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UBS Investment Research Buying Growth Get Set for the Next M&A Wave As Organic Growth Slows, Firms May "Buy Growth" via M&A U.S. nominal GDP growth is slowing (Chart 1), and this trend will continue due to baby boomers retiring, increased regulation, consumer deleveraging, and tax hikes to reduce the Federal deficit. Therefore many large firmswhich have ample cash, free cash flow, and borrowing powerwill likely attempt to "buy growth" via M&A. We think now is a good time to do so because equities are not expensive (Chart 5) and profits should grow for the next few years. In this report UBS analysts summarize potential deal activity in 35 industries (Tables 1, 3). Will Companies Deploy Cash Effectively? Often they do not; M&A waves usually turn into manias (Table 5). However, since 2002 S&P 500 firms have used cash intelligently by accelerating dividend growth, reducing share counts via buy-backs, cautiously increasing capex, and making relatively rational acquisitions. Hopefully, this pattern will continue. Many of the possible deals discussed in this report have the potential to create value for the buyer if sensibly priced. Two Ways to Win One can invest in potential acquisition targets, preferably ones that will be good investments even if they are not acquired. Table 1 lists 30 potential M&A candidates, of which 15 are rated "Buy" by UBS analysts. Another approach is investing in companies that have a good track record of growing via M&A (Table 2); such companies tend to do numerous smaller deals, which are less risky than mega-deals. The financial distress of targets can create good opportunities for buyers in such industries as auto supply, insurance, and banking. Global Equity Research Americas Equity Strategy Equity Strategy 8 December 2009 www.ubs.com/investmentresearch US Equity Research Department Thomas M. Doerflinger, Ph.D. Strategist firstname.lastname@example.org +1-212-713 2540 Natalie Garner Strategist email@example.com +1-212-713 4915 Chart 1: Slowing U.S. Nominal GDP May Cause Firms to "Buy Growth" via M&A Seven Year Moving Average of Nominal GDP Growth -4% -2% 0% 2% 4% 6% 8% 10% 12% 14% 16% 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 Source: DRI, Bureau of Economic Analysis, UBS This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 59. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Buying Growth 8 December 2009 UBS 2 Table 1: Thirty Potential M&A Candidates Industry Potential Target Ticker Rating Market Cap $ bil Plausible Buyers Beverages PepsiCo PEP Buy 99.6 Anheuser-Busch InBev Tobacco Lorillard LO Buy 12.6 Reynolds American Packaged Foods General Mills GIS Buy 22.4 Nestle Hain Celestial Group HAIN Neutral 0.7 Unilever, Nestle, Heinz Biotech Human Genome Sciences HGSI Buy 4.5 GlaxoSmithkline Protalix BioTherapeutics PLX Buy 0.6 Teva, Pfizer, others Life Sciences Luminex LMNX Neutral 0.6 Bio-Rad Specialty Pharma Allergan AGN Buy 17.9 GlaxoSmithkline Managed Care Health Net HNT Neutral 2.3 Aetna Restaurants Green Mountain Coffee Roaster GMCR Not rated 2.7 MCD; others building breakfast business Media DreamWorks Animation DWA Neutral 3.0 Studio looking to improve computer animation GSI Commerce GSIC Buy 1.3 Accenture, IBM, HP Scripps Networks Interactive SNI Neutral 6.5 TimeWarner, NewsCorp, Viacom ValueClick VCLK Neutral 0.8 Publicis Homebuilders Ryland Group RYL Neutral 0.8 KB Home, D.R. Horton Diversified Financials Federated Investors FII Not rated 2.7 Franklin Resources, Invesco, Affiliated Management Group REITs Extra Space EXR Neutral 1.0 Public Storage Life Insurance Phoenix Companies PNX Buy 0.4 Larger insurer Telecom DIRECTV DTV Buy 30.2 AT&T or Verizon Information Technology F5 Networks FFIV Neutral 3.8 HP, Cisco, Juniper Brocade BRCD Buy 3.0 HP, Cisco, Juniper Riverbed RVBD Neutral 1.4 HP, Juniper Semi Equipment Rubicon RBCN Buy 0.4 MEMC Aerospace & Defense TransDigm TDG Buy 2.2 United Technologies, Goodrich Machinery Joy Global JOYG Neutral 5.6 Caterpillar Airlines UAL UAUA Buy 1.2 Continental Airlines Industrial Services ICF International ICFI Neutral 0.4 SAIC Hewitt HEW Buy 2.9 ACN, IBM, ADP, private equity Energy--E&P Anadarko Petroleum APC Buy 30.3 Integrated major or a Chinese Company Coal Walter Energy WLT Neutral 3.7 Steel maker (domesti or foreign) Source: FactSet, UBS Buying Growth 8 December 2009 UBS 3 Table 2: Industries and Companies that Successfully Grow EPS via M&A Industry Firms with Good M&A Track Record Comment Household Products Procter & Gamble, Church & Dwight PG can acquire product, sell on global platform. Packaged Food Ralcorp, Dean Foods RAH and DF do smaller deals, which are less risky. Some large deals in the industry have destroyed value in the short & intermediate term. Life Sciences Thermo Fisher Scientific, Life Technologies Fragmented industry; large players can create revenue & cost synergies with deals Specialty Pharma Cephalon, Teva, Allergan Use deals to buy growth, add new products Auto Suppliers Johnson Controls, BorgWarner Targets are in financial distress. Apparel VF Corp. Acquire "boutique" brands and expand distribution Diversified Financials JP Morgan Chase Targets were in financial distress. Life Insurance Ameriprise, Prudential Financial volatility has created attractive opportunities. Information Technology Cisco System Strong M&A track record, but at $35 bn in revenue, CSCO is fighting "law of large numbers" Aerospace & Defense United Technologies, Precision Castparts Use deals to grow share in adjacent markets or in target markets Diversified Industrials Danaher, Cooper Industries, Emerson Electric Bolt-on acquisitions; many small targets available Source: UBS Table 3: Potential M&A Activity in Thirty-five Industries Industry Analyst Page M&A Activity Beverages Kaumil Gajrawala 11 Buyers are looking for revenue growth, cost synergies. If PepsiCo and Anheuser-Bush InBev were to merge, the Newco would have a formidable global distribution system better able to compete with Coca-Cola. Cost savings would be significant, and the new company would have more clout with big retailers. Other plausible targets: Cott, Hanson Natural. Tobacco Nik Modi 12 Buyers are looking for revenue growth, to target adjacent markets, and / cost synergies. Reynolds American may acquire Lorillard, whose Newport menthol cigarettes would greatly strengthen RAI's brand portfolio. Packaged Foods David Palmer 14 Companies do acquisitions to gain cost efficiencies; to gain scale vis--vis competitors, suppliers, and retailers; or to enter new geographies. Nestle may acquire General Mills. Hain Celestial may be acquired by Unilever, Nestle, or Heinz. Biotechnology Maged Shenouda and Jeff Elliott 16 Large phama companies will continue to acquire biotech firms to fill their product pipelines, gain access to technology, strengthen distribution in specialized markets. Many deals are likely over the next few years. Human Genome Sciences may be acquired by GlaxoSmithkline. Other plausible targets: OSI Pharmaceuticals, Protalix BiTherapeutics, Biogen Idex, Vertex Pharmacuticals, and Acorda Therapeutics. Life Sciences Derik DeBruin 19 Deal drivers: product portfolio diversification, geographic expansion, accessing new technology to "future proof" the business. Bio-Rad could be interested in Luminex. Other plausible targets: PerkinElmer, Dionex. Specialty Pharma Marc Goodman 21 Buyers are looking for geographical expansion, product pipeline to maintain revenue stream. GlaxoSmithkline may buy Allergan. Other plausible targets: King, Medicis. Companies that successfully grow via acquisition: Cephalon, Teva, Allergan. Managed Care Justin Lake 22 Deal drivers are revenue generation, cost synergies. Aetna may be interested in HealthNet to gain access to California market or it could look consider Coventry to gain scale / efficiency. Restaurants David Palmer 23 McDonald's may buy Green Mountain Coffee Roaster and Yum Brands may buy Dunkin Brands, which is private. Rationale: use a national brand coffee to drive breakfast, the one remaining long-term growth opportunity in restaurants. Media Michael Morris, Matthiew Coppet, Brian Pitz, Brian Fitzgerald 25 With Internet undermining traditional media, and convergence of media and technology, many deals are likely. DreamWorks, GSI Commerce, Scripps Networks and ValueClick are all logical targets for strategic buyers. Specialty Retailing Roxanne Meyer 26 Acquirers generally aim to maintain top-line growth and secure synergies / economies of scale. Li & Fung might possibly acquire Christopher & Banks in order to grow vertically from sourcing for retailers into retailing itself. Homebuilders David I. Goldberg 27 Many deals may occur as buyers attempt to increase sales and operating leverage, access new product types and geographies, and access land positions. KB Home could acquire Ryland, which has underperformed peers during the downturn. Other plausible targets: Toll Brothers, Lennar. Auto Suppliers Colin Langan 28 Financial distress of major firms (Visteon, Delphi) creates opportunity for well-managed, financially healthy firms (Johnson Controls, Borg Warner) to buy into adjacent product markets at attractive prices. Apparel & Footwear Michael Binetti 30 Deal drivers: international expansion, cost synergies, enter new categories. VF Corp., Nike, or adidas may buy DC Shoes, a private company, to build share in the fast-growing "action sports" / skateboarding category. VFC has been an effective acquirers. Buying Growth 8 December 2009 UBS 4 Table 3: Potential M&A Activity in Thirty-five Industries (cont'd) Industry Analyst Page M&A Activity Lodging William Truelove 32 There are no strategic reasons for acquisition in lodging; it's all about private firms buying public lodging companies that look cheap relative to the buyer's cost of capital. Starwood Capital may buy Starwood Hotels; TRT Holdings may buy Gaylord Entertainment. Toys Robert Carroll 33 Mattell and Hasbro regularly acquire small companies with "hit" products, which are sold to the 3 key retailers (WMT, TGT, Toys R Us) which sell 70% of toys. However the deals are generally too small to drive much growth. Leisure Robin Farley 34 Cruise lines in the past have grown via M&A, but balance sheet issues and valid anti-trust concerns make deals unlikely over the next 3-4 years. Gaming Robin Farley 35 Any acquisitions in the near future would be conducted through either debt purchases resulting in debt holders eventually owning the properties, or through bankruptcy court proceedings. Diversified Financials Glenn Schorr 36 Buyers are looking to grow revenues and get the right business mix. Federated Investors may be bought by an asset management company. U.S. trust banks would look to buy European trust banks as a source of growth. European banks are likely willing to sell as this is a non-core business and some need capital and / or less leverage. REITs Ross Nussbaum 37 Buyers want faster top-line growth, geographical expansion. Public Storage could buy Extra Space Storage, which would be accretive, would have cost synergies, and would expand PSA's share of a fragmented industry. Life Insurance Andrew Kligerman 38 The industry is consolidating; big players enjoy economies of scale and scope. Activity has picked up in past six months as capital markets improved; fear of commercial real estate problems may slow it down. Prudential or MetLife are plausible buyers of ING's Korean businesses. Phoenix Companies may be acquired by a stronger firm. Telecom Services John C. Hodulik, Batya Levi 40 Deals are driven by top-line slowdown, cost synergies, and industry shock (risk of video over the Internet). DIRECTV could be acquired by AT&T or Verizon; MetroPCS may acquire Leap Wireless; CenturyTel may acquire Qwest. Information Technology Nikos Theodosopoulos 42 Large firms, such as Hewlett-Packard, Cisco, and Juniper are making acquisitions to increase scale and create end-to-end product solutions for customers. F5, Brocade, and Riverbed seem logical targets. Semi Equipment / Solar Stephen Chin 43 Deal drivers: improve top-line growth, diversify sales. MEMC may buy Rubicon; Applied Materials may acquire Varian (VSEA). Computers Maynard Um 44 Dell and Hewlett-Packard are likely to make acquisitions in the storage / storage software space. Aerospace & Defense David Strauss 45 Deal drivers: revenue growth, bigger market share, more exposure to high-margin / less cyclical service or aftermarket business. TransDigm Group, Alliant & Goodrich are logical targets. TransDigm may be bought by Goodrich or (more likely in our view) United Technologies. Machinery Henry Kirn 47 Companies make acquisitions to enter new geographies and product lines and to achieve cost synergies. Caterpillar may buy Joy Global to achieve all these goals; Kennametal could be bought by Illinois Toolworks or other diversified firms.. Diversified Industrial Jason Feldman 48 Leading firms in this industry grow partly via acquisitions, but their targets tend to be very small. Danaher, Cooper Industries, and Emerson Electric all have good M&A track records. Airlines Kevin Crissey 49 Continental Airlines (CAL) may acquire UAL (UAUA) as a competitive response to Delta / Northwest deal. Reducing the number of hubs would cut costs and improve pricing power. Industrial Services Jason Kupferberg 50 In fragmented industry, convergence of IT hardware and IT services, desire of customers for "one-stop shopping" are driving deals. ICF Int'l, Genpact, and Hewitt may be bought while SAIC, Accenture & IBM are logical buyers. SAIC would buy ICFI to increase exposure to civilian agencies in the federal government. Engineering & Construction Steven Fisher 52 Companies do deals to enter new markets, gain new customers / skill sets, recruit engineers efficiently rather than one-by-one. URS may acquire Foster Wheeler to gain international and oil & gas exposure. Energy -- E&P, Integrated Companies William Featherston 53 Buyers want access to resources and geographical expansion while sellers want liquidity. Majors can also secure cost synergies. Anadarko Petroleum may be bought by a major oil company or a Chinese company. Chesapeake and Conoco Philips may sell assets. Coal Shneur Gershuni 55 Expect consolidation of a fragmented industry, led by firms like Alpha Natural and Massey. Walter Energy, which owns high-quality met coal, may be bought by domestic or foreign steel company. Small & Mid-cap E&P Andrew Coleman 56 Not too much activity near-term. Such firms as Petrohawk, Concho Resources and Cabot Oil and Gas may be bought, probably by larger E&P's rather than integrated firms Small & Mid-cap Energy Service Andrew Coleman 57 The land drillers and / or well servicing names could consolidate. Potential targets include Basic Energy, Complete Production, Pioneer Drilling and Bronco Drilling Paper Gail Glazerman 58 Not much activity near-term. Bankrupt / financial stressed firms will be bought. Successful firms are realigning / focusing their business mix. Source: UBS Buying Growth 8 December 2009 UBS 5 Buying Growth Get Set for the Next M&A Wave Typically there is a cyclical pick-up in M&A activity after a recession (Chart 2). Few deals get done during recessions even though, as investors realize in retrospect, stocks were very cheap. Operating in crisis management mode as business conditions deteriorate, CEOs are too busy to launch deals, and they are disinclined to assume extra risk while profits are weak, their stock price is falling, financial markets are rewarding issuers that have strong balance