Canada is in pretty good shape. Real growth in the first half of the year averaged slightly above 3.5% and the country’s net debt-GDP ratio of 30.1% in 2006 is the lowest of any member of the G8 group of industrialised countries. Its unemployment rate stood at a 33-year low of 6% as of September 2007.
The second half of the year looks as though it will be a little tougher. Weakened credit markets and the rocketing strength of the Canadian dollar – which has broken through parity with the US dollar for the first time in more than 30 years – are expected to put the brakes on the economy and to slow growth to 2.8% to the end of 2007, and maybe 2.5% next year. But continued favourable terms of trade should limit the damage – they have improved by 20% since 2002, driven by rising foreign demand and rising prices for Canadian energy exports.
A dominant sector
Natural resources clearly dominate the Canadian economy and markets as never before (see table below). Of 460 equity issues in the year to October, 153 were from the mining sector and 114 from oil, gas and energy, according to data from Scotia Capital. And of C$36.9bn ($38.6bn) in total issue value, mining, gas and energy accounted for more than 50%, at C$17.6bn.
“There’s no getting away from the fact that resource-based sectors including oil and gas, mining and infrastructure related to those sectors are driving the Canadian market,” says Roman Dubcak, head of equity capital markets at CIBC World Markets in Toronto. “It’s a very big story and well understood by the investor base.”
Although some people are uncomfortable with an economy and capital market so heavily skewed towards so few sectors, Richard Talbot, head of equity and debt research at RBC Capital Markets, says there is little danger that growth will stall in the near future. “The rising prices for commodities and resources are likely to continue; they have grown outside of the cyclical bull market,” he says.
“Demand is driven by a combination of thirsty developing economies and nervous geopolitics. Access to vast resources and the stability guaranteed by a very stable democracy make Canada a very attractive market in which to invest,” he says.
New resources come online
Rising prices are also bringing resources that were previously uneconomic into play, most notably the oil sands in northern Alberta, where the high cost of extracting the oil had prevented any development in the past. “Canada has the second largest probable and proven oil reserves in the world, but when oil was $27 a barrel, extracting it was not economic,” says Ted Nash, head of mergers and acquisitions (M&A) at CIBC. “But when oil is hovering at the $88-a-barrel mark, it becomes a completely different story. And that is pushing M&A activity as companies fight to get access to the resources.”
With demand for oil growing faster in countries outside the Organisation for Economic Co-operation and Development (OECD) than within it (many believe that within five years non-OECD countries could represent the majority of world oil demand), Mr Nash says he does not believe that demand will shrink in the near future. “There is a huge sucking sound coming from Asia and I don‘t see it stopping anytime soon,” he says.
Equity issuance flows
That demand feeds straight down into equity issuance and M&A activity. In January, Enbridge, a Canadian operator of crude oil and liquids pipelines, raised C$600m in a bought equity deal to help fund new pipelines and support projects, such as the $1.3bn Southern Lights project. In April, rival pipeline operator TransCanada launched a $1bn hybrid.
“The appetite for and quick succession of the deals show the depth of the market,” says Sarah Kavanagh, head of equity capital markets at Scotia Capital.
In M&A, activity in the sector has been dominated by the strategic bid. An example of this is BHP Billiton’s £67bn ($140bn) move on Rio Tinto to create the world’s biggest miner of iron ore, copper and aluminium, and a big producer of coal, zinc and diamonds.
Ongoing consolidation in the oil sector, too, is a sure indicator that the industry believes in the long-term growth story. In April, Norwegian energy group Statoil Hydro acquired Alberta-based North American Oil Sands in an all-cash deal for $2.2bn, aiming to broaden its production base away from maturing North Sea oil fields. That was followed by Marathon Oil’s acquisition of Western Oil Sands in a cash and securities transaction worth $6.9bn, which was completed in October. The deal gives the US refiner access to the tar-soaked sands at a time when access to fields outside the US is reduced because oil-rich nations such as Russia and Venezuela are limiting foreign access.
“The key to these transactions is belief in the numbers,” says William Quinn, head of M&A at TD Securities. “[The oil sands] are a long-term story and so you have to be very bullish on the long-term economics. Therefore acquirers are strategic, such as Marathon, Shell and Statoil.”
