European stocks set to surf on M&A wave

By Francesco Canepa and Vikram Subhedar

LONDON, April 30 (Reuters) - European shares, stuck in neutral for nearly two months, are likely to get a shot in the arm from corporate deal-making, which has posted the best start to a year since 2008 and so far is outweighing sluggish earnings expectations.

Confidence (BSE: CONFIDE.BO - news) in Europe's economy is pushing companies to loosen their purse strings and deploy the record levels of cash they hold. Telecom (Frankfurt: NZT.F - news) and healthcare have led the charge, but deals in sectors more closely linked to economic growth, such as capital goods and energy, are grabbing headlines.

This week, the battle for French power company Alstom (TLO: ALSO.TI - news) heated up with both General Electric (Swiss: GE.SW - news) and Siemens AG in the fray. Siemens also entered talks to buy assets from Britain's Rolls-Royce.

"We're just at the very beginning of the process and we expect it to continue and to accelerate," said Patrick Legland, global head of research at Societe Generale (Paris: FR0000130809 - news) .

"It's going to be tilted towards very capital-intensive industries - that is, industries where companies have to invest a lot to generate their revenue (and) are coming under increasing pressure from shareholders to add to their returns."

That is keeping the STOXX 600 at a price-to-earnings multiple just shy of nine-year highs, despite simmering tension in Ukraine, a United States-led selloff in technology stocks and mixed results from Europe Inc.

Year-to-date, M&A activity involving a European target has grown to more than $312 billion. That's more than double the value over the same period last year and the highest since 2008, according to Thomson Reuters (Frankfurt: TOC.F - news) data.

THE QUICKER FIX

However, 49 percent of the European companies tracked by StarMine missed earnings expectations for 2013, a trend that has worsened for the ongoing first-quarter results season. More than half the companies in Europe that have reported have missed forecasts.

At the end of last year, investors had hoped that the economic recovery in the West would translate into a pick-up in capital spending and in turn drive earnings.

"The capex cycle has not recovered as much as was expected," said Fadi Chamsy, a strategist at Deutsche Bank (Xetra: DBK.DE - news) .

Instead, companies returned cash to shareholders in record amounts in the form of dividends and share buybacks.

European shares are back to pre-Lehman levels, but the profits they generate with money invested by shareholders - the return on equity - is just 9 percent, or half of what it was in 2008, according to Thomson Reuters data.

"With the macro environment improving relatively quickly, M&A is the easier, quicker fix. Companies which need to react fast may seek inorganic growth as the best use of cash," said Deutsche's Chamsy.

One popular starting point to identify companies that might be attractive targets is to screen for EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) - a popular metric when valuing mergers - and net debt to equity.

Among non-financial constituents of the Stoxx 600 that have an EV/EBIDTA multiple below 10 and low net debt to equity are British services firm Rentokil and German engineering group Bilfinger (Berlin: GBF.BE - news) , which said it is eyeing some acquisitions of its own. [ID: nL6N0MH35R]

READY FOR DEALS

An important driver is that investors, having pushed up valuations in anticipation of an earnings recovery, are now willing to back deals and have bid up prices of acquirers.

McKesson Corp added $3 billion to its market cap in the two days after it announced its offer for Celesio AG (Other OTC: CAKFF - news) while Merck (Other OTC: MKGAF - news) shares rose 5 percent after it announced its offer for AZ Electronics.

Following the 2008 crisis and during the ruction in Europe two years ago, companies focused on preserving cash.

But balance sheets have now moved from being conservative to inefficient, Paras Anand, head of Pan-European equities at Fidelity Worldwide Investment, said in a note, adding that he expects American and Asian companies to be likely buyers of European businesses.

"European companies are now ready for deals in a way they have not been previously," said Fidelity's Anand. (Reporting by Vikram Subhedar and Francesco Canepa; Editing by Larry King)