Opinion: Mark Wilson

Today (June 2), the Department of Health posted a report on their website which had been commissioned by the previous government and requested through the Freedom of Information act (the report can be found here - (www.dh.gov.uk/en/MediaCentre/Statements/DH_116522).

Drafted by the management consultants McKinsey it provides a blueprint for achieving up to £20 billion in recurring savings in the NHS (England) by 2013/14 budget year.

It passes the weight test! At 124 pages it provides a very thorough review of the different areas of spending within the NHS, from optimising spend within care pathways such as decommissioning non-effective interventions to shifting care into more cost effective settings such as from acute to primary care. The DoH press department wouldn’t be drawn on whether this would form any part of the Coalition government’s austerity strategy, however we suspect that a lot of these measures will be ultimately implemented or at least be part of an overall direction of travel.

Some points are clear:

• more acute care will be delivered by primary care providers
• substantial productivity increases will be sought from primary care providers
• increases in self care measures will be achieved through providing elderly care in the home
• reduced variability in prescribing practices will be sought
• pressure on drugs costs will continue relentlessly

We will be publishing a report on the Healthcare Services sector in June which looks more deeply at the implications for healthcare service providers and the resulting impact on M&A.

Our research shows that the combined revenues of the top 20 waste management firms has grown by around 5% in the last twelve months, which although not stellar demonstrates a solid performance in difficult times. It is not a huge surprise therefore to see that Biffa, whose revenues dropped an estimated 13% in the same period, has finally replaced its chief executive after less than two years in the job.

The departing Andre Horbach has apparently overseen the company’s transformation from “a traditional rubbish collector into an environmental services company focused on recycling and energy from waste”, however the reality has seen them drop from top dog to third place behind Veolia and SITA – surely not why their private equity fund backer (Montagu Private Equity) bought them.

Reports that his departure was amicable are a little disingenuous given that a director of Montagu has stepped in as interim CEO. This would tend to suggest that there has been a wide divergence in the agreed strategy at the time of the buy-out and the subsequent execution. Their performance over two years has been awful - market share has dropped from 19% to 14% and from what we can make out of publicly available information, profits have plummeted as well. They are still heavily indebted and cash management will no doubt remain a top priority.

The outlook for Montagu’s investment is therefore uncertain. As we have seen from the decision by Irish firm NTR plc to take Greenstar off the market after appointing Morgan Stanley to manage its disposal and Carlyle’s effective withdrawal from the Shanks bid, there will probably not be an easy exit in the short term.

The pipeline of unfunded energy from waste (EfW) projects in the sub £100 million capital value range is mounting rapidly in the UK.

These projects are being developed by a range of interested parties from EfW technology companies (such as specialists in anaerobic digestion or gasification), land developers, EPC contractors, smaller energy companies, waste management specialists, food processors and a host of other parties.

It is fascinating to see how different parties are approaching these projects to unlock them, especially in light of much lower current availability of affordable debt funding.

In the case of technology companies, whose interest is principally in selling the technology solution rather than participating in the project vehicle (SPV), often the initial development costs (design, planning, securing supply and offtake agreements, project financing, etc) are being absorbed by the company until the SPV receives funding, at which point they get paid.

These development costs can add up quickly and the success of these businesses depends on the strength of their balance sheets. This is especially important given the protracted development timelines and the need for these companies to work on multi projects simultaneously. Too many of these businesses have insufficient balance sheet strength, a problem which becomes more acute when project guarantees are required as part of an overall EPC contract when the project kicks-off.

Establishing the right capital structure in the business is the cornerstone to being successful in this market. It is clear that the companies that have addressed this early are reaping the benefits.

It cannot have escaped the notice of US corporate development executives that the British companies they bought in August last year would today be 10% cheaper (assuming basic deal terms remained the same) thanks to the steady weakening of sterling over the period (whilst Japanese firms, who have been relatively absent from UK cross-border deals of late, would be 17% cheaper today!)

Exchange rates often rank quite low on the decision criteria used by M&A departments to assess overseas acquisitions, however this is changing, and we have seen a marked increase in interest from both American and Japanese firms looking to buy in the UK.

How long this window will last is difficult to say given the difficulty in forecasting currency movements, especially given the current political uncertainty. There are good reasons though to suspect that sterling will remain weak against the major currencies for at least the next six months. The economy, whilst improving, is doing so only very slowly and the expectations of further quantitative easing from the Bank of England are both likely to hurt the pound.

With no strengthening expected in the short term, we would expect to see a significant increase in inbound M&A across the British economy by overseas firms during 2010.

A couple of months ago we published a review of M&A activity in the UK's engineering sector. One of our starkest conclusions was that, in spite of the rise of China and India, US corporates remain the single most important source of inward investment for companies in the UK engineering sector, a tradition that dates back 60 years or more.

