The Beginning Of A New M&A Cycle?

We have been arguing for a mergers and acquisition (M&A) cycle over the past few months. Why are we saying that?

Demand For Capacity Or Assets Is Going Up

Private capital expenditure (capex) has been depressed since 2009. It is almost at its previous low of the financial year 2001-02 and may have troughed. In the meantime, growth is accelerating. Demonetisation has had a transient impact. The economy now has support now from three pillars - exports, public capex and consumption. We expect growth to continue to recover in the months ahead. Rising growth and limited capacity additions mean capacity utilisation is heading higher. The long lead time for creating new capacity means that most sectors will experience higher pricing power in the coming months as utilisation rates rise.

The Willingness To Sell

Private sector debt is still high, even though accretion to debt has stopped. There remains enough distress in the system to create willing sellers. The debt problem is concentrated, though declining at the margin.

Note that for most sectors it takes 3-4 years to set up new capacity and hence acquisitions could be a faster way to build capacity at the turn of the growth cycle.

The Ability To Buy

On aggregate, corporate India has the best free cash flow in its history. Free cash flow turned positive a couple of years ago and reflects improving operations and depressed capex. Over the past 12 months, companies have preferred to pay out this free cash flow. Indeed, on aggregate, 90 percent of corporate profits have been paid out - India's highest payout ratio since financial year 2002-03. More than half this payout has happened through buybacks. The lack of growth signals and attractive stock valuations explain this.

The quickest way to do this is to acquire, in our view. Banks will likely help in this cause. The loan-deposit ratio sits at a post-crisis low and it is likely that banks will want to push loan growth higher.

Cycle In Favour

Foreign demand for Indian assets is also sitting at all-time highs. Foreign Direct Investment (FDI)-to-GDP has galloped ahead in the past two years, which underpins the government's success in convincing corporate boards about the ease of doing business in India, coupled with the market's positive view on India's growth prospects. That the M&A is at cycle-low in terms of value and number of transactions is a good starting point.

Equity valuations are in the middle of the range, which is likely to encourage transactions. If valuations are too high or low, this is likely to dissuade buyers and sellers, respectively. So we see a sweet spot of ability to buy and willingness to sell, making this just the beginning of an M&A cycle.

Implications Of A Potential New M&A Cycle In India

• Net demand for Indian equities is rising, implying the potential for a valuation overshoot. Domestic investors are already significant buyers of Indian equities and corporate buying will add to this demand.
• At a sector level, we think those with the least pricing power and/or most distress will be the most favored for M&A. These include banks, steel, infrastructure, cement, property, and telecoms.
• Consolidation should lead to better margins and, eventually, better earnings growth.

Risks

As usual, there are risks of which readers need to be aware.

On the external front, global growth is expected by Morgan Stanley's economists to accelerate to 3.4 percent in 2017 versus 3 percent in 2016. This will likely support the recovery in Indian exports and thereby provide a fillip to domestic demand growth.

The key change for India's growth outlook in the past three to four months has been the recovery in Indian exports caused by better global growth.

It is quite possible that in certain stressed sectors, such as steel and infrastructure, assets are valued below the current enterprise value, implying a haircut for both the equity and debt holders. Any reluctance on the part of banks could delay the M&A cycle.

While global commodity prices are increasing on a year-on-year basis, the spillover to broader price pressures is limited, due to trailing excess capacity. A $10 increase in commodity prices would have a 0.4 percent impact on the consumer price index and a 0.3 percent impact on the current account deficit - as a percentage of GDP. A rise in commodity prices hurts India's terms-of-trade, brings inflation into play and thus hurts growth.

Ridham Desai is managing director at Morgan Stanley India and also serves as head of equity research and India equity strategist.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.