sheets, and no one can be sure how bad the downturn will be. Financing for deals is difficult to obtain, and potential targets are unwilling to "sell out at the bottom." These factors quickly reverse once the recession ends, stock prices rebound, and companies ponder how they will grow EPS and improve their competitive position during the coming economic expansion. That's where we are today. Chart 2: Annual Value of U.S. Domestic M&A $ billion - 200 400 600 800 1,000 1,200 1,400 1,600 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Thomson Financial, UBS Buying Growth when Investment Opportunities Are Scarce In the coming M&A wave, many companies will attempt to "buy growth" at a time when organic top-line growth is becoming harder to generate. Some companies will succeed brilliantly (think VF Corp.'s acquisition of North Face, or Cisco's purchase of Scientific Atlanta); others will not (AOL Time Warner). To prepare investors for the coming M&A wave, this report sets out to do three things: Q UBS analysts summarize potential deal activity in thirty-five industries (Table 3), providing a "roadmap" of what they expect during the next M&A wave. Activity will be heavy in some, but by no means all, industries. Q Based on this extensive research, we highlight thirty possible deals that we think have relatively greater potential to occur (Table 1). We would be surprised if several of these deals did not occur in the next two or three years. Q We also identify industries and companies where growth via acquisition is likely to be an effective tool for growing EPS, at least for some companies (Table 2). Buying Growth 8 December 2009 UBS 6 Many large companies are struggling to grow organically because U.S. nominal GDP is expanding at the slowest rate since the 1930s (Chart 1). The average growth in U.S. nominal GDP over the seven years ending in 2011 will be about 3.9%. In the 1990s, by contrast, the average value of this metric was 5.9%, and in the 1980s it was 9.2%. The resulting "investment opportunity dearth" will only get worse, because the secular economic growth rate in North America and Western Europe (which still account for about 84% of S&P 500 revenue) will be restrained in coming years by these factors: Q Slowing labor force growth as baby boomers retire. Q Taxes and insurance subsidies mandated by healthcare reform may lead to structurally higher unemployment in the U.S. Companies have an extra incentive not to hire, and fewer workers will seek a job in order to "get the benefits." Reform may also have perverse incentive effects by raising the marginal tax rates of middle class workers; as they earn more, they could get a smaller insurance subsidy. Q Cap & Trade Legislation, as well as efforts by the Environmental Protection Agency to curb carbon emissions, would raise energy costs and restrain growth. Even if a Federal law does not passed, action by individual states (led by California) will have a significant effect. Q U.S. consumers will continue to deleverage; at the very least we will not see the secular decline in the savings rate that boosted consumption growth over the past 25 years. Q Tax hikes and spending cuts are needed to cut the huge structural Federal budget deficit. Buying Growth 8 December 2009 UBS 7 Ample Corporate CashWill It Be Spent Wisely? Given this secular slowdown in organic growth, an increasingly important driver of corporate EPS growth will be intelligent deployment of capital, including M&A. Most companies have plenty of money to spend on deals. In the S&P 500, cash as a percentage of both assets and equity market cap is high by historical standards (Chart 3), while financial leverage is not particularly high (Chart 4). The free cash flow of non-financial companies has held up surprisingly well during the recession, because although operating cash flow has declined along with profits, cap ex has declined more (Table 4). For 399 non-financials in the S&P 500, cash flow from operations in the first three quarters of 2009 declined 7% versus the first three quarters of 2008, capex fell 22%, and free cash flow increased 8%. Dividends rose slightly, but both buy-backs and M&A activity declined sharply. Bottom line: most large U.S. firms have ample cash, cash- flow, and borrowing power to finance deals. Chart 3: S&P 500 Cash as a Percent of Assets and Market Cap 0% 5% 10% 15% 20% 25% 30% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Cash as a % of Assets Cash as a % of Market Cap Source: Standard & Poor's, UBS Chart 4: S&P 500 Financial Leverage is Moderate Debt / Equity - 0.5 1.0 1.5 2.0 2.5 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Standard & Poor's, UBS Buying Growth 8 December 2009 UBS 8 Table 4: S&P 500 Uses of CashNonfinancials ($ billions) YTD y/y chg1 3Q09 2Q09 1Q09 2008 2007 2006 2005 1 Cash Flow from Operations -7% 274 225 198 996 1,001 855 824 2 Free Cash Flow (1 - 6) 8% 177 124 97 465 524 454 477 3 Dividends (Cash) 3% 43 46 60 195 177 152 139 4 Net Share Buy-Backs -82% 22 (2) 21 260 407 290 226 Share Buy-Backs -68% 32 23 31 312 498 361 284 Share Issuance -2% 10 25 10 53 91 70 58 5 Dividends + Net Share Buy-Backs -49% 65 44 81 454 585 443 367 6 Capital Expenditures -22% 96 101 101 531 477 403 347 7 Net Mergers & Acquisitions -78% 4 12 2 109 99 54 63 Capital Expenditures as a % of Depreciation 104% 108% 107% 133% 143% 151% 132% Total Payout Ratio (as a % of Pro Forma Income) 50% 38% 77% 76% 98% 79% 71% Dividend Payout 33% 40% 57% 32% 30% 27% 27% Net Buy-back Payout 17% -2% 20% 43% 68% 52% 43% Capex + M&A as a % of Cash Flow from Operations 37% 50% 52% 64% 58% 53% 50% Depreciation as a % of Cash Flow from Operations 34% 42% 48% 40% 33% 31% 32% Pro Forma Net Income as a % Cash Flow from Operations 48% 52% 53% 60% 60% 66% 63% 1 For the same companies Source: FactSet, UBS But will companies use cash flow effectively to grow EPS and total return? Often they do not. M&A waves usually turn into value-destroying manias (Table 5). And in the late 1990s, companies overspent on capex and M&A; one result was a deterioration of asset turns (assets divided by sales) during the decade. Furthermore, in the 1990s companies deemphasized dividends in favour of share buy-backs, which did more to hide the dilutive impact of copious employee stock option issuance than to actually shrink share counts and boost EPS. Over the past few years, by contrast, non-financial companies chastened by the 2000-2002 stock market crash and by Sarbanes Oxley have mended their ways and spent cash flow in a disciplined and balanced manner. We hope to see that continue, along these lines: Q Significant dividend growth, somewhat in excess of the secular earnings growth rate of 6-7%. Dividend growth accelerated after the 2001 recession to a 9.9% annual rate, 2002-2008, but payout ratios are still low compared to history or compared to Europe. Q Reducing Share Counts via Buy-backs. Although buy-backs have declined during the recession, many companies have continued to buy in shares. The share count change of the median company has been just +0.3% over the past year; in 2007 and 2008 the share count of the typical firm fell 1-2% annuallymuch faster than in the late 1990s. Q Higher capital spending designed less to expand capacity than to save labor and energy. (Healthcare reform creates an extra incentive to substitute capital for labor.) UBS economists expect real capital spending to rise 1.1% in 2010 and 6.3% in 2011. In comparison to the 1990s, capital spending has been restrained over the past few years. Buying Growth 8 December 2009 UBS 9 Q M&A that really does create value for shareholders by driving EPS growth. This is disconcertingly rare. A detailed study of 12,000 mergers over twenty years found that M&A destroyed shareholder wealth, mainly due to losses suffered by large firms1. This is not too surprising, because buyers pay a premium for a property about which they know far less than the seller. As noted, most M&A booms have eventually deteriorated into costly manias. (See Table 5 and, for a detailed analysis of M&A waves, see Daniel Stillit's October 16, 2007 Q-Series report, European M&A. Table 5 is partly based on this report.) That said, there are many potential dealsincluding those in Table 1that we think would add value if done at the right price. Now Is a Good Time for Firms to Buy Even after the 60% run-up from the March lows, stocks are fairly inexpensive by historical standards (Chart 6). Public companies don't have to compete much for acquisitions with private equity funds, as they did from 2004 to 2007. Declining credit costs are making it cheaper to finance deals. And the economy should expand for the next few years; in 2010 buyers will not be buying at the top of the business cycle. Chart 5: S&P 500 Price/Book Value 0 1 2 3 4 5 6 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010E Source: FactSet, Standard & Poor's, UBS 1 Sara B. Moeller, Federik P. Schlingemann, Rene M. Stulz "Do Shareholders of acquiring firms gain from acqusitions?" National Bureau of Economic Research, March 2003 Buying Growth 8 December 2009 UBS 10 Two Ways to Win For investors trying to profit from the M&A wave by owning potential targets, we prefer the "icing on the cake" strategy of owning stocks rated "Buy" by UBS analysts. These stocks could be acquired at a nice premium (the "icing on the cake"), but even without a bid they should be good investments (the "cake" itself). Of the thirty stocks in Table 1, fifteen are rated "Buy." Alternatively, one can invest in industries and companies that should be successful in using M&A as a tool for growing EPS, shown in Table 2. These firms tend to share certain common characteristics: Q Most have developed M&A expertise after doing many deals. Q They tend to do fairly small deals, which are less risky. Q In some industriesnotably autos, banking, and insurancebuyers have good M&A opportunities because of the financial distress of competitors. They can buy or (in the case of JP Morgan) already have bought attractive assets cheaply. Table 5: Most M&A Booms have Turned Into Manias that Eroded Value Trustification Roaring Twenties Conglomerates Leveraged Restructuring Tech bubble Private Equity Boom Now Dates 1898-1903 1922-29 1965-72 1984-89 1995-2000 2003-2007 2009 - ? Economic Rationale Create larger, more stable companies with pricing power Economies of scale in utility industry Diversification; apply "systems" management approach to acquired firms Rationalize conglomerates; unlock asset values (such as land) not reflected in equity market caps Acquire technology needed to remain competitive in "New Economy" based on Internet Higher returns through leverage Boost top-line growth, broaden product line Financial Innovation Stock-for-stock mergers "rolled up" many firms, creating trusts with dominant share of an industry Leveraged utility holding companies Boost EPS by using high-PE stock of conglomerate to buy companies with lower valuations Original Issue Junk Bonds, hostile takeovers, leveraged buy- outs, leveraged re- capitalizations Compensation via options create incentives to do deals that lift stock price quickly Private Equity Not clear; leverage is out of fashion but large firms have ample cash, FCF, borrowing capacity Financial Conditions Supporting Boom End of deflation due to gold discoveries supports bull market in equities Bull market; low interest rates due to commodity deflation, Fed policy to support Pound Sterling 15 years of prosperity & rising stock prices enhance credibility of acquisitive corporate managers Decline in inflation & interest rates give raiders buying power Tech companies have very high PE equity as deal currency Very low interest rates for extended period; healthy profit growth & free cash flow generation Low interest rates, weak U.S. GDP growth, reasonable equity valuations Signature deal or company U.S. Steel Commonwealth Edison ITT, Textron, Gulf + Western, LTV, City Investing RJR Nabisco LBO; failed UAL LBO AOL TimeWarner Equity Office Properties ? Signature deal-makers J.P. Morgan Samuel Insull Harold Geneen, Felix Rohatyn Michael Milkin, KKR, Bruce Wasserstein various Blackstone, KKR, others ? Source: UBS Buying Growth 8 December 2009 UBS 11 Potential M&A Activity in Thirty- five Industries Beverages Kaumil Gajrawala Deal Metric: Q EV / EBITDA Recent Deals Q Anheuser-Busch / InBev merger at 12.4x EB/EBITDA Q PepsiCo buys PBG (7.6x EV/EBITDA) and PAS (8.4x EV/EBITDA) Deal Drivers Q Cost savings via synergies Q Industry shock Q Geographical market expansion Possible Deals Target Plausible Buyers Rationale PepsiCo (PEP) InBev (ABI) Cost savings and geographic growth Cott (COT) Dr. Pepper Better retail presence Hanson Natural (HANS) Coca-Cola (KO) Global rollout of strong brand Merger of PepsiCo and Anheuser-Busch InBev This deal would create a dominant global consumer packaged goods player. If InBev (ABI, rated "Buy") and PepsiCo (PEP, rated "Buy") combined beer and soft drink distribution around the world, NewCo would be better able to compete with Coca-Cola (KO, rated "Neutral."). PepsiCo would benefit, as InBev is a leader in beverage distribution through its dominant beer businesses. InBev would reap the benefits of further cost savings opportunities, access to top tier managers in marketing, and asset rationalization opportunities. Furthermore PepsiCo would be able to use its global dominance in snacks to increase NewCo's importance with retailers. These two companies recently signed a joint-purchasing agreement in the US, where they jointly purchase all materials, supplies and services not related to actual finished product. While they have not quantified the savings from this agreement, we believe it provides additional EPS flexibility for both companies. In addition, ABI already has a solid understanding of PEP as they bottle and distribute PEP products in Latin America where beer and soft drinks are distributed on the same vehicles. Given the size of the two organizations (~$80b), there would be integration risk, especially in the area of IT. Top management from PepsiCo could look to leave, given InBev's history of deep cost cutting and reputation of not being a brand builder. Globally, there is always significant risk when changing means of distribution. Depending on the geographic market, the two companies vary as to who is a more dominant player. A global competitor for Coca-Cola Buying Growth 8 December 2009 UBS 12 Tobacco, Household Products Nik Modi Deal Metrics: Q EV / EBITDA Q Price / Sales Recent Deals Q Altria (MO) acquired smokeless tobacco company UST for $11.5 billion, or 11.9x EV/EBITDA Q Energizer (ENR) bought Skintimate and Edge brands for $275 million, or an estimated 1.5-2.5x Last Twelve Months Sales. Deal Drivers Q Cost rationalization / synergies Q Target serves markets adjacent to buyer's current portfolio mix Q Increase in long-term growth rate Likely Deal Lorillard (LO, rated "Buy") is likely to be acquired by Reynolds American (RAI, rated "Neutral") or Imperial Tobacco (IMT.L rated "Neutral"), which would be looking to strengthen their cigarette portfolios by adding the #1 menthol brand, Newport. Deal Rationale: A Reynolds American Lorillard deal is the most compelling M&A scenario from a financial standpoint, in our view. By purchasing Lorillard, we believe Reynolds American could substantially strengthen its brand portfolio with Newport. (Salem continues to lose share and Kool has become more of a support brand). We believe there are substantial cost synergies and even modest revenue synergies (through joining