Over the last month we have seen some great examples of US investment in other sectors: in Food & Drink Kraft has finally persuaded Cadburys shareholders to sell, in healthcare one of the world's largest companies UnitedHealth Group Inc acquired Scriptswitch and today in chemicals, it was announced that RPM, an Ohio based business that Catalyst knows well, acquired Universal Sealants, a traditional British family business.

Clearly US corporate appetite for deals has not been diminished by last year's chaos. This is good news for UK shareholders thinking of selling to a US buyer as they are also generally good payers, as deeper analysis of these deals shows, and seasoned transactors.

A couple of weeks ago Adrian Ewer, CEO of John Laing suggested that PFI credits for waste contracts would soon be a thing of the past, especially if the conservative party wins the general election next May. This could have important ramifications for M&A in the sector.

The major waste players have made PFI an important part of their strategies to date, often spending millions on bids to secure the 20 year plus municipal contracts. The resources required for PFI have to some extent been diverted away from M&A during this period. However, with a less active PFI market expected in the future, these resources will become more available for alternative uses and M&A is clearly an attractive alternative to secure growth. At the recent Waste Seminar held by Catalyst and Pinsent Masons and attended by WRG, Cory and Veolia amongst others, we heard that M&A was still very much on the agenda – for a host of additional reasons.

There was consensus amongst the delegates that the industry will disaggregate over the next few years, meaning that the transport and logistics operations will ultimately split from disposal (landfill, resource and energy recovery) activities, a process helped through M&A. There was also an expectation that more foreign players will buy-in to the UK market in order to participate in the reconfiguration of the UK’s waste infrastructure – likely to last at least 10 years. There was also a recognition that a large number of innovative, fast growing independent businesses are emerging, which are either offering highly customer-centric services or creating alternatives to landfill, and are now being ‘tracked’ by the majors.

The message from the majors to those in the audience thinking of selling their businesses in the next couple of years was clear:

• be precise about the short-term ‘return’ for the buyer
• demonstrate that your business is not a ‘one trick pony’, overly exposed to market volatility
• use your gate fee pricing history to demonstrate your strong customer relationships
• prove you can manage recyclate price volatility through your track record
• adopt proven recycling and energy recovery technologies – no one wants technology risk
• don’t expect an unrealistic valuation for your business!

It is not just the UK that is seeing tentative signs of recovery in the M&A market. Three of our international Mergers Alliance partners announced deal completions on the same day in September.

First, our French partners Marceau Finance advised TFN, a leading facility management business with sales of Eur 508 million on the acquisition of VPNM, a subsidiary of Veolia Environement with sales of Eur 341 million. This is both one of France's largest deals of 2009 and the largest in the European FM market in general.

Next our American colleagues Brocair, based in New York, announced the sale of 'The Center for Wound Healing and Hyperbaric Medicine' to a consortium of private equity investors led by Candescent Partners. The Center develops and operates wound care centers and hyperbaric oxygen therapy (HBOT) facilities within hospitals. The business was started in 2005 and facilities were rolled out on the east coast as well as in select Midwest states.

Finally, CH Reynolds Corporate Finance based in Frankfurt advised Brückner Technology Holding on the sale of Kiefel Extrusion, a firm specialising in blown film extrusion and part of the larger Kiefel Group which had sales of c. Eur 120 million in 2008. The buyer was Reifenhäuser GmbH & Co based in Troisdorf. CH Reynolds originally advised Brückner in its acquisition of the Kiefel Group in 2007.

Today housebuilder Persimmon announced its results. Whilst profits were down on the same period in 2008 (no surprise there!) there was much that was positive in their announcement.

If they are a reasonable barometer for the sector, then we can expect to see a significant ramp up in cash generation across the industry for three reasons:

1) the sector has largely destocked and this will help resiliance in sales rates (and pricing) as demand is much more balanced to supply

2) operational restructuring is mostly complete and the benefits are now beginning to flow through to the bottom line

3) financing costs are dropping as free cash has been used to pay down debt levels and interest payments are lower (Persimmon's interest payments of £24.7 million for the six months to June 2009 are 30% lower than the same time last year)

The markets have by and large reacted positively to the news with little movement on the share price today and none of the 50% share price gain since June has been lost. Valuations in the sector finally seem to be on the rise.

This should be positive news for all housebuilders, large and small, public and private!

We have consistently maintained the view that the levels of funding growth received by the NHS in recent years has been unsustainable. The only way to ensure delivery of services with the desire clinical outputs with reduced funding will be to involve the private sector.

According to research from the King's Fund health think tank, NHS funding could be cut be as much 2% each year from 2011 onwards. This funding short fall could mean a gap between UK population's healthcare needs and delivery of up to 31%, according to the report.

Some argue that productivity improvements will help meet this gap, however over the past decade it appears that productivity has actually been falling.

We are already seeing success for private sector services in both the social care, secondary care. However provision of primary care (PC) by the private sector is a lamentable 2% of all spend (some £30 billion). This contrasts markedly with the elderly and physical disability (PD) sector where private sector provision is closer to 70%.

