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Ingredients for New M&A Boom Abound. Will CEOs Start Cooking?

“Eat or be eaten” could be the motivating principle for corporate CEOs in 2014, as all the elements of a merger-and-acquisition boom finally embolden bidders and restive investors to pursue deals.

For the past few years, most of the conditions for an M&A revival have been in place. Companies have plenty of excess cash, profit margins are strong, but probably peaking, stock prices have been rising, and borrowing costs are at historic lows.

Yet CEOs have remained largely risk-averse, scarred by the 2008 financial crisis and real and imagined aftershocks to the global economy, not to mention perceived fiscal and monetary “policy risk.” Big companies are running their businesses lean, redeploying extra cash into share buybacks and dividends, essentially shrinking their financial footprint rather than pursuing bold new growth opportunities.

Sure, there have been some marquee transactions this year, such as the $23 billion purchase of H.J. Heinz Co. by private-equity firm 3G and Berkshire Hathaway Inc. (BRK-A, BRK-B), and the pending agreement for Verizon Communications Inc. (VZ) to swallow the 49% of Verizon Wireless owned by Vodafone plc (VOD) for $130 billion.

But the run rate of deals in terms of number and total dollar value has lagged. Through the first nine months of the year, M&A volume was 33% below the levels seen in 2007, the last time the major stock indexes traded near 2013 levels.

Friendly debt markets

It now seems, at last, that companies will entertain more deal-making in the coming year, for a variety of reasons in addition to the cash-rich, cheap-debt elements noted above.

Investment-research firm Strategas Group says, “A combination of recession-like nominal GDP growth, vast cash hoards on corporate balance sheets, and a growing activist investor base could make 2014 the year the much-anticipated M&A boom finally takes place. We’ve asked rhetorically before, if Apple (AAPL) isn’t safe from the influence of activists like Carl Icahn, what company would be? Next year might very well be a use-it-or-lose-it year for cash.”

The persistently low nominal growth rate of the global economy has reinforced corporate managers’ resistance to investing heavily in their own businesses through capital spending and research-and-development efforts. The idea of “buying growth” by acquiring an established company is likely to seem more attractive.

Strategas points out that assets under management at dedicated activist hedge funds has doubled since 2009 to a record near $80 billion, an amount of cash that can be amplified as it is mobilized, considering that Icahn is exerting pressure on Apple’s balance-sheet strategy with a reported stake of only $1 billion.

Activists tend to stalk companies perceived to be hoarding cash, resisting the idea of putting themselves up for sale or carrying several unrelated businesses that could be separated or sold. All of these raise the prospect of quickening M&A action.

Sifting for potential activist targets has become a popular exercise among professional investors. Strategas maintains a Buyout Index of companies that appear more likely than most to fetch a bid, which includes such names as Deckers Outdoor Corp. (DECK), Atlas Air Worldwide Holdings Inc. (AAWW), Verifone Systems Inc. (PAY), Frontier Communications Corp. (FTR) and Cliffs Natural Resources Inc. (CLF).

And with the Federal Reserve proceeding gingerly on a course toward removing some of its stimulus efforts, interest rates are inching higher. This could increase the sense of urgency felt by buyout firms and CEOs who might want to tap today’s quite-generous debt markets to finance a deal. Borrowing costs might not be this attractive for years.

Greater share of deals

Sean Darby, global equity strategist at Jefferies & Co., expects the Standard & Poor’s 500 to rise more than 8% in 2014 to 1950, and he sees M&A activity as a key theme that should benefit equity investors. Deals not only deliver a premium to the owners of targeted companies, but the trend toward increasing scale in a variety of industries can protect profitability – at least for a while.

“We expect the equity markets to experience a wave of mergers as companies seek to grow market share while maintaining margins,” Darby writes in his year-ahead outlook report.

“One of the problems facing corporate investment decisions is the perception that growth is not strong enough to support new spending,” he goes on. “With U.S. population growth maturing and the economy still experiencing weak household spending, companies appear to be seeking alliances or mergers in order to maintain profitability … . The extent of mergers and acquisitions within some industries has forced the major players into oligopolistic behavior.”

Not the best news for consumers or upstart companies in such industries, but with inflationary forces weak right now, it is fully understandable and not as threatening as it otherwise might be.

Industries that are more fragmented than average, and so should see an outsized share of any consolidation, include financial-services (including insurance), transportation, coal and metals mining, says Darby.