Lorillard and Reynolds brands within the same retail trade contract). Lorillard could also provide Reynolds American with best practices on costs and promotional strategies given Lorillard operates the most profitable "per stick" business model across US tobacco. Deal Feasibility: We see this as a high probability M&A scenario. We believe Reynolds American is a willing buyer and Lorillard's management team and board could be willing sellers at the right price. A key consideration would be potential antitrust issues. However, the approval by the Dept. of Justice on Molson-Coors/SABMiller combining their US operations could set a positive precedent. Potential antitrust issues in menthol could be resolved by a sale of Salem and / or Kool (though how much RAI would get for either brand is still a big question). The Newport brand would strengthen RAI Buying Growth 8 December 2009 UBS 13 Base Case M&A Modeling Assumptions Q Takeout valuation of 12.5x EBITDA = 2 year present value of $108 per LO share. Q 7.5% incremental borrowing costs gross leverage reaches 4.1x EBITDA. We believe RAI would be willing to stomach a temporary debt downgrade to acquire this asset. Q 80% financed through debt/cash Based on the above assumptions, we estimate per share accretion at approximately $0.47 (+10%) by year 1 and $0.88 (+18%) by year 2. Here are some potential "Ripple Effects" that could happen if Reynolds American acquired Lorillard: Possible bidding war for Lorillard Given the growing nature of its business, we believe other players would have to at least consider taking a look. While we believe Imperial Tobacco needs time to digest Altadis, they might have to jump into the mix if Reynolds makes a bid. However, it is hard for us to see how Imperial could outbid Reynolds American given the sheer magnitude of synergies a RAI-Lorillard combination could produce. Share Gains for Marlboro Menthol. Marlboro Menthol could likely benefit from a Reynolds American-Lorillard integration through likely reduced focus by the new entity on less attractive menthol brands (Salem and Kool, which together hold 18% of the menthol segment). In the event they are divested due to antitrust issues, we believe Marlboro Menthol would be able to capitalize as the brand transitions to another owner. Divestments? If antitrust concerns were to arise around the combined company's large share in the menthol segment (54% before divestments), Reynolds American could divest some of its existing menthol brands. While it is hard to assess the ultimate sale value of Kool or Salem, we believe companies like Imperial, Japan Tobacco or smaller US players could make a bid for these brands. Potential valuation of a deal if it occurred now: If it occurred now we estimate LO would go for $116, which is 12.5x EV/ EBITDA. However, our LO price target implies the value of a deal 2 years out which in present value terms would be $108. Companies that Can Grow Via M&A Q Procter & Gamble (PG, rated "Buy") Can buy product lines and sell on a global platform, with plenty of opportunities for cost-synergies. Q Church & Dwight (CHD, rated "Buy") Good track record in doing successful M&A, and plenty of opportunities for cost synergies. Buying Growth 8 December 2009 UBS 14 Packaged Food David Palmer Deal Metric: Q EV / EBITDA Recent Deals Q Ralcorp Holdings (RAH) purchase of Post Foods from Kraft Foods (KFT) for $2.6 billion (8.7x trailing EV/EBITDA) Fall 2007 Q Blackstone purchase of Birds Eye Foods for $1.3 billion (8.7x trailing EV/EBITDA) November 2009 Deal Drivers Q Cost efficiencies through scale and overhead leverage Q Geographic expansion Possible Deals Q General Mills (GIS, rated "Buy") is acquired by Nestle (NESN, rated "Buy") in order to get additional access to the U.S. market and buy respected brands in generally healthy eating categories something Nestle is looking for. Q Hain Celestial (HAIN, rated "Neutral") is acquired by Unilever (UNC, rated "Neutral"), Nestle or Heinz (HNZ, rated "Neutral") in order to add several solid brands in natural / organic foods and beverages. Nestle buys General Mills A deal would increase the number of "good-for-you" categories that Nestle participates in (examples include cereal, soup, yogurt and snack bars). It would also greatly expand Nestle's presence in the US, where General Mills generates 80-85% of its sales. General Mills also participates in categories favored by aging American baby boomers. In addition, Nestle and General Mills currently are partners in a joint venture (Cereal Partners Worldwide) that sells Big G cereals outside of the US. There would likely be reasonable cost synergies, and a deal would also improve Nestle's bargaining power and relationships with key US retailers. Downside Risks from a Deal: EPS dilution would be likely, as General Mills is among the best US packaged food companies, is hitting on all cylinders right now, and would not be cheap. There would also be some integration risk, as the companies have different nationalities and different corporate cultures. Indeed, prior food deals have often had painful integrationsincluding General Mills / Pillsbury. Potential valuation of a deal if it occurred now: Certainly higher than recent deals, which involved lower-quality assets. We estimate General Mills could sell for around 12x EV / EBITDA. Increase the number of "good-for-you" categories Buying Growth 8 December 2009 UBS 15 Growth via M&A The mega-deals of the early 2000's had a mixed track record of delivering shareholder value. We believe companies have learned several lessons from that M&A wave including: 1) scale across the supermarket is less important than scale in the supermarket aisle, 2) long-term double-digit EPS growth likely does not make sense, and using M&A synergies to achieve this will likely lead to trouble ion the long run. Many companies have limited themselves in recent years to "bolt-on" acquisitions as a way to enter a new category or geography while limiting risk. Two examples of successful consolidators over time include: Q Ralcorp (RAH, rated "Buy") has a good track record with regard to smaller acquisitions of other private label companies. We believe they are likely to pursue M&A over the next 12 months, as prices for companies available for sale have become more attractive lately. Q Dean Foods (DF, rated "Buy"), similar to Ralcorp, has been a serial acquirer of smaller dairies. Many smaller dairies are now capital and/or cash- constrained, and we believe Dean is likely to continue with bolt-on acquisitions. Buying Growth 8 December 2009 UBS 16 Biotechnology Maged Shenouda, Jeff Elliott Deal Metrics Q Price / sales Q Premium to current share price Q Risk-adjusted DCF Recent Deals Q Eli Lilly (LLY) acquired ImClone (closed November 2008). LLY paid $6.1 billion (7.8x 2008 revenue of $778.6 million) or a 75% 3-month premium to where shares were trading prior to the announcement of a potential deal. Q Roche and Genentech (closed March 2009). Roche paid $46.8 billion or $95 / share for the 44% of outstanding shares it did not already own, implying a valuation of $106.5 billion or 7.9x 2008 revenues of $13.9 billion. Q Bristol-Myers Squibb (BMY) and Mederex (closed September 2009). BMY paid $2.4 billion for MEDX, or approximately a 90% premium to the pre-announcement closing price. Deal Drivers: Q Diminishing pipelines at large pharmaceutical companies Q Economies of scale in marketing Often large drug companies can gain economies of scale by detailing an additional compound at a much lower incremental cost than would be spent by a biotechnology company on its own or under a co-promotion agreement. Q Research capability/technology acquisition Some of the innovative science that will drive the next-generation of drug development is being done at biotechnology companies. These companies are likely take-out targets as R&D progresses and likelihood of commercial success rises, enticing a pharmaceutical company to acquire the company. Q Manufacturing capacity Biotechnology drugs are generally difficult to manufacture and require specific expertise to produce at sufficient yield and specifications. Therefore, M&A may be driven by infrastructure and capital requirements to manufacture the complex biologic products being developed. Q Marketing network Some biotechnology M&A is driven by value of existing specialty sales and supply chain at certain companies. Because some biotech products are sold to small and select groups of prescribing physicians (such as oncologists) it may make sense for a pharma or biotech company to acquire the infrastructure already established in a particular company or region. Big pharma fills its pipeline Buying Growth 8 December 2009 UBS 17 Possible Deals Human Genome Sciences (HGSI, rated "Buy") is acquired by GlaxoSmithkline (GSK, rated "Buy"). GSK is partnered with HGSI on potential blockbuster Benlysta for Lupus. OSI Pharmaceuticals (OSIP, rated "Buy") is acquired by Roche, which is partnered with OSIP for blockbuster lung and pancreatic cancer treatment Tarceva. Roche would be buying the profit split and royalty it pays OSIP on Tarceva sales along with any contribution from OSIP's other assets including a second royalty stream from the DPP-IV patent estate and other earlier-stage in- house compounds. Protalix BioTherapeutics (PLX, rated "Buy") is acquired by Teva (TEVA, rated "Buy"), Pfizer (PFE) or others. Many companies would be interested in acquiring PLX as a platform technology company. PLX has a proprietary plant-based biologics manufacturing technology, which would enable the acquiring company to either manufacture proprietary biologics, or to enter the biosimilars field Biogen Idex (BIIB, rated "Neutral") is acquired by Roche, Johnson & Johnson, or others. BIIB has historically been thought of as a take-out candidate, and has previously placed itself on the block, although no buyer was found. BIIB is now influenced by activist shareholder Carl Icahn, who controls two board seats and has called for the sale of the company in the past. Vertex Pharmaceuticals (VRTX) is acquired by Johnson & Johnson, which is partnered with VRTX for potential blockbuster HCV therapy telaprevir. Currently JNJ only has ex-US rights to the drug, which we believe could quickly become standard of care if approved. Acorda Therapeutics (ACOR) is acquired by Biogen Idec (BIIB, rated "Neutral"). BIIB is partnered with ACOR for ex-US rights to MS therapy Fampridine-SR. Given BIIB's expertise in MS and an existing sales force targeting MS specialist physicians, we believe if the drug is approved, BIIB may bid for ACOR and fold it into its own MS operations. Buying Growth 8 December 2009 UBS 18 GlaxoSmithkline buys Human Genome Sciences Human Genome Sciences has been the best performing biotech stock so far in 2009. With the stock up ~ 1,200% YTD, HGSI has become one of the top biotech companies by market cap. This growth has been entirely driven by (somewhat surprising) clinical success of Benlysta (belimumab) in Systemic Lupus Erythematosus (Lupus). The unmet medical need in this sizable population (estimated 325,000 actively treated lupus patients in the US) is considerable. With pricing assumptions similar to other biologics including BIIB's Avonex (approximately $30k a year), we somewhat conservatively estimate worldwide Benlysta sales will reach almost $3bn by 2015. Also, based on the mechanism of action of Benlysta, we believe the drug may also have potential in several additional indications such as MS and RA, although we have yet to give value for these additional indications in our model. GlaxoSmithkline is partnered with HGSI with a 50:50 worldwide commercialization and profit spit for Benlysta. Given the scarcity of unencumbered biologics with multibillion dollar revenue potential, HGSI remains an attractive M&A candidate in our view. The downside risks to a potential take-out of HGSI by GSK are also important. The valuation potentially required for shareholder approval may be considerable. While clinical data have read-out positively, the drug has yet to be approved by the FDA and could face potential delays should regulators take a more critical view of the responder index used as the primary endpoint, as well as the meaningfulness of the clinical benefit. However, many of the more traditional M&A concerns such as EPS dilution, integration risk, anti-trust issues, etc. generally would not be prominent in a HGSI-GSK deal due to the relative size of the players. Potential valuation of a deal if it occurred now: Assuming GSK could possibly pay roughly 10x peak revenues, and risk-adjusting Benlysta sales, the potential valuation could be around $40 per share. Companies that Grow via M&A As large pharmaceutical companies struggle with internal pipeline gaps and pipeline productivity issues, they will likely continue to look to biotech to fill related gaps. Historically, large pharma biotech mergers have not focused on near-term EPS growth but rather on technology acquisition or other longer-term goals that are difficult to characterize as value-creating or value-destroying. Given the lengthy development timelines in drug development, (sometimes ten years from initial discovery to market) pipeline or platform technology acquisitions are very difficult to assess from a strictly financial perspective. Buying Growth 8 December 2009 UBS 19 Life Sciences Derik deBruin Deal Metrics: Q Price / Sales Q EV / Sales Recent deals Q Agilent Technologies (A) acquired Varian, Inc. (VARI); Valuation: $1.5 billion; $52 per share (35% premium); ~1.8x EV/Sales Q Danaher (DHR) acquired the mass spectrometry assets of Life Technologies (LIFE) and MDS, Inc. (MDZ). This business, called Sciex, was a 50:50 J.V. between LIFE and MDZ. Valuation: $1.1 billion or ~1.6x sales Deal Drivers Q Portfolio diversification, especially the addition of more consumable products and diagnostics Q Geographic Expansion, especially into Asia. Smaller companies cannot compete effectively in increasingly global markets Q The acquisition of new technology in order to "future proof" businesses and augment the organic revenue growth profile. Possible Deals Target Plausible Buyers Rationale PerkinElmer (PKI) Danaher, Emerson Election, GE Expands life sciences foot print, cost synergies Dionex (DNEX) Thermo Fisher, Danaher Enhances TMO & DHR mass spectrometry franchise by adding more HPLC products; high demand for IC in applied markets (e.g., food safety, environmental testing, water quality); increased exposure to key Asian markets. Luminex (LMNX) Life Technologies, Millipore, Bio-Rad Expands drug discovery and diagnostic market foot prints; cost synergies (especially for BIO); attractive technology platform Bio-Rad (BIO, not rated) buys Luminex (LMNX, rated Neutral) In our view, this deal would make strategic sense for both companies. Luminex is a key suppler of Bio-Rad, as the company's proprietary xMAP technology is a critical component of Bio-Rad's Bio-Plex multiplex testing platform used within life sciences research and clinical diagnostics labs. Sales to Bio-Rad represented 17% of Luminex's total 2008 sales, making Bio-Rad the second largest customer of the company. In acquiring Luminex, Bio-Rad would gain a high organic revenue growth business with the potential for margin gains. Luminex's FY08 revenues grew 39% y/y, and we project 14% and 24% growth in FY09 and FY10, respectively. In addition, Bio-Rad would expand its portfolio within diagnostics, a key focus area for the company, because Luminex currently markets FDA-approved molecular