Much greater opportunity in PC for the private sector will emerge in the short term as the NHS is forced to seek better value for money and increased productivity. Some interesting businesses have emerged in the last few years which are challenging conventional GP surgery model and more private companies are competing for APMS contracts to run PC operations.

This is attracting considerable interest from both private equity and M&A from the listed trade players.

After a year in consultation, the Governement has finally published the 'UK Renewable Energy Strategy'.

During this year we have witnessed extreme energy cost volatility due to the sharp movements in oil and gas prices and also seen the Government successfully drive two important Bills through Parliament; the Energy Act 2008 and the Climate Change Act 2008.

This new strategy sets out how renewable energy will be promoted to individuals, communities and businesses in order to achieve the various 2020 targets enacted in those Bills.

In presenting the report, Ed Milliband, energy secretary made the difficult point that “there will be no low-cost, high-carbon energy option for the future”. Analysts estimate that industrial bills could rise by 17% and domestic bills by 8%. This bold statement paves the way, in our opinion, for a much more realistic perspective on the economics of renewable energy investment and should be helpful for both project developers and investors.

What is absolutely clear is that to achieve the targets set out in the report, huge investment will be made in the sector. The Government estimates in their report £100 billion of investment opportunities will be generated and will create half a billion more jobs in the renewable energy sector.

Our Clean Technology report published in May indicates that over £84 billion will be needed to establish an onshore and offshore wind infrastructure. Our expectation is that investment across the sector will exceed the Government's forecasts by some way.

We also outlined where we expected most investment to be channeled over the next decade and the Government's report does not change our views. As the Government points out there are now a range of incentives which they have put (or are putting) in place which will influence how investors select their investments.

Amongst the most important actions coming from the report with regards to financial incentives are:

1) Expansion and extension of the long-term incentive for major renewable electricity developments through the Renewables Obligation

2) Introduction of ‘clean energy cash-back’ for use of renewable heat and small-scale clean electricity generation from new guaranteed payments through Feed-In Tariffs from 2010 and a Renewable Heat Incentive by 2011

3) Amending or replacing the Renewable Transport Fuel Obligation to impose an obligation designed to deliver 10% renewable energy consumed in transport

4) Facilitating up to £4 billion of lending from the European Investment Bank to deal with immediate funding pressures resulting from the global crisis

In May we issued a report into the CleanTech sector which included a detailed look at the funding environment for renewable energy in the UK. One of the observations we made then was that there is a worrying funding gap developing which will limit our ability as a nation to meet the Government's 2020 renewables targets.

In particular we focused on the wind sector highlighting that there was c. £84 billion of investment required to deliver the onshore and offshore programme.

This weeks sharp fall in the Scottish & Southern Energy’s (SSE) share price, one of the UK's key investors in renewable energy has been due to concerns about a potential cash call. Moody’s has put SSE on review for a potential downgrade. The ratings agency has described SSE’s expenditure plans as “ambitious” and recognised its difficult trading conditions.

This is not the only power company to express concerns over the level of funding required for energy asset replacement. RWE, the German energy giant which acquired npower, expects to be investing three times its annual free cash flows to upgrade the UK's infrastructure - replacing coal and gas fired power stations, nuclear and wind generation.

There are three major implications.

1) It is likely that there will be a number of mega M&A deals involving power companies as they try to scale up their businesses and their balance sheets. SSE could easily become a target if it's share price continues to drop.

2) There is a huge opportunity for non traditional investors to particpate in the power infrastructure build out, which could include international private equity and infrastructure funds.

3) The Government will continue to drive fiscal incentives within microgenration, which will attract investors into the sub 5MW generating space.

Persimmon Plc provided a trading update yesterday, which would suggest the bottom of the housebuilding market has been passed. Unit sales are up on this time last year and the company has been able to pay down more debt than envisaged.

Whilst these signs are good there are still some underlying issues, which are causing concern within the industry and within the analyst community. The two principle issues include constrained land supply and a lack of capacity to build at volume. Both these issues we believe could stimulate acquisitions in the sector.

Mike Farley, Persimmon CEO mentioned that they "are finding it difficult to find good land available on the market at attractive prices". This is of course a function of the market and is both a misalignment in vendor's expectations and constrained supply. When the mortgage market returns to some sort of normality there will be significant step-up in demand; only 80,000 units are expected to be built in 2009 compared to a structural demand of 240,000.

This will put pressure on housebuilders to find suitable land immediately avaialble to build, despite holding large land banks they are not normally immediately available for development. One solution is to acquire smaller housebuilders who have good developments under way.

The second issue revolves around construction capacity. The housebuilders of today are very different from two years ago and the availablity of skilled tradesmen will not be easily switched on. The major housebuilders may see the easiest route to achieve the capacity they need by acquiring either exisiting housebuilders or construction firms.

Whilst no one believes we will return to the deal making of the mid 2000's we do expect to see some new M&A in the next 12 months.