Big mergers give small comfort to large cap stocks

The announcement that pharmaceutical giant Merck was bidding $41.1 billion US for rival Schering-Plough — the second blockbuster merger in the pharmaceutical industry in recent weeks — suggests the opportunity that may exist in stock investing, as valuations on beaten-down stocks attract takeover bids.

The pharmaceutical industry has not been immune to the global downturn — in fact, it was suffering well before the downturn occurred. Many of the large players who rely on so-called “blockbuster” drugs for sales face losing the patents on those drugs over the next few years. Big pharmaceutical companies have to stave off competition from generic manufacturers while facing slower sales and rising operating costs.

Many observers have pointed to consolidation as inevitable, which is why U.S. drug giant Pfizer pulled off an even larger deal than Merck, with a planned $68 billion purchase of Wyeth announced at the end of January.

Whether the uptick in mergers and acquisitions is a sign of desperation or bargain-hunting, there could be opportunity for investors. Merck will pay Schering-Plough’s shareholders $10.50 in cash and 0.5767 Merck shares for each Schering-Plough share tendered. Assuming the deal goes through, that’s roughly a 34% premium to Schering-Plough’s closing stock price on Friday.

However, the deal did little to kick-start the U.S. stock markets on Monday, but the fact that capitalized large cap stocks are willing to make acquisitions is a hopeful sign that companies may be anticipating a bottom to share prices.

By all accounts, Monday’s deal was a case of one well-capitalized competitor acquiring a rival that, while distressed financially, had solid core businesses — including longer patents on some of its key drugs.

While similar dynamics are at play in other sectors, consolidation has yet to sweep the market. Some of the more bullish commentators are willing to bet consolidation is on the rise as potential buyers become more comfortable with the price-to-earnings ratios of their targets.

In the meantime, market watchers are busy calculating where the bottom might be. David Rosenberg, Merrill Lynch’s chief North American economist, believes the S&P 500 will likely reach its nadir at around 600.

“October came a little early for us, because we had been calling for a macabre-style bottom of 666 [for October] on the S&P 500 for some time now but didn’t think it would happen this suddenly,” Rosenberg says. “We got to 666 as of October because we applied a classic recession multiple trough of 12 times to our 2010 forward operating earnings forecast of $55.50. However, given that we are still in March, it is probably prudent to apply that multiple to an average of 2009 and 2010 earnings, which would be $50. On that number, it is conceivable that we could see 600 on the S&P 500, and that is where we are now leaning.”

The market could fall below this “fundamental low” of 600, which he points out is not unusual in elongated bear markets.

“We went back to the five major bear markets of the past five decades and found that the bottom happens after the market breaks below what was universally perceived to have been the fundamental low for the cycle. It is at this stage that sentiment gets washed out once and for all,” Rosenberg says. “At this stage, our work would suggest that there is another 70 or 80 points of downside potential. That is hardly good news, but considering how far the market has come down, the silver lining is that more than 90% of the bear market is now behind us, even with that possible last leg down we expect to occur.”

Predicting the duration of this bear market remains problematic. Another report from Merrill Lynch, released Monday, highlights the bear market experienced by the Dow Jones Industrial Average is already the second worst in its history — since the 150-week bear market that ran from 1929 to 1932. The question is how long can it continue? Historically speaking, this bear market is not unusually long.

Rosenberg points out that the current bear market, as measured against the DJIA, has already run 73 weeks, from peak to trough. “But both the 1973–74 and 2000–02 bear markets were longer. And the Dow Jones would need to fall 77% over the next 76 weeks to match the magnitude and duration of 1929–32 losses.”

According to Merrill Lynch, the sector most likely to see massive consolidation going forward — U.S. financials — is one sector it is staying away from for now, due to relatively low transparency, weak loan demand, deteriorating credit quality and increased regulation. Those looking for merger arbitrage opportunities could still be burned even with the premium earned in an acquisition.

Ironically, Rosenberg points to financials as the sector that will eventually lead the large cap stock markets out of the bear market.

“We also have to respect the fact that the financials, which led the bear market by six months back in 2007, will very likely be the group that leads us out with a similar lead time. Considering that the S&P Financials [sub-index] just hit a fresh 17-year low, we can say with some degree of confidence that the bottom to the overall market is still probably at least six months away at this point,” he says.

(03/09/09)