diagnostics tests for respiratory infection and cystic fibrosis, and has several others in late-stage development. Conversely, Luminex would become a part of a global, stable franchise that maintains a strong presence across a wide range of labs. Portfolio and geographic diversification LMNX is growing rapidly Buying Growth 8 December 2009 UBS 20 What are the risks? While there is the potential for a deal to be accretive given the strong top-line contribution from Luminex and the reduction of operating costs, the company's partnership modelwhereby Luminex technology is licensed to partners that then develop their own final contentdoes hamper profitability and increase uncertainty on future revenue streams as Luminex is dependent on its partners for product development and marketing. In addition, sales of Luminex's consumable products are frequently lumpy, which could add unwanted volatility. Finally, many other companies are developing multiplex technologies, and competitive risk does exist should Bio-Rad commit itself to a technology that proves to be inferior to a technology developed at a later date. Potential valuation of a deal if it occurred now: Q Potential valuation: $18-22 per share Q Valuation Method(s): Price/sales & EV/sales Q Assumptions: An EV/Sales multiple of 5-6x (a premium to the diagnostic group average of ~4x due to higher revenue growth profile) on projected FY10 Luminex revenues of $147 million. Growth via M&A In this industry some companies do grow successfully via acquisition, and we do not expect that to change. The life sciences and diagnostics industries remain fragmented, and the opportunity for revenue and cost synergies via complementary technology and / or service offerings is significant. Two examples: Q Thermo Fisher Scientific Inc. (TMO, Rated "Buy") has a good track record, very strong global distribution platform, and opportunities for cost synergies. There are many financially weak targets. Q Life Technologies (LIFE, Rated "Buy") has many smaller, financial weak targets; cost synergies; and a global platform. Buying Growth 8 December 2009 UBS 21 Specialty Pharma Marc Goodman Deal Metrics: Q EV / EBITDA Q Price / Sales Recent Deals: Q Sepracor acquired by Japan's Dainippon Sumitomo for 2.1x Price/Sales or 6.9x EV/EBITDA in Sept. 2009 Q Procter & Gamble (PG) drug unit acquired by Warner Chilcott (WCRX) for 1.4x Price/Sales and 3.5x EV/EBITDA Deal Drivers Q Need for product pipeline to maintain revenue stream Q Geographic Expansion Possible Deals Target Plausible Buyers Rationale Allergan (AGN) GlaxoSmithkline (GSK) Buying growth King Pharmaceutical (KG) Teva (TEVA) Expand into pain franchise Medicis (MRX) Inamed Capture 100% of Dysport Cosmetic GlaxoSmithkline (GSK, rated "Buy") may buy Allergan (AGN, rated "Buy"), which would add growth by taking GSK into new therapeutic directions, namely in ophthalmology and cosmetic indications. In addition, there are existing overseas synergies and GSK already promotes Botox in Japan and China. With this deal, GSK would get Botox globally, along with cosmetic expansion to supplement the recently acquired skin products of Stiefel. The downside risk from a deal would be EPS dilution. Companies that Grow via M&A Companies in this industry have successfully grown via acquisition. They should be able to continue to do so if they buy assets which are accretive, with high probability of success, or in areas with unmet needs. Three companies that are effective acquirers are: Q Cephalonbecause they acquire overlooked assets in attractive therapeutic areas, at a low cost. Q Teva is great at extracting synergies Q Allergan is smart about leveraging existing franchises GSK adds growth, moves into new therapeutic directions Buying Growth 8 December 2009 UBS 22 Managed Care Justin Lake Deal Metrics Q P/E is the primary metric Q EV / EBITDA Q Price per member Recent deal Q Sierra acquired by UnitedHealth (UNH) announced in March 2007, closed 2008. This $2.6 billion deal ($43.50 per share) represented ~16x 2008 EPS estimate and ~10x '08 EBITDA estimate Deal Drivers Q Market expansion (geographic and by product line) Q Cost efficiency Q Generate growth as top-line slows Possible Deals Target Plausible Buyers Rationale Health Net (HNT) Aetna (AET) Geographic Density Coventry (CVH) Aetna Gain scale / efficiency Health Net (HNT, rated "Neutral") would provide Aetna (AET, rated "Buy") with additional scale in the key California market. California represents nearly 1/7th of the commercially insured population, and Aetna currently has little in the way of membership. There is opportunity for meaningful growth if Aetna purchases an existing platform. Managed care is a local business. National scale helps on the SG&A side (about 12-15% of costs) but offers little benefit on medical costs, which are negotiated at the local level. Most plans have found it more cost efficient to purchase an existing entity in new geographies rather than trying to break into new markets with well-entrenched incumbents. Health Net's industry-low margins offer potential for improvement, with greatest synergies likely to come from lower SG&A and underwriting capabilities. While an acquisition of Health Net by Aetna would likely not be blocked on anti-trust grounds, a deal would likely receive significant attention given the current health care reform landscape. Furthermore, with Aetna experiencing a challenging 2009, there would likely be some concerns around adding more to its plate at this point. Lastly, managed care acquisition integration has the potential for systems integration and other business issues that caused problems for most large acquirers (AET 2000/2001, UNH 2007/2008, WLP 2008.) Potential valuation of a deal if it occurred now: around 12-14x current earnings for Health Net's go-forward business (i.e. ex TRICARE contribution). After accounting for the ~$5 cash per share that Health Net is projected to receive from its pending sale of non-core assets to UnitedHealth, this would leave a potential valuation of ~$26, representing a ~20% premium to the company's current quote. Entering California Buying Growth 8 December 2009 UBS 23 Restaurants David Palmer Deal Valuation Metric: Q EV / EBITDA Recent Deals: Q Triarc Companies' purchase of Wendy's International for $2.34 billion (10.5x EBITDA on announce date, but all-equity transaction) Q Golden Gate Capital's purchase of 80.1% stake in Macaroni Grill from Brinker International for $131.4 million, at a low-single-digit multiple of EBITDA. Deal Drivers: Q For buyers, A) leverage scale by purchasing a new concept, such as breakfast, B) invest in a turnaround opportunity Q For sellers, A) sell peripheral chain to improve focus on the core business, B) financial problems. Possible Deals Target Plausible Buyers Rationale Green Mountain Coffee Roaster (GMCR) McDonald's (MCD) Breakfast Dunkin Brands Yum Brands (YUM) Breakfast The strategic rationale of the above deals is that breakfast is the remaining long- term growth opportunity in restaurants, and coffee occasions will likely drive this day-part. A national franchised chain can capture instant synergies by adding a national coffee brand to its existing asset base. The upside to these potential deals is the multi-year incremental EPS growth that can result from growing sales per restaurant. Downside Risks: EPS dilution from the deal itself, plus the risk of poor consumer acceptance of the combined concept. Can Companies Grow Successfully via M&A? Yes, but the track record is mixed with respect to restaurant companies buying chains to create a "portfolio of brands." For instance Brinker (EAT, rated "Buy") recently sold many of the concepts it bought in previous years. Synergies are limited in this industry, but there are ways that some restaurant companies can capture synergies better than others. For instance, global franchised restaurant companies can add brands to existing assets, or use a new brand to grow globally (e.g. buy a coffee brand to add to US franchised stores). A dominant market player can acquire new concepts to leverage its capabilities and broaden growth opportunities. An example of this might be YUM China which continues to buy restaurant chains in China as a way to leverage its real estate and supply chain capabilities. Darden Restaurants (DRI, rated "Buy") Casual dining is a low growth industry where high single-digit EPS growth will require capturing market share by expanding existing concepts or buying new concepts. While the jury is still It's all about breakfast Buying Growth 8 December 2009 UBS 24 out on its acquisition of RARE, we believe Darden has the ability to refine/develop concepts and finance their expansion. While sales trends continue to be weak at acquired chains, Darden has been delivering upside to its merger- related synergies forecasts. Wendy's/Arby's Group (WEN, rated Neutral) is keen on pursuing international expansion. The company may consider M&A as a way to accelerate this expansion. We believe this strategy is less likely to be successful due to fewer synergies and a limited track record operating internationally. Wendy's/Arby's may also buy a coffee brand (e.g. Caribou) as a way to expand its breakfast business. Yum! Brands (YUM, rated "Neutral") is a multi-concept fast food company with a sophisticated global infrastructure. We believe it is possible YUM could purchase a domestic brand and leverage its global distribution and franchisees network to grow the brand globally. YUM may also buy a coffee brand as a way to expand the breakfast business of its Taco Bell chain. Buying Growth 8 December 2009 UBS 25 Media Michael Morris, Matthieu Coppet, Brian Pitz, Brian Fitzgerald Deal Valuation Metric: Q EV / EBITDA Recent Deal: Q In August 2009 Walt Disney acquired Marvel for cash and shares; implied Marvel value was 13.0x consensus 2010 EBITDA. Q In October 2009 GSI Commerce acquired Retail Convergence for cash and shares; implied multiple was roughly 12.0x 2010 EBITDA. Deal Drivers: Q Internet is undermining traditional media business models Q Structural Change convergence of traditional media and technology Q Cyclical upturn in advertising Q Need for private equity to monetize assets Possible deals Q DreamWorks Animation (DWS) rated "Neutral" by Michael Morris with a $34 price target. DWA could bolster the computer-generated animated feature films slate of many studios as well as bring the expertise in-house. Q GSI Commerce (GSIC) rated "Buy" by Brian Fitzgerald with a $26 price target. GSIC develops and operates for-commerce businesses and provides marketing services for clients. Customers include retailers, branded manufacturers, media companies, and professional sports organizations. It provides website design, electronic commerce technology, customer service, online marketing, etc. GSIC would be a strategic asset to any company looking to expand in the realm of online eCommerce, perhaps Accenture, IBM, or Hewlett-Packard. Q Scripps Networks (SNI) rated "Neutral" by Michael Morris with a $39 price target. SNI's five national television networks (HGTV, Food Network, DIY, Fine Living, and Great American Country) could be attractive to major U.S. content owners such as Time Warner, News Corp. or Disney. It also owns some e-commerce online properties (Shopzilla and BizRate) that increase its attractiveness to some potential buyers. Q ValueClick (VCLK), rated "Neutral" by Brian Fitzgerald with an $11 target, provides Internet advertising solutions for publishers of websites and online advertisers. Offers performance-based Internet advertising solutions for websites publishers and online advertisers, offering performance-based Internet advertising solutions, where an advertiser pays only when an Internet user clicks on its text or banner advertisement or fills out an application. As a leading U.S. online ad network (size / reach) VLCK would be a strategic asset for an advertising agency seeking to bolster or broaden out its digital capabilities and online reach. For example, Publicis would be able to further leverage its digital agency VivaKi with ValueClick's assets. Structural change drives deals Buying Growth 8 December 2009 UBS 26 Specialty Retailing Roxanne Meyer Deal Valuation Metric: Q EV / EBITDA Q Price / Sales Recent Deals Q Dress Barn (DBRN) acquired Tween Brands (TWB) was announced June 2009 and is expected to close in October 2009; stock for stock exchange; $157 mill equity value (20% premium to TWB's stock price) and $230 mil total value. Valuation: 5.5x LTM EBITDA. Q Advent International (private equity) acquisition of Charlotte Russe (CHIC) privatization has been more common than M&A in specialty retail; announced 8/24/09; all cash transaction; $380 Million total value; Valuation: 0.5x Price/ FY08 Sales Deal Drivers: Q Maintain top line growth Q Cost synergies / economies of scale Possible Deals Q Li & Fung (494HK, rated "Buy") or private equity firm acquires Christopher & Banks (CBK, rated "Sell") Q Gap Stores (GPS, rated "Neutral") acquires a small but successful niche on- line retailer We do not think it is likely that another specialty retailer would acquire Christopher and Banks, but it could make sense for a company such as Li & Fung to buy CBK as part of its strategy to grow vertically. Right now Li & Fung provides the sourcing for retailers, but if it had its own stores and product, there would certainly be cost efficiencies. CBK is behind the curve operationally (technology / processes, etc) which would be the rationale for private equity to bid for it. Buying Growth 8 December 2009 UBS 27 Homebuilders David I. Goldberg Deal Valuation Metric: Q Price / Book Value Recent Deals: Q Pulte (PHM) acquired Centex at 1.0x tangible BV or 0.5x tangible BV if you add back in FAS allowances against deferred tax assets. Q Stanley Works (SWK) acquired Black & Decker (BDK, rated "Neutral"); this was a building products deal, not a homebuilder. In this case, valuation is based more on future EPS multiples; the deal got done at 21x 2010 EPS estimates. Deal Drivers: Q Increase operating leverage by driving more sales Q Access or grow exposure to a product type or geography Q Access a land position Possible Deals Target Plausible Buyers Rationale Toll Brothers (TOL KB Home (KBH), Lennar (LEN) Access to high-end buyers; succession planning at TOL, access to TOL's land position Ryland (RYL) KB Home (KBH); DR Horton (DHI) Chance to turn underper- formance; more dynamic product offering Lennar KB Home, DR Horton Lennar decides to focus more on the land side, sell home building Q KB Home Acquires Ryland. It is very difficult to be specific about the synergies that would be created by such a move, but we would note the following. KB Home (KBH, rated Neutral) and Ryland (RYL, rated Neutral) are both focused more as merchant builders, controlling minimal amounts of land, which would make a combination more feasible. Further, Ryland has underperformed peers during the downturn; introducing KB Home's Design Studios might help improve margins. Finally, KB has been very active in redesigning products to be more competitive with foreclosures; adopting this strategy could drive increased sales for Ryland. Buying Growth 8 December 2009 UBS 28 Auto Suppliers Colin Langan Deal Valuation Metric: Q EV / EBITDA Q EV / Sales (for distressed companies with negative EBITDA) Recent Deals: Q On November 2, Faurecia, a seating and exhaust supplier, acquired EMCON Technologies, a supplier of emission technologies. EMCON had 2008 sales of 2.4bn and EBITDA of 53m. The deal will be funded