Bargain basement prices tempt bidders back to market

Private equity and corporate bids abound. With prices so low, there are more to come

The UK stock market is cheap. This became the consensus view after the FTSE 100's lurch downwards in the first half of last month, and the strength of the rebound since suggests that market players really have some confidence this time. One of the things making them feel so sure is the wave of corporate activity sweeping the market.

For the past couple of months it has seemed almost every day brings news of a bid received, agreed or spurned. Just this week there have been details of takeover approaches for Somerfield, the supermarket chain, Chubb, the security group, AWG, the water utility, and Amey, the rail maintenance group. Enough already?

Few people think this wave of bids will ebb, particularly since this initial flurry would have been months in the planning. "They are not thought up over breakfast and delivered by lunchtime," Rolf Elgeti, head of European equity strategy at Commerzbank, says.

"The implication is that the opportunistic value investor and financial buyers believe the companies are cheap. We believe that with the Iraq war looking to be decided and with most of the forced selling being done as far as European insurance companies and pension funds are concerned, equities can't get derated any further. We think we have reached a floor and the corporate activity reflects that."

It was the rise in the dividend yield from UK shares that clinched the argument for many of the new anti-bears (few are predicting a bull market just yet, just an end to the sickening three-year slide). The historic yield on the FTSE 100 topped 4 per cent and still stands at 3.6 per cent. That's an impressive amount of real money in punters' pockets, taking into account the likelihood that dividends will rise over time, when compared with the returns from bonds and cash on deposit.

While stock market investors have until recently been reluctant to call the bottom, companies themselves have been taking advantage of the market's weakness to pick up their own shares on what they see as cheap terms. Share buybacks – which have the happy effect of supporting demand for the shares as well as boosting earnings per share – have been increasingly popular and some estimates suggest UK companies will spend some £10bn on them this year.

Mergers and acquisitions – such as the William Morrison offer for Safeway and Amey's sale to Ferrovial of Spain – suggest that companies see value in their rivals' shares as well as their own. But activity may be constrained by institutional shareholders' scepticism that big deals in fact create the value that is claimed for them.

Certainly the bulk of activity this year, the Safeway saga notwithstanding, has involved private equity, the financial buyers famed for their toothcombing of company balance sheets and cash flow statements. Both halves of Six Continents, the leisure conglomerate now split into the Mitchells & Butlers pubs group and InterContinental Hotels, are being eyed up by private equity houses, and a number of mid-cap companies have already attracted formal bids. Most recently, offers for Somerfield, AWG, Selfridges and Waste Recycling have been made with venture capital backing.

Private equity funds have achieved a greater degree of acceptance as a legitimate investment for institutional money and have continued to attract cash throughout the bear market in equities. The European Venture Capital Association says its members received a net inflow of €15bn (£10bn) in 2002 and funds are hugely underinvested. This wall of money has to go somewhere, and an estimated £10bn could find its way to buyouts of UK public companies.

With insurance companies and pension funds hamstrung by regulatory changes that have forced them to scale down their exposure to equities, and with companies themselves still faced with a sceptical shareholder base, the most aggressive buyers of UK equities in the coming year could be venture capitalists on an acquisition spree.

This is a thesis being argued at the moment by Graham Secker, strategist at Morgan Stanley, whose latest research note is entitled Looking for Private Equity Opportunities. In an effort to find companies that venture capitalists might find attractive, he has analysed the UK market for strength of cash flows, debt levels and asset backing for valuations. He has even come up with a "hit parade" ranked on these measures.

Top of the pops is De La Rue, the banknote maker whose shares have plunged after a string of profits warnings, but whose cash flows remain robust. Associated British Foods, with its £835m cash mountain, is the runner-up. Dixons, the electrical goods retailer whose shares are being punished for poor Christmas trading, Debenhams, the department store chain, and RMC, the cement maker, are also Top 10 candidates.

Mr Secker admits that a number of the companies thrown up by his analysis would be out of reach of private equity – Shell for instance is simply way too big – and that venture capitalists have traditionally preferred to fish in limited ponds, such as the retail, leisure and manufacturing sectors. Happily, these sectors are well represented, with Big Food Group, the owner of Iceland, Signet, the jewellers, and the engineers IMI, FKI and Bodycote all ranked high up.

The list, compiled a week ago, already looks prescient. Somerfield, at number 12, has received an approach from John Lovering and Bob Mackenzie, with backers believed to include HBOS – the same bank that has been funding Philip Green's retail empire building.

Because stock market investors have been demanding high dividends and rewarded companies with strong cash flows, free cash flow as a percentage of company valuations is at a 15-year high. This is appealing to venture capitalists, who concentrate their efforts on wringing cash from the business to pay back the purchase costs as quickly as possible. But Mr Secker cautions conditions are not as favourable for private equity on his other measures.

"Taken together, the four measures suggest to us that valuations for the wider market do not look that compelling to private equity investors. It is at the stock level, however, that some real value emerges," he says.

"The estimate of £10bn currently available for investment in 'public to private' deals in the UK is equivalent to 1 per cent of market capitalisation and as such is unlikely to influence wider market direction. However, as we have seen recently, individual bid approaches are very effective at highlighting perceived undervaluation of specific stocks and, consequently, also proved opportunities for other investors to make money."