Doug Guzman, head of investment banking at RBC Capital Markets, believes that there is more consolidation to come. “The developing world is consuming commodities at a rate that we’ve never seen before and there is a strong belief in the continuation of the commodity cycle. That will push further consolidation, and for us that means more M&A business up and down the market capitalisation spectrum, as well as financing at the smaller end of the market,” he says.
Outside interest
Foreign appetite continues unabated. Abu Dhabi National Energy Company (TAQA) was the first Middle Eastern company to enter the Canadian energy market with its acquisition of Northrock Resources for C$2bn in May and is continuing its buying spree of Canadian energy assets. At the end of September, it announced a C$5bn acquisition of PrimeWest Energy Trust, hot on the heels of buying the Canadian operations of Pioneer Natural Resources in August for C$540m. TAQA says that it plans to make more Canadian acquisitions.
Nor is foreign appetite for Canadian assets restricted to energy. The steel sector, for example, has proved very attractive to overseas companies. “The bulk of the Canadian steel industry has been sold into foreign hands, and only one of the acquirers was from the US; the rest went to Russia, Sweden, India and Luxembourg,” says CIBC’s Mr Nash.
Overseas investment has caused some disquiet in Canada, where it has become an emotive topic. “There has been a lot of concern over acquisition of venerable Canadian companies,” says Mr Nash. “It is referred to as the ‘hollowing out’ of corporate Canada.”
Acquisitive nature
Canadian corporates, however, are becoming increasingly acquisitive themselves, perhaps spurred on by the growing buying power of the strong Canadian dollar, which has appreciated 15.5% against the US dollar in the past 12 months alone (and a staggering 66% since January 2002).
In the financial sector, for example, TD Bank acquired the US’s New Jersey-based Commerce Bank for $8.5bn in October, and in the same month, Royal Bank of Canada said it would buy Trinidad’s largest bank, RBTT Financial Group, for $2.2bn in cash and stock. In other sectors, Canadian Pacific Railway has just completed its acquisition of Dakota, Minnesota & Eastern Railroad Corporation and its subsidiaries in a deal said to be worth at least $1.48bn, and financial information company Thomson Financial Corporation is in the process of acquiring UK news agency Reuters in a deal valued at $17bn.
“We are seeing more Canadian companies make outbound acquisitions and become global champions,” says Peter Buzzi, co-head of M&A at RBC Capital Markets. “But people are still worried about the headquarters of acquired companies being moved and those well-paid jobs being lost to other economies, as well as wholesale foreign ownership of Canada’s natural resources. So-called ‘hollowing-out’ is still very much an issue in Canada.”
Canada has not felt the full brunt of the subprime crisis and subsequent credit crunch, but it has not escaped entirely unscathed either [see Growth of the Maple Bond market, page 32]. It may not have a high-yield market to speak of but it has experienced rising levels of private equity-related activity and the credit crunch must surely signal a slowdown.
“In the past two years, Canada has reached sponsor-related deal levels comparable with other M&A markets. There may not be that many home-grown private equity firms but there has been no shortage of US private equity companies crawling all over the market,” says RBC’s Mr Guzman. “If there is going to be a paring back of activity, then that may have a dampening effect on activity. But private equity still has a lot of cash, so deals may be a little smaller and leverage a little lower – and, as a lender, we think that’s probably a good thing – but they will still get done.”
Insulation for the markets
Additionally, one fact that has insulated Canadian markets is that the majority of private equity-related activity is in deals valued at less than C$1bn, generally in the C$500m range, and leverage there has not reached the levels of larger deals. “I don’t think that the negative impact will be so noticeable in Canada in terms of the number of transactions precisely because of the private equity industry’s focus on the small to medium-sized sector,” says CIBC’s Mr Nash.
And anyway, says Mr Nash, if private equity activity goes down, the corporate sector looks very healthy. Strategic buyers are back in the driving seat. “I’m much more encouraged than at the end of the last cycle,” he says. “This market is not a one-trick pony; it is much more diversified. While it’s a major resource story, we have had a lot of activity across most sectors. Corporate profits are historically high and equity valuations are reasonable.
“I don’t have the feeling that the market is vulnerable in the way it was at the end of the last boom. And at least strategic buyers are finally able to do transactions without paying through the nose,” he says.