through issuance of 21m Faurecia shares (about 300m). Faurecia will also assume 70m in debt. Q On November 17, Autoliv acquired some assets from Delphi's safety division, which are expected to generate sales of $125m in 2010. Deal Drivers: Q Financial distress of major firms (Visteon, Delphi), which may be broken up. (A UBS survey revealed over 40% of suppliers expect Delphi and Visteon to be broken up.) Q Financially strong companiesJohnson Controls (JCI) and BorgWarner (BWA) can buy into adjacent markets at attractive prices. Q M&A, unlike capital spending, enables companies to grow without exacerbating industry over-capacity. Q Reducing industry fragmentation tends to boost margins. Possible Deals A UBS survey shows that suppliers expect the U.S. supply base to shrink by 23% due to industry consolidation. The best way for investors to participate is to buy the shares of financially healthy companies that can afford to make acquisitions, including Johnson Controls (JCI, rated "Buy") and Borg Warner (BWA, rated "Neutral"). Both companies have a good track record of growing via acquisition. It is easy for investors to underestimate the potential for these companies to benefit from the consolidation trend, because managements have little incentive to talk up the value of assets they would like to buy. We see three plausible deals: Q Johnson Controls buys Visteon or Delphi Electronics. Electronics are an increasingly important part of the vehicle and are expected to grow at a 7- 15% annual rate. Visteon and Delphi are significant players in this market through their electronics divisions (audio systems, driver information systems, infotainment products). One of the best operators in the industry, JCI may be able to restructure either business in order to achieve better operating margins. Q Johnson Controls buys Visteon Interior, which produces cockpit modules, door panels and trims, and console modules. It is the second largest interiors supplier globally and, more importantly, the largest interiors supplier in China. By acquiring Visteon Interiors, JCI would further improve its already strong presence in that growing region. Buying assets of financially distressed firms Buying Growth 8 December 2009 UBS 29 Q BorgWarner buys Delphi Powertrain. Delphi's fuel injection systems for gasoline and diesel engines would complement BWA's turbo-charging capabilities. Direct injection technology is used in diesel applications and turbochargers are used in gasoline engines. With this deal, BWA would be able to supply the two main components needed to downsize engines (turbos and direct injection). Although we think this would create a very interesting offering for automakers, it would be a dramatic shift for BWA because: Delphi Powertrain is almost equal in revenue to BWA, A deal would also be outside BWA's expertise in air management, The mix of Delphi's power-train business is unclear and likely includes some low value components. Buying Growth 8 December 2009 UBS 30 Apparel & Footwear Michael Binetti Deal Metric: Q EV / EBITDA Q EV / Sales Recent Deals: Q VF Corp. (VFC) purchased 7 For All Mankind. Deal was announced 7/26/07 and closed 8/31/07. Valuation: 3.1x EV/Sales (EV/EBITDA not available) Q VF Corp. purchased Vans, Inc. Deal announced 4/27/04 and closed 6/30/04. Valuation: 0.8x EV/Sales (EV/EBITDA not available) Deal Drivers: Q International expansion Q Potential to build single-branded stores for a brand that is acquired (e.g., building "North Face" stores, instead of just selling through Dick's Sporting Goods) Q Synergies with existing infrastructure Plausible DealAcquisition of DC Shoes (a Private Company) Q DC Shoes is acquired by VF Corp., Nike (NKE), or adidas in order to expand existing brand portfolio and increase exposure to a growing U.S. footwear category, action sports. We are focusing on DC Shoes, but the apparel / footwear industry is filled with small, independent, and boutique brands. Any one could be a target, and brand portfolio companies like VF Corp (and even smaller companies like Wolverine Worldwide) are considering acquisitions. The US athletic footwear industry is comprised of large, established players that have very little "white space" growth potential today. Action sports is one of the few rapidly growing sub-sectors. Most of the largest companies already have an action sports / skateboarding brand (Nike SB, adidas Skateboarding, and VF Corp's Vans brand). It's a difficult category in which to earn credibility; it has taken Nike a long time to get its Nike SB brand to where it is today. That said, large footwear retail chains (especially Foot Locker) are pushing hard to chase this growing category. Foot Locker has been trying for the last few years to get the right mix of brands into its stores. Foot Locker even bought online action sports retailer CCS, and has started building CCS-branded stores to chase faster growth in this area. DC is a small brand, but one with solid credibility in the action sports sub-sector. The brand is privately owned, so it is hard to estimate revenues. But for companies like Nike and adidas with large US businesses (and investor concerns about US growth), we wouldn't be surprised to see an acquisition of DC. VF Corp could be another potential buyer even though it already owns one of the best known skate brands in the world, Vans. We believe that VF Corp is looking for acquisition targets, and with Vans being its only significant footwear Buying boutique brands Buying Growth 8 December 2009 UBS 31 brand, we think the company believes there would be significant synergies in adding a second footwear brand. What are the downside risks for the buyer? We believe the risks for the large companies listed above would be minimal since they have established the distribution and logistics capabilities needed to absorb a small brand like DC. The biggest risk would likely be near-term integration/execution risk as an acquirer would look to move production over to its own sourcing and supply chain. This raises the risk of stock-outs at retail as the company integrates supply chains. Valuation: Over the past five years, M&A deals in footwear and apparel have averaged 8.3x trailing 12-month EV/EBITDA Companies that Grow EPS via M&A Companies in this industry can grow via M&A by buying small "boutique" brands. The best example is V.F. Corp. Its 2000 purchase of North Face is a great example; it has had a 23% revenue CAGR since the deal, from a base of $200 million in 2000. Since being acquired by VFC in 2004, shoe retailer Vans has grown revenues at a 20% pace. Despite a good track record overall, VFC has also made mistakes, such as its 2003 purchase of Nautica, which we think has suffered from overexposure to the volatile department store segment and insufficient brand differentiation vs. casual sportswear competitors. Buying Growth 8 December 2009 UBS 32 Lodging William Truelove Deal Valuation Metric: Q EV / EBITDA Recent Deals: Q Blackstone acquired Hilton Hotels for EV / EBITDA multiple of 14x in 1997 Q Appollo Investment Corp. acquired Innkeepers USA Trust for 12.5x EBITDA in 1997 Deal Drivers: Q Acceleration of profits during the 5-7 year lodging cycle Q Private companies use higher debt levels, reducing the cost of capital Possible Deals Q Starwood Hotels (HOT, rated "Neutral") could be acquired by Starwood Capital, as we believe the former CEO of HOT, Barry Sternlicht, may want to purchase the company he used to run. Q Gaylord Entertainment (GET) could be acquired by TRT Holdings; Robert Rowling of TRT has acquired a significant position in TRT and has the option to purchase more, should he offer a 25% premium to the market price. There are typically no strategic reasons for acquisition in lodging. It is all about private companies trying to buy public lodging companies that they believe are cheap relative to fundamentals. The only time a strategic move was made was when Hilton purchased Hilton International, which was used in turn to sell to Blackstone. Buying Growth 8 December 2009 UBS 33 Toys Robert W. Carroll Deal Metrics: Q EV / EBITDA Recent Deals Q Hasbro (HAS) acquired 50% stake in Discovery Kids Network (23x EV/EBITDA). This valuation is way above average in both the toy and media space, and heavily predicated on future potential. Deal Drivers Q R&D Effect Toy industry is extremely hit driven with unpredictable returns on R&D spending. If a hit product is brought to market by a smaller competitor it is often acquired by larger operators and overlayed onto their production and distribution network to maximize its commercial potential. Q Modified Wal-Mart Effect. Wal-Mart, Target, and Toys R Us represent ~70% of sales for the major U.S. toy makers, which are favored suppliers because of their scale and ability to deliver the quantity needed. To maintain these relationships with retailers, toy makers need to be able to provide the product demanded by the retailers, which often requires buying outside properties. Q Intellectual Property relationships often start out as licensed agreements and evolve into acquisitions. Possible Deals Given the fragmented, hit-driven nature of the industry it is too difficult to accurately predict where their M&A activities will focus. Growth via M&A At their core the toy companies are low level manufacturing companies with branded product. Acquisitions of strong brands at reasonable prices allow the overlay of new products on a more efficient manufacturing platform with broader distribution. But these acquisitions tend to be very small. We may continue to see benefits from the acquisition of new brands, but the size and scale of the companies makes their impact on EPS modest. Very few candidates are large enough and available for sale at a reasonable price. Q Hasbro (HAS) Industry Innovators Tend to see opportunities that others do not. Q Mattel (MAT) Successful track record (Fisher Price) but few available targets, and management currently averse to new deals. A hit-driven industry Buying Growth 8 December 2009 UBS 34 Leisure Robin Farley Deal Metrics: Q EV / EBITDA Q $ / berth for the cruise industry Recent Deals Q Royal Caribbean (RCL)'s 2006 acquisition of private Spanish cruise operator Pullmantur for $900M, or $199,000/berth, or 15-17x estimated EV/EBIT (vs. then current multiples for the cruise operators of ~14x EV/EBIT) Q Apollo's August 2007 acquisition of a 50% stake in private operator Norwegian Cruise Lines valuing the company at $4B or $202,500/berth. Deal Drivers Q Scale, Scale, Scale, and Scale Q Geographic diversification / expansion Possible Deals None are likely soon. Carnival Corp. (CCL, rated "Buy") is currently the only cruise operator with the financial capacity to undertake an acquisition of any size. Given the conservative nature of CCL management we would not foresee the company considering an acquisition for multiple years with it becoming an option roughly 3-4 years from now when lower capacity growth and capex spending in 2012-2014 results in significant free cash flow generation. Other cruise operators are currently focused on reducing debt and do not have the balance sheet capacity to undertake an acquisition. Growth Via M&A Carnival has grown successfully through acquisition, but this strategy is now limited by valid anti-trust concerns given the oligopolistic structure of the industry, with the top three players controlling ~90% of the market. Anti-trust is an issue Buying Growth 8 December 2009 UBS 35 Gaming Robin Farley Deal Metrics Q EV / EBITDA Recent Deals Q Acquisition of Harrah's by Apollo Management and TPG @ 10x EV/EBITDA in late-2006 Q Acquisition of Station Casinos by Colony Capital and STN management team @ 10.5-11.5x EV/EBITDA in late-2006 (currently in bankruptcy) Deal Drivers: Q Availability of capital Q Slowing top-line growth Q Attractive valuations given strong potential for free cash flow generation from casinos Possible Deals None. Any deals likely to be completed in the near future will be conducted through either debt purchases resulting in debt holders eventually owning the properties, or through bankruptcy court proceedings. Growth via M&A Some companies have done it, but it's been very difficult. It cannot be done right now because of the difficult operating environment and the capital intensity of the industry. Debt holders may gain control Buying Growth 8 December 2009 UBS 36 Diversified Financials, Banks Glenn Schorr Deal Metrics: Q For asset managers the main metrics are PE, Percentage of Assets under Management, and EV/EBITDA Q For universal banks and brokers, it is Price / Book Value and P/E Q For trust banks, P/E is the main metric Recent Deals Q BlackRock (BLK) purchased Barclays Global Investors for 0.9% of Assets Under Management, 12x EBITDA, 19X EPS Q Invesco Ltd (IVZ) acquired Morgan Stanley's Retail Investment Business for 1.3% of Assets Under Management, 16x 3Q 2009 run rate earnings Deal Drivers Q Strategic; get business mix right Q Diversification / Revenue Enhancement Q Capital Needs / Divestitures Possible Deals Q State Street (STT, rated Neutral) and Bank of New York Mellon (BK, rated Neutral) acquire European Trust Banks for growth Q Franklin Resources (BEN), Invesco (IVZ), or Affiliated Management Group (AMG) acquire Federated Investors (FII) to diversify business mix and scale up. The US trust banks would look to buy European trust banks as a source of growth, when their domestic business is facing revenue headwinds, and also as a way to expand their international footprint. The European banks are likely willing to sell as this is a non-core business, they are not investing in it, and some need capital and/or need to de-leverage. The US trust banks are currently trading at ~14x 2010E EPS, so any deals would likely be around this level. There are potential cost synergies but also a risk of client disruption. Other risks of these deals are culture clashes, integration costs, overpaying, and diluting capital ratios. For the asset managers, we expect continued consolidation in the industry as scale will become increasingly important given the consolidation of the large distributors. In addition, there may be some diversified firms that will look to sell their asset management businesses, as we saw with Bank of America's sale of Columbia. Companies that Can Grow Via Acquisition Some firms in our space have done this successfully, and we think that a few will continue to do so. For example, JPMorgan Chase will grow EPS as a result of both the Bear Stearns and WaMu deals. Federated investors Trust banks may buy in Europe Buying Growth 8 December 2009 UBS 37 REITs Ross Nusbaum Deal Valuation Metric: Q Capitalization rate Recent Deals: Q None in the past two years Deal Drivers: Q Slow internal growth; acquisitions needed to drive growth Q Geographic expansion Q Cost synergies / Market share gains = pricing power Possible Deal: Q Public Storage (PSA, rated "Buy"), which is flush with cash and looking to grow, may look to acquire Extra Space Storage (EXR, Rated "Neutral"). Public Storage is the industry leader in self storage. It has bought two other smaller self storage REITs in the past ten years, and has ambitions of continuing to consolidate a very fragmented industry. PSA will have $1 billion of cash on its books by mid-2010 and could easily fund a purchase of EXR, the second largest self storage REIT, which has an equity market cap of ~$1 billion. A deal would be immediately accretive to PSA given its higher multiple and would increase the company's market share. Cost synergies