European M&A keeps booming as credit stays cheap

By Anshuman Daga and Lincoln Feast - Analysis

LONDON (Reuters) - A fresh burst of takeover activity has broken out across Europe and few see any sign of a let up, as concerns subside about the longevity of the cheap credit underlying many deals.

Private equity firms -- many feeding off buoyant credit markets to fund highly leveraged deals -- are sniffing around again for even larger prey and European chief executives continue to be hungry for takeovers as markets recover.

"European M&A activity reached new highs in 2006 and the trend should continue in 2007 ... The low cost of borrowing leaves room for the arbitrage between debt and equity to continue," ABN AMRO strategists said in a note.

With European Central Bank interest rates at 3.75 percent, firms are being rewarded for putting cash to work.

ABN noted that, at the extreme, a buyer could afford to pay 27 times a company's annual earnings to provide roughly the same return as cash at the rates offered by the ECB.

At the same time, valuations suggest European companies are still not expensive. The average price-to-earnings ratio of the DJ Stoxx 600 .STOXX is 13.5 times forward earnings, below a long-run average of around 15 times.

DEAL LINEUP

Both trade and financial buyers are taking advantage of this apparent disconnect.

Research firm Dealogic says European transactions valued at about $120 billion have been announced since February 26, the day before global markets were shaken by problems in the U.S. lending market, focused on borrowers with poor credit history.

So far this year, deals worth $311 billion involving European targets have been announced in all, slightly below the record levels hit in the first quarter of 2006.

"We have the issue that fundamentals for corporate activity, even with credit spreads widening, still remain strong because the gap between the return on capital and cost of capital remains near high levels," said Mislav Matejka, a European strategist at JPMorgan.

The cost of capital in Europe is estimated at a near-record low 4 to 5 percent, while both company earnings and European stock markets have jumped by almost 50 percent in the last two years.

The lineup of deals is staggering.

Britain's third-biggest bank, Barclays (BARC.L), is in talks on a $80 billion takeover of the biggest Dutch bank, ABN AMRO AAH.AS, for instance, while Imperial Tobacco (IMT.L) has offered $15.3 billion for Franco-Spanish rival Altadis ALT.MC, which rejected that approach saying it was too low.

The surge in takeover activity helped stock markets quickly recover from recent weakness. The pan-European FTSEurofirst 300 index .FTEU3, which fell as much as 8 percent after the sell-off in global stocks began in late February, has since recouped more than half its losses.