with the cash flow of the target company.

For example, Cadbury’s forecasted 2009 free-cash flow yield is 5.5% while its 2014 bond is yielding 4.6%, which means there are 90 basis points of free cash flow to finance the acquisition. And if cash flow improves (which is also being speculated on now because of the overall improvement in economic conditions), the numbers will look even better.

Xerox’s deal will triple its service revenue to an estimated $10 billion next year and give the combined company $22 billion of annual revenue, $17 billion of which coming on a recurring basis. Meanwhile, Abbott sees Solvay as a way to expand into emerging markets in Eastern Europe and Asia while adding new drugs for hypertension and Parkinson’s disease.

Another indication implying improving equity markets is that initial public offering (IPO) activity is picking up. The value of global IPO’s has risen sharply to $23 billion in the latest quarter, double the previous quarter and the highest level since mid-2008. Last week, there were five initial public offerings of stock, the most in a five-day period since 2007, and one of them was in entertainment, for Shanda Games Limited. (The I.P.O. raised $1.04 billion, though the share price soon dropped).

An additional driver for stock markets is that the G-20 clearly indicated that emergency stimulus measures would be remaining in place for the foreseeable future and on Monday, ECB President Trichet echoed that theme.

“It would be premature to declare the crisis over,” Trichet said. “Now is not the time to exit. However, at some point in time an exit strategy will have to be implemented. The ECB has an exit strategy and stands ready to put it into action when the time comes.”

The ECB looks set to provide banks with unlimited lending for at least a year

“The euro-area economy shows signs of stabilization,” he said. “In the period ahead we expect to see a very gradual recovery.”

The ECB is now predicting growth of about 0.2% in 2010, revising a June forecast for a 0.3% contraction. The Central Bank also upgraded its 2009 assessment for the 16 nation euro-area, saying that the economy will shrink about 4.1% for the year as compared to the 4.6% contraction predicted just 3 months ago.

Trichet also said it is “extremely important” to have a strong U.S. dollar, but his comments may have more to do with global confidence in the greenback rather than its exchange rate.

“In the present situation it is extremely important that we can have in the framework at the level of global finance and the global economy a strong dollar as the authorities in the US are saying. The solidity of the dollar is very important.”

There’s at least one heavy hitter who’s calling for a strong 4th quarter for the S&P 500. Byron Wien, vice chairman of giant private equity firm Blackstone Group, told Bloomberg on Monday that the benchmark index is poised to reach 1200 by the end of the year, about 13% higher than Monday’s close. He had predicted that the S&P would rise 33% at the beginning of the year.

“In March, that didn’t look too good and people wouldn’t make eye contact with me,” Wien said. “But now, with three months to go, that looks like it may be realized. The economy will be stronger and corporate earnings both in the third and fourth quarters will be better than expected.”