would also be sizeable as PSA could eliminate EXR's executive management and regional management teams, as well as its call centre and advertising program. Consolidating the storage industry Buying Growth 8 December 2009 UBS 38 Life Insurance Andrew Kligerman Deal Metrics: Q Price / Book (GAAP) Q Price / Book (Statutory) Q P / E Q Price as Percentage of Assets under Management (AUM) Recent deals: Q In Sept. 2009 Ameriprise (AMP) announced agreement to acquire Columbia Management from Bank of America for ~$0.9 1.2 billion (depending on net flows). Deal was valued at ~7x run-rate EBITDA and 0.6% of AUM. Q In October Reinsurance Group of America (RGA) announced agreement to buy the U.S. & Canadian life, accident, and health reinsurance business of ING sub ReliaStar. Price not disclosed Q In October AIG (AIG) sold its Taiwanese life insurance business to a consortium led by Primus Financial Holdiong and China Strategic Holdings for $2.15 bill Q In October, Lincoln National (LNC) sold its United Kingdom operations to Sun Life Financial (SLF) for 195 million pounds or ~$300 million in after- tax net proceeds. Q In August Lincoln National (LNC) announced sale of its asset manager Delaware Investment for $428 million, which was 0.74% AUM and ~15x forward operating earnings. Deal Drivers: Q Industry is consolidating because insurance is a scale-based business; firms without economies of scale & scope are at competitive disadvantage. Q Firms seek revenue growth Q M&A activity has picked up in last six months due to improved capital market, which has lifted valuations, improved access to financing, and alleviated capital pressure on potential buyers. Possible Deals Q Prudential Financial (PRU, rated "Buy") and MetLife (MET, rated "Buy") are plausible acquirers of ING's Korea life insurance business and Latin American pension business. The buyer could gain scale at historically attractive prices. Q Phoenix Companies (PNX, rated "Buy") may be acquired by insurers that are well-capitalized and have high credit ratings. Buying Growth 8 December 2009 UBS 39 Phoenix Companies Is Acquired Phoenix is a likely take-out candidate in our view given its limited scale, digestible size, relative underperformance vs. publicly-traded peers, and cheap market valuation. Given the loss of key distribution relationships in 1H09 and the post-2Q 2009 rash of downgrades to its insurance financial strength ratings, Phoenix's earnings growth prospects are limited. High surrender levels are eroding its in-force policy base and sales are extremely weak. As such, the value of Phoenix's in-force policies would be higher in the hands of a well-capitalized highly-rated insurer. This would reduce surrender activity and the acquirer would achieve back-end operational cost synergies. In addition, we think a larger well-capitalized insurer may be better-poised to harvest / extract the embedded value of Phoenix closed block via a capital markets/securitization type transaction in time. Downside risks: minimal because we think a potential acquirer would only purchase Phoenix for the value of its in-force policies and would only do so if the transaction price were EPS and ROE accretive. Potential valuation of a deal if it occurred now: Per our 10/5/09 note, we estimated at least $8 per our adjusted statutory BV analysis. PNX current share price is $3.25 or 0.27x 3Q09 BVPS (ex-aoci) as of 11/11/09this compares to 0.87x 3Q09 BVPS (ex-aoci) for our U.S. life group. We would expect the take- out price to be notably higher than PNX's current stock price. Companies that Grow EPS via Acquisitions Q Ameriprise Financial has extensive M&A experience, although its more recent deals (H&R Block Financial Advisors and J&W Seligman) were not well timed given the hard-to-predict capital markets meltdown. Ameriprise recently agreed to acquire Columbia Management at attractive terms in our view. It expects the acquisition to be EPS and ROE accretive and it expects to realize $130-150 million in net run-rate synergies from the transaction. This acquisition will provide a 5-year strategic distribution agreement with Bank of America and its affiliates and a better relative investment performance track record. Q Prudential Financial has a strong track-record of doing deals at opportune times (and at attractive prices that are EPS and ROE accretive) and of successfully integrating acquired businessesas exemplified by its acquisitions of Gibraltar Life in Japan, Skandia's U.S. variable annuity business, and Cigna's U.S. retirement business, among others. PNX assets are worth more to a financially strong insurer Buying Growth 8 December 2009 UBS 40 Telecom Services John C. Hodulik, Batya Levi Deal Metrics: Q EV / EBITDA Q FCF multiple Q EV per subscriber or per access line Recent Deals Q CenturyLink (CTL) merged with EMBARQ, announced October 2008; 4.5x 2009E EBITDA Q Verizon's (VZ) pending sale of 4.8 million rural lines to Frontier Communications (FTR) for $8.6 billion. Announced May 2009; ~5.0x 2009E EBITDA and ~$1,800 / access line Deal Drivers Q Top-line slowdown, especially in wireless and for large telcos such as Verizon and AT&T Q Cost efficiencyimproving scale in wireless, RLEC footprint, or cable Q Industry shock (video over the Internet, which is the driving rationale behind Comcast-NBC Universal deal) Q Diversification to reduce earnings volatility (Comcast NBCU) Possible Deals DIRECTV Group (DTV, rated "Buy") is acquired by AT&T or Verizon. Telcos need to gain scale to control programming costs and DTV is the second- largest pay TV provider behind Comcast; having national video capability is compelling once 4G/LTE wireless is available across the country in 2010-12. See below for details. Leap Wireless (LEAP) is acquired by MetroPCS (PCS, rated "Buy"). The companies have similar pricing and promotion strategies, target similar customers and use the same technology; their networks complement each other geographically; LEAP and PCS already have a roaming agreement; cost synergies the last time PCS proposed this deal (Sept. 2007) were pegged at $2.5B. Qwest Communications (Q) is acquired by CenturyLink (CTL). CenturyLink is in the process of integrating EMBARQ assets. However we believe the company will look to further consolidate ILEC assets to ensure free cash flow growth amid top-line pressure Potential Acquisition of DIRECTV The split-off of Liberty Entertainment and its combination with DTV (on 11/19/09) was a necessary step to simplify DTV's capital structure and potentially pave the way for a telco take-out. We believe DTV is an attractive asset for Verizon or AT&T as both companies have national wireless businesses. First, both AT&T and Verizon are looking for ways to gain scale in video to T or VZ may buy DTV Buying Growth 8 December 2009 UBS 41 bring down programming costs, as they each have a few million video subscribers vs. DTV's 18M. We believe DTV spends close to $30/mo in programming cost per sub while AT&T and Verizon incur at least 20-25% higher cost. Buying DTV would help solve the problem of escalating programming expenses, as a combined VZ-DTV or T-DTV would be second only to Comcast in terms of video customers. Also, once LTE/4G is available (2010-12), with speeds of up to 10Mbps to the handset, being able to provide a video signal nationwide to the home television or the mobile device becomes very compelling and could represent a meaningful way to provide the triple play even in markets where a carrier does not have copper phone lines. Downside Risks We have yet to see how the Genachowski FCC will react to a large media-industry merger. Given the FCC's efforts so far to ensure "Net neutrality" and potentially wireless Net neutrality, we would expect regulators to try to extract concessions from a telco in exchange for allowing the purchase of DTV. Regulators might also look at market concentration; a federal appeals court recently struck down ownership limits that allowed individual cable companies to control no more than 30% of the U.S. cable subscribers. In seeking merger approval, DTV and a telco would likely try to have regulators evaluate the whole pay-TV marketcable, satellite and telcoand not look only at one segment of the industry. We believe AT&T or Verizon would pay a premium as long as the deal would be FCF accretive in Year 1. Potential valuation of a deal if it occurred now: around $35-40/share for DTV shareholders plus assumption of ~$3.5B in DTV net debt or $36-$40B in EV or roughly $1,950-$2,200 per U.S. subscriber. This assumes the full value of a deal is based on U.S. business and assigns no value to LatAm assets, which could be sold or spun off to help generate cash for the deal and/or assuage regulatory concerns. Companies that Grow M&A Q CTL / EQ. We believe CTL can take out roughly ~15% of EQ's cash operating cost in 2-3 years and maintain its EPS (which would have declined on a stand-alone basis). Q T or VZ combo with DTV should allow the telco to grow EPS by taking significant synergies out of the combined company. In addition, the pro forma company can use free cash flow to lower debt or buyback shares (and boost EPS). Buying Growth 8 December 2009 UBS 42 Info. Technology -- Nikos Theodosopoulos Deal Valuation Metric: Q P/E Q Dilution or accretion to EPS in out years Recent Deals: Q Cisco / Tanberg Q Cisco / Starent Q Hewlett-Packard / 3Com Deal Drivers: Q Improving scale and end-to-end product solution for customers Q New markets for growth; mega-cap companies are increasingly invading each others' traditional markets, such as networking, the data center, storage, etc. Possible Deals Target Plausible Buyers Rationale F5 (FFIV) HPQ, CSCO, JNPR Data Center Brocade (BRCD) HPQ Data Center Riverbed (RVBD) HPQ, JNPR Networking With the recent announced acquisition of 3Com by HP, it is not likely HPQ would do another networking acquisition in the near term. Remaining pure play networking companies that are still potential targets longer term include F5, Brocade (networking and storage networking) and Riverbed. Of these, F5 offers HP additional strategic networking product content for the data center and cloud computing markets on top of their current and future offering post the 3Com deal. F5, however, has appreciated considerably in 2009 and trades at a premium to the sector on a P/E and EV/EBITDA basis which will likely make F5 less likely of a near term takeout from HPQ's perspective and more of a partner. Downside risks. Judging from history, technology M&A has a low probability of success. Company with Good Track Record of Growing Via M&A Q Cisco is more successful than most. Its acquisition of Scientific-Atlanta is the best deal of the last few years. Pure play networking companies Buying Growth 8 December 2009 UBS 43 Semiconductor Equipment, Solar - Stephen Chin Deal Metric Q Price / Sales Recent Deals Q Semicap: Applied Materials (AMAT) announced intent to acquire Semitool on 11/18/09 for $364 M or 1.8x Semitool's FY 2010E sales Q Solar: MEMC (WFR) acquired SunEdison on 11/23/09 for $340 million. This is a private company, so valuation not available Deal Drivers: Q Improve top-line growth Q Diversify sales, reduce earnings volatility Possible Deals Target Plausible Buyers Rationale Rubicon (RBCN) MEMC (WFR) Synergies in making wafers & new sales channel Varian (VSEA) Applied Materials (AMAT) Big product hole that needs to be filled MEMC May Acquire Rubicon: MEMC knows how to make semiconductor wafers well and MEMC knows how to make solar wafers well. Rubicon knows how to make LED wafers very well. MEMC could use another revenue growth driver. The LED wafer market has pricing power, and MEMC knows how to prosper when it has product pricing power from the semiconductor and solar bull markets. The LED market has strong secular growth of 30%+ compared to the semiconductor wafer secular growth rate of 5-10% which would be attractive to MEMC. We estimate a deal could be gross margin accretive since LED wafers will likely have gross margins over 35%. Downside Risk of Deal: MEMC's management team is spread thin right now while trying to integrate its acquisition of SunEdison. We believe that MEMC considered acquiring Rubicon three years ago and passed on the opportunity. Potential valuation of a deal if it occurred now: We think MEMC would likely need to pay at least $22 / share for Rubicon or 25x Rubicon's calendar year 2011E EPS of $0.88 Companies that Can Grow EPS via M&A KLA acquired Tencor and created value. In the semicap space, it is more difficult to create value as the number of customers that buy semicap equipment continues to get smaller. Applied Materials (AMAT, rated "Buy") has a good track record in crystalline solar equipment. We expect AMAT will consider entering the LED equipment market in a strong way for the first time in early 2010. If AMAT's LED equipment does not gain strong customer traction in 2010, we think it will look to acquire an established LED equipment supplier such as Aixtron (AIXG) or Veeco (VECO). LED is an attractive market Buying Growth 8 December 2009 UBS 44 Computers and Communication Technology Maynard Um Deal Metrics Q P/E Q EV / Sales Recent Deals Q Hewlett Packard (HPQ) acquired 3Com (COMS) @ 2.2x EV/Sales and 25.5x forward P/E Q Dell Inc. (DELL) acquired Perot Systems at 1.5x CY 2010 EV/sales, 29x CY2010 PE Deal Drivers Q Diversification to reduce earnings volatility Q Cost efficiency bigger companies really do have economies of scale that cut unit costs and boost market share Q Industry is consolidating; firms will "eat or be eaten" Possible Deal Hewlett Packard and / or Dell are likely to acquire storage companies and storage software companies. Although both have storage offerings, they may look to acquisitions to help bolster their presence. With continued growth of data and digital content, storage remains a priority area of spending. Depending on the size of the acquisition, there could be some integration risk as well as competitive issues concerning existing partnerships, etc. Companies Growing via M&A Companies in this industry have successfully grown via deals, but it is becoming more difficult because of the law of large numbers and a dearth of large acquisition targets. Antitrust may also play a bigger role in the future as consolidation continues. Best positioned to grow via deals are Hewlett-Packard and IBM which have: Q Proven track record of integrating deals Q Lots of cross synergy opportunities (across services, software & hardware) Q Sale and global platform. Buying Growth 8 December 2009 UBS 45 Aerospace & Defense David Strauss Deal Metrics: Q P/E Q EV / EBITDA Recent Deals Q Precision Castparts (PCP) buying Carlton for $850 mil. or 8-9x EV/EBITDA Q Boeing (BA) buying Vought 787 operations for $580 million in cash plus forgiven advance payments totalling roughly $400 million; valuation not available Deal Drivers: Q Growth top line is slowing or declining Q Market share Q Increase aftermarket or service component of revenue, which is less cyclical Possible Deals Target Plausible Buyers Rationale TransDigmn Group (TDG) United Technologies (UTX), Goodrich (GR) Increase aftermarket / service content Alliant Techsystems (ATK) Lockheed Martin (LMT), Raytheon (RTN) ATK is growing faster Goodrich (GR) United Technologies Increase aftermarket / service content Acquisition of TransDigm Group (TDG), with most likely buyers being either United Technologies (UTX) or Goodrich (GR). TDG is a $2.1 market cap Tier II/III supplier of niche products (ignition systems, pumps, actuators) to the aerospace and defense