Fitch: M&A Pace Increases Risk of US Companies Overleveraging

The breakneck pace of merger and acquisition (M&A) activity continues to increase the risk that US companies will overleverage balance sheets and/or miscalculate synergy prospects, according to Fitch Ratings. While M&A activity in 2014 supported Fitch's rated portfolio, the risk of M&A-driven downgrades is heightened.

In some cases consolidation has led to stronger competitive positions (including operating synergies) while in others it has been a driver of top line growth for industries facing secular challenges and difficulty in growing revenues organically. Nevertheless, the rapid pace of transactions over the past couple of years increases the risks mentioned above. Mis-execution makes it difficult for companies to de-lever within a reasonable time frame and instead may lead to a more permanent change to financial policy as it relates to leverage and commitment to current credit ratings.

M&A remains an event risk and we expect consolidation will continue as cheap cost of capital from historically low interest rates combined with rapidly changing industry competitive and operating dynamics continues to spur activity across a wide scope of corporate sectors.

U.S. mergers & acquisitions activity in May was $245.2 billion, surpassing the previous record of $225.8 billion recorded in May 2007, according to Dealogic. Sectors with recent large M&A transactions over the past couple of years include telecommunications/cable, healthcare, technology, and energy.

For some sectors like utilities, energy, and healthcare, M&A is a key near-term credit risk given the active consolidation within the sectors and, for some issuers, the limited headroom in ratings due to previous acquisition activity. For utilities, increased use of debt in acquisition financing and rising transaction multiples is a near-term credit risk.

M&A activity within the energy and healthcare sectors contributed to one-half of the corporate downgrades in 2014. More recently, we downgraded Wisconsin Energy Corp by one notch on June 2 to 'BBB+' from 'A' with the expectation that the company will issue $1.5 billion of senior bonds to finance the acquisition of Integrys. The increases in parent-level debt and integration risks outweigh the benefits of regulatory diversification and higher cash flow projections. We placed Teva on Rating Watch Negative on April 22 following its unsolicited bid to buy Mylan as the proposed 50% cash and 50% stock funding will require significant new borrowings.

In contrast, three recent M&A transactions in the telecoms and technology sectors were neutral or positive for ratings. Charter Communications' and Time Warner Cable's merger agreement last week is positive for Charter as it will strengthen its overall leverage and credit profile despite elevated integration risks since it also has the Bright House acquisition to integrate. Charter's 'BB-' ratings remains on Rating Watch Positive on the back of the deal.

Intel Corporation's June 1 announcement it will acquire Altera Corporation for $16.7 billion is neutral for its 'A+' rating. While there are expectations for significant incremental debt issuance to fund the acquisition, the operating profile will remain strong and credit protection measures are solid for the rating. Avago Technologies' acquisition of rival chip maker Broadcom Corp. should modestly strengthen Avago's operating profile with increased scale and diversification. We affirmed Avago's IDR at 'BB+'.

Charter and Avago are both in the leveraged finance sector. We noted a significant shift in the use of proceeds toward M&A activity in this space in the second half of 2014, although it did remain restrained compared with the market peak in 2007. Fitch expects a mix of uses of proceeds to maintain its orientation toward acquisitions, leveraged buyouts, and capex in 2015 and 2016.