Takeaways: Growth has slowed to something that looks solid, but unspectacular. The Fed has thrown another spanner in the works. Earnings estimates are falling. We know companies aren’t just resting on their laurels amidst the squall – capital and operational optimisation are top of the agenda and M&A activity is certainly maintaining its heady pace. But can private equity still teach companies a few tricks?
Keeping the door open for December
Two sagas have dominated 2015: first Greece, now the Fed. The supposedly dead-rubber October meeting brought another twist in the tale last week, as the FOMC unexpectedly removed its warning about global financial and economic risks and firmly put December back on the table. With the ECB strongly hinting that it’ll be moving the opposite direction, we’re “divergence-on” again in anticipated monetary policy. The dollar hit its highest level against the Euro since August last week. So that’s more currency-related earnings concerns in the pipeline, but maybe more bargains in the Eurozone aisle?
But, is this the Fed signalling that it’s ready to move – or are they just keeping the door open for December? I’d suggest the latter. To do this they obviously need to acknowledge diminished emerging market turmoil. Arguably, this part of the statement should have generated a big circular reference warning, since recent emerging market calm is in good part due to their previous signal that they weren’t ready to raise rates. Right on cue, emerging market equities and currencies did retreat again on this news, but (for now) it seems more orderly than previous Fed inspired moves. China’s stimulus, its trial of looser capital controls and the ECB’s QE near-promise have softened the blow…or perhaps investors have just heard ‘wolf’ too many times.
Plus softer US figures just don’t shout ‘raise!’ US GDP growth slowed to an annualised 1.5% in Q3, from 3.9% in Q2. The fall is mainly due to a drag on inventories and domestic consumption still looks positive – but will the Fed really feel confident enough to move now?
Looking under the UK’s bonnet…
UK GDP also slipped back in Q3 to growth of 0.5%, from 0.7% in the previous quarter. The first estimate should always be treated with caution, but other surveys confirm that Q3 growth was softer – especially in manufacturing and construction. Our data shows a 39% increase in profit warnings compared to the previous quarter – the biggest increase in almost four years. Profit expectations were disrupted by global uncertainties and the impact of low commodity prices – which is still working its way through the supply chain. Some companies are also still struggling to come to terms with the demands – and costs – of the new digital economy. Even in what we might term the consumer sweet spot, FTSE Travel & Leisure issued the most warnings for almost eight years. This was in part due to one-off factors, but also the impact of rising costs and increasing competition and regulation.
So, how do we square this rise in profit warnings with the confidence displayed in our latest UK Capital Confidence Barometer, where UK executives expressed overwhelming optimism in corporate earnings – rising to 93%, from 62% in the last survey? The discrepancy may be partly due to the nature of profit warnings, which measure any fall in expectations. Executives may now feel that short-term pain of adjustment is past and that they have taken steps to correct their models and invest and acquire in the right areas. In other words, companies are fighting back and have confidence in their ability to place the right bets.
What this fight back might mean – and actually what we’re starting to see – is that companies may spend more than they expected on keeping up with technological change and shifting geographical growth patterns. In making that more than budgeted investment, companies are obviously expressing their faith in their actions securing future earnings – but investment in areas like fulfilment doesn’t come cheap.
Where and how well companies have placed their bets also will make a massive difference if the global economy is diverging as much as it is and technology is moving at such a pace. Thus, we’re also seeing a bifurcation of corporate experience – that is companies, even in the same sector, experiencing the market in very different ways. This is most apparent amongst smaller businesses, which tend to be less diversified and issue the most profit warnings. Our Capital Confidence survey focuses on the experience of larger companies, which should have greater resilience. This isn’t to say larger companies aren’t issuing profit warnings; but again their experience may be atypical –increasingly so in a more divergent global economy.
In such a fluid situation, companies really need to be on their mettle to this growing list of pitfalls. UK executives do recognise that there are many challenges ahead. Most have confidence in the UK and global economies, but they are also mindful of the risks, with 28% in our survey citing slowing growth in key emerging markets as the greatest economic threat to their business and oil and currency volatility continuing a drive towards cost reduction and operational efficiencies. However, the crucial thing here is that they’re not just submitting to these slings and arrows. More than half of UK companies say they intend to buy assets over the next 12 months, driven by the need to accelerate earnings in a low growth economy and to meet disruptive challenges affecting their business model.
With M&A high up the corporate agenda, it’s interesting to see a new paper from the University of St Gallen, highlighted by the FT Alphaville Blog this week, which suggests that Private Equity firms secure the ‘best’ deals. Their data shows that between 1985 and 2013, PE generally bought targets at lower earnings multiples than strategic acquirers – and in the details we find the clues to this difference.
The discrepancy is higher in the purchase of smaller targets on public markets by smaller funds and in club deals, which suggests that any PE market savvy might come into play more in negotiating public deals. The authors also suggest that corporate vendors prefer not to sell to competitors, thus forcing companies to pay more for businesses where they have a greater strategic need – a need than PE won’t have. Companies can also justify a higher price through greater synergies. This is where size comes in, since it’s those larger ‘strategic’ deals where companies have historically paid big prices.
I say historically, since their data ends in 2013 and by then the difference between multiples paid by PE and strategic buyers had significantly diminished. This marries with the trend we’ve noticed in recent years for companies to approach deals with increasing rigor– in part due to competition from private equity players and the acknowledgment that companies have something to learn from their more formalised processes . This rigour includes price. Recent record levels of M&A will of course prompt concerns, but our Global Capital Confidence Barometer shows that ‘heated buyer competition’ is the top cause for walking away from deals. Companies are prepared to withdraw rather than overpay for assets. This is a more sustainable cycle for corporate M&A.