markets. TDG's products are low dollar value, and it is sole source on most of its products which allows the company to pass through price increases and maintain high margins. TDG's margins are the highest among all suppliers at 40%+. It generates 35% of revenues but 75% of profits from aftermarket. The high aftermarket mix is likely attractive to both GR and UTX, which have built their business model around higher margin service content. UTX would appear to be the more likely buyer given its size ($63 billon market cap) and purchasing power as this would be a large deal for GR to absorb ($7.5B market cap and 10%+ in revenues). UTX has a more aggressive acquisition appetite than GR and might be looking for growth to offset market share losses at its Pratt & Whitney business over the past decade as well as a declining business market. TDG would serve as an extension of current business with potential for some cost synergies. Main deterrent to a deal would likely be TDG's high financial leverage at 60%, although TDG generates $150-200M in free cash flow a year and could delever relatively quickly. Downside risk to a deal is likely loss of TDG management; it is not clear that they would stay and be part of a larger corporation. Management is Increase exposure to a high-margin business Buying Growth 8 December 2009 UBS 46 entrepreneurial, having formed the company and taken it public. They reaped financial rewards from the IPO and recently paid a special dividend to shareholders, including themselves. Integration risk is likely low to moderate. We do not see material anti-trust risk as UTX does not compete with TDG on its aerospace businesses. Potential valuation of a deal if it occurred now: Likely on higher end of aerospace multiples given track record, high margins and cash generation. Using 9x our FY10 EBITDA estimate it would be roughly $3.5B. Companies that Can Grow via M&A Q Precision Castparts (PCP, rated "Neutral") Solid acquisition track record, focused on driving efficiency and raising margins. Typically buys adjacent businesses for market share gains or a company that allows for vertical integration in order to reduce input costs. Q United Technologies (UTX, rated "Buy") Tends to target companies that allow it to grow market share in targeted markets (housing, aerospace, fire & security, military) or increase international exposure. Vast financial resources allow it to invest in business and maximize product reach. Buying Growth 8 December 2009 UBS 47 Machinery Henry Kirn Deal Metrics Q EV / EBITDA Q EV / Sales Recent deals Q In 2007 Korea's Doosan Infracore bought Bobcat from Ingersoll Rand (IR) for roughly 1.9x 2006E sales and 12.3X 2006E EBITDA Q In October 2008 Manitowoc (MTW) bought foodservice equipment maker Enodis for roughly 1.7x FY 2007E sales and 15.4x FY07E EBITDA Deal Drivers Q Geographic expansion or expanding into new product lines Q Cost synergies Possible Deals Target Plausible Buyers Rationale Joy Global JOYG Caterpillar, Komatsu, sovereign- wealth funded companies Take out cost, expand product line Kennametal (KMT) ITW, other diversified industrial companies Cost synergies Caterpillar Buys Joy Global The two companies sell complementary products to the same customer base. If CAT bought JOYG, it would be able to sell the JOYG products with its own products as a package (revenue synergies) through its existing dealer network (potential cost synergies). Additionally, while both companies have personnel at the customers' mine sites, there could be synergies from consolidating the service personnel. Deal risks include: Q Channel confusion as JOYG equipment is now sold through CAT dealers Q Brand confusion as JOYG equipment is rebranded as CAT Q Additional leverage on CAT balance sheet could lead to a ratings downgrade, which would be negative for CAT Financial Companies that can Grow Successfully via M&A Q Illinois Tool Works (ITW, Rated "Buy") has a 30-year track record of acquiring companies and improving their margins Q Parker Hannifin (PH, rated "Sell") has a history of growth via M&A. It now has a large number of targets available and a strong balance sheet to go after them. Q PACCAR (PCAR, rated "Sell") has a good long-term track record of buying businesses and expanding into new regions. CAT, JOYG: complementary products Buying Growth 8 December 2009 UBS 48 Diversified Industrials Jason Feldman Deal Valuation Metric: Q EV / EBITDA Q Price / sales Recent Deals: Q Danaher (DHR, rated "Buy") acquisition of AB Sciex/MDS for 1.6x sales Q Emerson Electric's (EMR, rated "Neutral") acquisition of Avocent for 1.8x sales Deal Drivers: Q Increase revenue growth Q Diversification across product lines Q Geographic expansion Possible Deals Most of the deals in this space are modest in size relative to the size of the buyer. Mergers are rare; usually a large company buys a much smaller firm. Therefore, it is difficult to pick potential targets with any accuracy. The only deals being seriously discussed are GE's potential acquisition of Areva's transmission and distribution business, and the potential GE joint venture with Comcast for NBC. Companies that Grow Via M&A More so than in many other industries, companies in this space have been able to grow successfully via deals. Some notable examples: Q Danaher excellent track record and very sophisticated M&A methodology Q Cooper Industries many opportunities for small / mid-size bolt-on acquisitions; their head of business development is extremely experienced. Q Emerson Electric (EMR, rated "Neutral") good track record, very good underlying business platforms to add to. Many small deals Buying Growth 8 December 2009 UBS 49 Airlines Kevin Crissey Deal Valuation Metric: Q EV / EBITDAR Recent Deals: Q Delta (DAL) bought Northwest in 2008 at 5.5x EBITDAR (Earnings before interest, taxes, depreciation, amortization, and rent) Deal Drivers: Q Geographical market expansion Q Eliminate competing capacity to gain pricing power on key routes Q Respond to M&A of key competitors Possible Deal Continental Airlines (CAL, rated "Buy") may acquire UAL Corp. (UAUA, rated "Buy"). A combined CAL/UAUA would be a competitive response to the aforementioned DAL/NWA deal and would provide a broader global network for CAL and UAUA to drive revenue as the carriers have little overlap in their current markets. (Where there is overlap, capacity can be reduced, thereby improving pricing power). CAL and UAUA both have strong transatlantic / European operations, so they could rationalize capacity on those routes. UAUA has a strong Pacific operation and CAL has a strong Latin American operation that would complement one another. From a cost perspective, hubs could be reduced. CAL could drawdown Cleveland given UAUA's operation in Chicago, and UAUA could reduce Dulles capacity given CAL's presence in Newark. Other cost savings may be found via the combination of reservation/call centers and other overhead, but given the amount of cost-cutting and restructuring in the airline industry in the past decade, most of those functions have already been streamlined. Improved pricing power would be a benefit to the entire industry, at least in the short-term, assuming there would be a rationalization of capacity in markets where CAL and UAUA compete currently. Specific to CAL and UAUA, a global network would be better able to serve all needs of the customer base, most importantly the profitable corporate customer. Downside risks: Integration risk would be the biggest hurdle over the long-term. Combining unionized labor groups is tremendously difficult, as is the integration of IT and reservation systems. Antitrust risk is always an issue. However, most airline deals in recent history have gained approval after relinquishing overlapping routes / slots / gates back to the marketplace. Create broader network; then cut overlap Buying Growth 8 December 2009 UBS 50 Industrial Services Jason Kupferberg Deal Metrics Q P/E Recent Deals Q Dell acquired PER for 30x CY2010E EPS Q Xerox acquired ACS for 13x CY 2010 EPS Deal Drivers Q Convergence of IT hardware and IT services companies Q Desire of customers for "one-stop shopping" Q High degree of fragmentation Possible Deals Target Plausible Buyers Rationale ICF International (ICFI) SAIC Inc. (SAI) SAI could increase penetration of non-defense (civilian) government agencies Genpact (G) Accenture (ACN), IBM Boost offshore business process outsourcing business; accretive for margins Hewitt (HEW) Accenture, IBM, ADP, private equity Acquire a leverageable technology platform and key domain expertise in HR services SAIC Inc. Acquires ICF International This deal would drive ample revenue synergies because it would further SAI's footprint among federal civilian agencies, who are expected to experience healthier budget trends than defense under the Obama Administration. ICFI would be backed by the powerful brand and sales force of SAI, creating an attractive combination for customers. Cost synergies would also likely be meaningful (mostly back-office overlap), but this would not be the strategic rationale for the deal. Downside risk could be near-term EPS dilution, as ICFI trades at a 40% P/E premium to SAI. Like any IT services M&A scenario, integration risk must be monitored closely because of the people-based nature of the business. Some ICFI employees could decide they don't want to be part of a larger and more bureaucratic organization, which could drive some employee turnover. SAIC increases exposure to non- defense agencies Buying Growth 8 December 2009 UBS 51 Companies That Can Grow Via Acquisition To a modest extent, companies in this industry can grow successfully via acquisition. This trend can probably continue, due to cost synergies resulting from M&A transactions. Companies that do this well are: Q SAIC Inc. (SAI) Good management team, strong track record, lots of potential targets Q Amdocs (DOX) Experienced at executing on M&A, need to expand beyond core telecom vertical Q CGI Group (GIB) disciplined acquirer, fragmented base of potential M&A targets Buying Growth 8 December 2009 UBS 52 Engineering & Construction Steven Fisher Deal Metrics: Q EV / EBITDA Recent Deals Q Quanta buys Price Gregory for 3.2x 2010E EBITDA. Deal was announced September 2009. Q Balfour Beatty acquired Parsons Brinckerhoff for undisclosed multiple Deal Drivers Q Entering new end markets or geographies Q Adding customer relationships / skill sets Q Efficient growth rather than hiring engineers one-by-one An interesting potential combination: URS (URS, rated "Neutral") with Foster Wheeler (FWLT, rated "Buy"); this deal could make some strategic sense for both companies. A June 12 Bloomberg article indicated that URS CEO Martin Koffel said he is "on the hunt for 'transformative acquisitions'." The article indicated that he "would like to pursue takeovers of North American companies that would provide engineering and technical services for oil and gas producers. The company also would consider takeovers to expand sales in northern Europe and Asia." Foster Wheeler would appear to fit the geographic and end market exposure which URS is seeking, and Foster Wheeler's Power business would seem to be better suited in a broader portfolio of power technologies, which URS has. Foster Wheeler's project based E&C business could also fit in well with URS's service agreement based business. It is possible that URS could try to accelerate debt reduction before pursuing a deal as large as Foster Wheeler, or it could pursue a smaller acquisition with similar characteristics. Companies that Grow Effectively via M&A Q Aecom Technology (ACM, rated "Buy") Q URS (URS, rated "Neutral") Q Jacobs Engineering (JEC, rated "Neutral") A good fit Buying Growth 8 December 2009 UBS 53 Energy: Exploration & Production, Integrated Energy William Featherston Deal Valuation Metrics Q For E&P, there are two: price-to-NAV (essentially a discounted cash flow analysis of proved and probable reserve base) Enterprise Value / EBITDX or Earnings Before Interest, Taxes, Depreciation and Exploration Expense Q For Integrateds, there are also two: PE ratio, EV/DACF or Enterprise Value / Debt Adjusted Cash Flow Recent Deals Q Apparent competitive bidding by XOM, BP and CNOOC for privately held Kosmos Energy's deepwater West Africa assets no finalized deal yet Q Chesapeake Energy's divestiture of working interests in its U.S. natural gas plays to reduce its financial leverage. Buyers were PXP, BP, and Statoil. Q Chinese are aggressive buyers of upstream oil and gas properties in non- OECD regions Deal Drivers: Q Buyers want access to resources; sellers want liquidity Q Geographical expansion Q Cost synergies (for the Majors only) Possible Deals: Q Anadarko Petroleum (APC, rated "Buy") is acquired by a Major Integrated Oil Company or a Chinese company. APC is a willing seller and has great assets. APC's CEO has been a willing seller several times in the past. He has built the E&P company with the best exploration portfolio in three major deepwater basins: Gulf of Mexico, West Africa, and Brazil. The Majors are unable to grow and are desperate for resources. We think either a Major or a Chinese national oil company will ultimately bid for APC in order to improve its resource base, and create value by accelerating development faster than the smaller independent APC would be able to accomplish. Q Chesapeake Energy Co. (CHK, rated "Neutral") may sell its Barnett Shale acreage to one of the European Majors, which need access to resources. CHK needs to improve its liquidity. Q Conoco Phillips (COP, rated "Neutral") could sell assets to an Independent. Downside Risks of Deals: Q Dilutive to EPS and ROCE, which is important for the Majors but not the Chinese. APC has great assets Buying Growth 8 December 2009 UBS 54 Q Buyer of APC would lose the intellectual capital of management and the upper echelons of its geotechnical staff. Q International buyers would have little interest in the majority of APC's onshore U.S. portfolio. Buying Growth 8 December 2009 UBS 55 Coal Shneur Gershuni Deal Valuation Metrics: Q EV / EBITDA Recent Deals Q Arch Coal (ACI, rated "Neutral") acquired Jacobs Ranch Assets was listed at 4.9x EBITDA at time (March 2009) Q Alpha Natural Resources (ANR) acquired Foundation Coal in an equity deal at a 21% premium to our DCF implied price target Deal Drivers Q Industry is very fragmented, especially in the East Q Fixed cost absorption spread the fixed costs over more production Q Capital and liquidity companies with cash generation could fund high IRR capital projects Possible Deals Q TECO's coal assets could be purchased by Alpha Natural or Massey which have ample cash and interest. TECO Coal is a medium sized company within a utility. It needs a larger production base to be able to weather the ups and downs of commodity pricing. Depending on the acquirer, there could be some optimization on the revenue, logistics, and possibly from a prep plant perspective. Q International Coal (ICO), Alpha Natural Resources (ANR) or Massey (MEE) or James River (JRCC) could buy coal reserves or micro-producers (mom and pop) in CAPP (Central Appalachia). Q Walter Energy (WLT) owns reserves, mainly in southern Appalachia (Alabama), of high-quality low-volatility metallurgical coal for making steel. WLT might be bought by foreign or U.S. steel companies that want backward integration to a supply of metallurgical coal, so that its margins would not be squeezed by spikes in coal prices. . Downside Risk of Deals Coal deals can look anti dilutive at times, depending on contracted tonnage for the upcoming year. (We expect coal prices to rise materially in 2011, but pricing should be challenging in 2010.) There could be some risk of losing employees if labour market is strong; however, many workers would prefer the acquirer given the stability of a larger company. Most miners will continue to work at existing mines. Employees in logistics, sales and other corporate positions might be a higher risk of flight. Companies that Can Grow Successfully via Deals Q ANR has a good track record on smaller deals; it is very focused on return on invested capital. If it purchased met coal ANR could achieve some revenue synergies as they are good at blending and upgrading lower-quality coal to meet customers' specifications. Consolidating a fragmented industry WLT: high-grade met coal Buying Growth 8 December 2009 UBS 56 Small / Mid-cap Exploration & Production Andrew Coleman Deal Valuation Metrics: Q Net Asset Value Q Enterprise Value / EBITDA Q Dollars per flowing thousand cubic feet of gas per day or per flowing barrels of oil per day Recent Deal: Q Denbury Resources and Encore Acquisition Company agreed to merge, creating an $8 billion market cap company on November 1, 2009. The deal values EAC at $4.5 billion, or 8.6x 12-month forward EBITDA. Deal Drivers: Q eliminating spare production capacity, Q cost synergies, Q way to find / generate production growth / new inventory Q Reduce financial leverage Possible Deals Balance sheets are in better shape after E&Ps raised equity and termed out debt in 2Q09 and 3Q09. With a steeper contango in the gas forward curve presently, M&A activity seems unlikely in the near term because of the disconnect between buyers and sellers. In the Small and Mid-Cap space, all companies can be acquisition targets, but the ones with the best assets (or more well defined exposure) look more interesting, such as: Petrohawk (HK), Cabot Oil & Gas (COG), and Concho Resources (CXO). So far, HK, Denbury Resources (DNR), and Forest Oil (FST) have identified $500+ million of assets each company would like to divest, while CXO, Arena Resources (ARD), and Unit Corporation (UNT) continue to look for bolt-on acquisitions. Firms with good assets Buying Growth 8 December 2009 UBS 57 Small / Midcap Energy Service Andrew Coleman Deal Valuation Metrics: Q Enterprise Value / EBITDA Recent Deal: Q Baker Hughes acquired BJ Services at 15x EPS and 11x EBITDA Deal Drivers: Q reduce industry capacity, Q gain spare parts for old rig fleets, Q cost synergies, Q economies of scale. Possible Deals Depending on natural gas prices, either the land drillers or well servicing names could see consolidation in the next year. There are only four public players in the well servicing space with a 60% market share, while private companies have 40%. Similarly, in land drilling seven public companies have a 60% market share. Historically, Patterson-UTI Energy (PTEN) was a consolidator in land drilling and Key Energy Services (KEG) was a consolidator in well servicing. Potential targets include the smaller players in each sub-sector --Basic Energy Svcs (BAS), Complete Production (CPX), Pioneer Drilling (PDC), and possibly Bronco Drilling (BRNC). Buying Growth 8 December 2009 UBS 58 Paper Gail Glazerman Deal Valuation Metrics: Q Enterprise Value per ton Q EV / EBITDA Recent deals: Q International Paper's acquisition of Weyerhaeuser's container-board / box business. Estimated prices was $665 per ton Q Merger of Abitibi and Bowater (merger of equals so hard to value) Deal Drivers Q Financial stress. At least two major companies filed for bankruptcy protection, could be acquired. (This has not happenedyet.) Q Portfolio consolidation/focus. Major companies have been honing their business focus by selling non-core assets (or buying core assets). As a result companies have bigger market shares. Q As housing market turns, there could be a particular focus on acquiring distressed building products companies, or their assets. Q Small bolt on deals Possible Deal Given the need to continue to fix balance sheets and still weak equity values, we do not anticipate much M&A activity near-term. Grant Forest Products / Georgia-Pacific Grant filed for bankruptcy with assets reportedly up for sale. GP has shown an interest/willingness to grow in the structural panel markets. Given high exposure to housing markets, these markets are extremely stressed. Buying Growth 8 December 2009 UBS 59 Q Analyst Certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. Buying Growth 8 December 2009 UBS 60 Required Disclosures This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Investment Research: Global Equity Rating Allocations UBS 12-Month Rating Rating Category Coverage1 IB Services2 Buy Buy 44% 39% Neutral Hold/Neutral 40% 35% Sell Sell 15% 27% UBS Short-Term Rating Rating Category Coverage3 IB Services4 Buy Buy less than 1% 33% Sell Sell less than 1% 0% 1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 September 2009. UBS Investment Research: Global Equity Rating Definitions UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA. UBS Short-Term Rating Definition Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event. Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event. Buying Growth 8 December 2009 UBS 61 KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained in the NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Securities LLC: Thomas M. Doerflinger, Ph.D.; Natalie Garner. Buying Growth 8 December 2009 UBS 62 Company Disclosures Company Name Reuters 12-mo rating Short-term rating Price Price date AECOM Technology Corp.1, 5, 16b ACM.N Buy N/A US$24.63 07 Dec 2009 Aetna Inc.4, 6a, 6b, 6c, 7, 16b, 22 AET.N Buy N/A US$29.89 07 Dec 2009 Allergan16b AGN.N Buy N/A US$59.40 07 Dec 2009 Anadarko Petroleum Corp.2, 4, 6a, 6b, 6c, 7, 16b, 22 APC.N Buy N/A US$58.27 07 Dec 2009 Anheuser-Busch InBev6b, 6c, 7, 16b ABI.BR Buy N/A 35.38 07 Dec 2009 Applied Materials Inc.16b AMAT.O Buy N/A US$13.25 07 Dec 2009 Arch Coal, Inc.16b ACI.N Neutral N/A US$19.99 07 Dec 2009 Bank of New York Mellon Corp.2, 4, 6a, 6b, 6c, 7, 16b BK.N Neutral N/A US$26.81 07 Dec 2009 Biogen Idec Inc.4, 6c, 7, 16b BIIB.O Neutral N/A US$48.30 07 Dec 2009 Black & Decker Corp.16b, 22 BDK.N Neutral N/A US$61.57 07 Dec 2009 BorgWarner Inc.16b BWA.N Neutral N/A US$31.00 07 Dec 2009 Brinker International16b EAT.N Buy N/A US$13.84 07 Dec 2009 Brocade Communications Systems Inc.5, 6b, 7, 16b BRCD.O Buy N/A US$7.29 07 Dec 2009 Carnival Corp.4, 5, 6b, 6c, 7, 14, 16b CCL.N Buy N/A US$32.41 07 Dec 2009 Chesapeake Energy Corp.2, 4, 5, 6a, 16b CHK.N Neutral N/A US$22.80 07 Dec 2009 Christopher & Banks Corp16b CBK.N Sell N/A US$6.21 07 Dec 2009 Church & Dwight16b CHD.N Buy N/A US$60.35 07 Dec 2009 Coca-Cola Co.2, 4, 6a, 6b, 6c, 7, 16b KO.N Neutral N/A US$57.87 07 Dec 2009 ConocoPhillips2, 4, 6a, 6b, 6c, 7, 16b, 22 COP.N Neutral N/A US$50.82 07 Dec 2009 Continental Airlines1, 4, 5, 6a, 6b, 7, 16b, 20 CAL.N Buy (CBE) N/A US$15.90 07 Dec 2009 Danaher Corporation4, 5, 16b DHR.N Buy N/A US$72.42 07 Dec 2009 Darden Restaurants Inc.16b, 22 DRI.N Neutral N/A US$32.15 07 Dec 2009 DIRECTV Group Inc.2, 4, 5, 6a, 16b DTV.O Buy N/A US$32.68 07 Dec 2009 DreamWorks Animation SKG, Inc.16b DWA.O Neutral N/A US$38.05 07 Dec 2009 Emerson Electric Co.4, 6c, 16b, 18a EMR.N Neutral N/A US$41.99 07 Dec 2009 Extra Space Storage Inc.5, 16b EXR.N Neutral N/A US$11.32 07 Dec 2009 F5 Networks, Inc.16b, 20 FFIV.O Neutral (CBE) N/A US$51.72 07 Dec 2009 Federated Investors4, 5, 6a, 6b, 6c, 7, 16b FII.N Not Rated N/A US$25.01 07 Dec 2009 Foster Wheeler Ltd.16b, 18j FWLT.O Buy N/A US$28.97 07 Dec 2009 Gap Inc.16b GPS.N Neutral N/A US$21.64 07 Dec 2009 General Mills Inc.6b, 6c, 7, 16b, 22 GIS.N Buy N/A US$69.00 07 Dec 2009 GlaxoSmithKline4, 5, 14, 16b, 18b GSK.L Buy N/A 1,304p 07 Dec 2009 GSI Commerce Inc1, 2, 4, 5, 6a, 16b GSIC.O Buy N/A US$24.54 07 Dec 2009 H.J. Heinz Company2, 4, 5, 6a, 6b, 6c, 7, 16b, 22 HNZ.N Neutral N/A US$43.34 07 Dec 2009 Hain Celestial Group5, 16b HAIN.O Neutral N/A US$16.57 07 Dec 2009 Health Net Inc.16b HNT.N Neutral N/A US$21.97 07 Dec 2009 Hewitt Associates, Inc16b HEW.N Buy N/A US$43.52 07 Dec 2009 Human Genome Sciences, Inc.2, 4, 5, 16b, 20 HGSI.O Buy (CBE) N/A US$27.52 07 Dec 2009 ICF International16b ICFI.O Neutral N/A US$24.49 07 Dec 2009 Illinois Tool Works2, 4, 6a, 16b ITW.N Buy N/A US$48.55 07 Dec 2009 Imperial Tobacco8, 13, 16b, 22 IMT.L Neutral N/A 1,890p 07 Dec 2009 Jacobs Engineering Group, Inc.4, 6a, 16b JEC.N Neutral N/A US$34.90 07 Dec 2009 Johnson & Johnson16b, 18c, 22 JNJ.N Buy N/A US$64.37 07 Dec 2009 Johnson Controls Inc.16b JCI.N Buy N/A US$26.80 07 Dec 2009 Joy Global Inc.4, 5, 6a, 16b, 20 JOYG.O Neutral (CBE) N/A US$52.81 07 Dec 2009 KB Home16b, 20, 22 KBH.N Neutral (CBE) N/A US$13.19 07 Dec 2009 Buying Growth 8 December 2009 UBS 63 Company Name Reuters 12-mo rating Short-term rating Price Price date Lennar16b, 20, 22 LEN.N Neutral (CBE) N/A US$11.99 07 Dec 2009 Li & Fung16a 0494.HK Buy N/A HK$32.85 07 Dec 2009 Life Technologies Corp.6b, 7, 16b LIFE.O Buy N/A US$50.62 07 Dec 2009 Lorillard16b LO.N Buy N/A US$79.05 07 Dec 2009 Luminex Corp.4, 6a, 16b LMNX.O Neutral N/A US$14.65 07 Dec 2009 MetLife2, 4, 5, 6a, 6b, 6c, 7, 13, 16b MET.N Buy N/A US$35.68 07 Dec 2009 Metro PCS Communications, Inc16b PCS.N Buy N/A US$7.00 07 Dec 2009 Nestl2, 4, 5, 15, 16b, 22 NESN.VX Buy N/A CHF49.84 07 Dec 2009 OSI Pharmaceuticals Inc.13, 16b OSIP.O Buy N/A US$34.90 07 Dec 2009 PACCAR Inc6b, 6c, 7, 16b PCAR.O Sell N/A US$35.97 07 Dec 2009 Parker Hannifin Corp.16b PH.N Sell N/A US$55.53 07 Dec 2009 PepsiCo Inc.2, 4, 5, 6a, 6b, 6c, 7, 16b, 18d PEP.N Buy N/A US$64.23 07 Dec 2009 Phoenix Companies, Inc.13, 16b PNX.N Buy N/A US$2.84 07 Dec 2009 Precision Castparts Corp.6b, 7, 16b PCP.N Neutral N/A US$111.30 07 Dec 2009 Procter & Gamble2, 4, 6a, 6b, 6c, 7, 8, 16b, 18e PG.N Buy N/A US$62.47 07 Dec 2009 Protalix Biotherapeutics, Inc.16b, 20 PLX.A Buy (CBE) N/A US$8.20 07 Dec 2009 Prudential Financial Inc.2, 4, 5, 6a, 6b, 6c, 7, 16b PRU.N Buy N/A US$47.49 07 Dec 2009 Public Storage, Inc.16b PSA.N Buy N/A US$78.07 07 Dec 2009 Qwest Communications2, 4, 5, 6a, 6c, 7, 16b Q.N Neutral N/A US$4.11 07 Dec 2009 Reynolds American16b RAI.N Neutral N/A US$53.94 07 Dec 2009 Riverbed Technology16b, 20 RVBD.O Neutral (CBE) N/A US$20.29 07 Dec 2009 Roche2, 4, 5, 15, 16b ROG.VX Buy N/A CHF168.70 07 Dec 2009 Rubicon Technology Inc.4, 6a, 6b, 7, 16b RBCN.O Buy N/A US$19.21 07 Dec 2009 Ryland Group16b, 20, 22 RYL.N Neutral (CBE) N/A US$18.30 07 Dec 2009 Scripps Networks Interactive Inc16b SNI.N Neutral N/A US$39.66 07 Dec 2009 Starwood Hotels & Resorts Worldwide, Inc16b, 22 HOT.N Neutral N/A US$33.22 07 Dec 2009 State Street2, 4, 6a, 6b, 7, 16b, 18f STT.N Neutral N/A US$40.84 07 Dec 2009 Teva Pharmaceuticals16b TEVA.O Buy N/A US$53.38 07 Dec 2009 Thermo Fisher Scientific Inc.16b, 18g TMO.N Buy N/A US$48.63 07 Dec 2009 Toll Brothers16b, 20, 22 TOL.N Buy (CBE) N/A US$17.65 07 Dec 2009 TransDigm Group Inc.2, 4, 5, 6a, 16b TDG.N Buy N/A US$46.31 07 Dec 2009 UAL Corp.2, 4, 5, 6a, 13, 16b, 20 UAUA.O Buy (CBE) N/A US$9.83 07 Dec 2009 Unilever NV2, 4, 5, 6a, 12, 15, 16b, 18i UNc.AS Neutral N/A 21.53 07 Dec 2009 Unilever Plc2, 4, 5, 12, 14, 16b ULVR.L Neutral N/A 1,864p 07 Dec 2009 United Rentals, Inc4, 16b, 19 URI.N Buy (CBE) N/A US$9.97 07 Dec 2009 United Technologies Corp.4, 5, 6a, 8, 16b, 18h UTX.N Buy N/A US$68.86 07 Dec 2009 URS Corporation16b URS.N Neutral N/A US$42.05 07 Dec 2009 ValueClick, Inc.5, 16b VCLK.O Neutral N/A US$10.03 07 Dec 2009 Vertex Pharmaceuticals Inc.16b, 20 VRTX.O Buy (CBE) N/A US$39.19 07 Dec 2009 Walter Energy Inc16b WLT.N Neutral N/A US$68.53 07 Dec 2009 Wendy's-Arby's Group Inc.16b WEN.N Neutral N/A US$4.13 07 Dec 2009 Yum! Brands Inc.16b, 22 YUM.N Neutral N/A US$34.10 07 Dec 2009 Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 1. UBS Securities LLC is acting as manager/co-manager, underwriter, placement or sales agent in regard to an offering of securities of this company/entity or one of its affiliates. Buying Growth 8 December 2009 UBS 64 2. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months. 4. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity. 5. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months. 6a. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided. 6b. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided. 6c. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. 7. Within the past 12 months, UBS Securities LLC has received compensation for products and services other than investment banking services from this company/entity. 8. The equity analyst covering this company, a member of his or her team, or one of their household members has a long common stock position in this company. 12. Directors or employees of UBS AG, its affiliates or subsidiaries are directors of this company. 13. UBS AG, its affiliates or subsidiaries beneficially owned 1% or more of a class of this company`s common equity securities as of last month`s end (or the prior month`s end if this report is dated less than 10 days after the most recent month`s end). 14. UBS Limited acts as broker to this company. 15. UBS AG, its affiliates or subsidiaries has issued a warrant the value of which is based on one or more of the financial instruments of this company. 16a. UBS Securities (Hong Kong) Limited is a market maker in the HK-listed securities of this company. 16b. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 18a. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Emerson Electric Co. 18b. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in GlaxoSmithKline. 18c. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Johnson & Johnson. 18d. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in PepsiCo Inc. 18e. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Procter & Gamble Co. 18f. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in State Street. 18g. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Thermo Electron Corp. 18h. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in United Technologies Corp. 18i. UBS Limited acts as broker to this company or one of its affilliates 18j. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 19. Because this company is an announced takeout candidate, UBS believes the security presents lower-than-normal risk. We have widened its rating band to +6%/-10% compared with +6%/-6%, respectively, under the normal rating system. 20. Because UBS believes this security presents significantly higher-than-normal risk, its rating is deemed Buy if the FSR exceeds the MRA by 10% (compared with 6% under the normal rating system). 22. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month`s end (or the prior month`s end if this report is dated less than 10 working days after the most recent month`s end). Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. Buying Growth 8 December 2009 UBS 65 For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Publishing Administration. Buying Growth 8 December 2009 UBS 66 Global Disclaimer This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. In certain countries, UBS AG is referred to as UBS SA. This report is for distribution only under such circumstances as may be permitted by applicable law. Nothing in this report constitutes a representation that any investment strategy or recommendation contained herein is suitable or appropriate to a recipient's individual circumstances or otherwise constitutes a personal recommendation. 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