Friday, December 21, 2012

Back to the Future Again: The Beginning of a New Debt Bubble?

You cannot blame investors reaching for yield given the current near zero interest rate environment. This has depressed credit spreads and increased the market appetite for higher risk transactions. Plentiful cheap credit has proved to be too much of a temptation for many firms to ignore.  An unintended consequence of this development has been an increase in corporate leverage for both investment grade and noninvestment grade corporate issuers. Much of this increase for investment grade firms is related to shareholder distributions such as debt financed dividends and share repurchases.  Issuers like Costco and others have been issuing new debt to fund these distributions. True, some of this is related to the expected increase 2013 tax changes. Nonetheless,  the net result is investment grade corporate leverage multiples are creeping up to 2X EBITDA.  Just like in the pre-crisis era, firms are scolded for lazy balance sheets with low debt levels and high cash balances. The rise in leverage levels for the noninvestment grade LBO is even more dramatic. Leverage as a multiple of EBITDA has increased to over 5.5X while equity levels have fallen below 35%. These levels are approaching their pre-crisis highpoints.

This is reminiscent of the 'optimizing balance sheets by leveraging up' themes prior to the crisis. The problem with leverage is the benefits are visible while the costs are hidden. This is because risk is difficult to measure. The key benefits are control, usually reflect in share accretion, taxes (because interest expense is tax deductible) and higher equity returns. The tax benefit associated with leverage comes from a value transfer from the IRS by reducing their take in the firm’s cash flows. This benefit was reexamined and revised  downward from the statutory tax rate times the level of debt by Merton Miller in 1977 once the impact of personal taxes are considered.

Leverage costs are reflected by the product of the probability of distress times the cost of distress. The probability of distress is a combination of business risk from factors including cyclicality, regulation, competitors , and others as outline in my previous  November 14, 2012 post "How Much Debt is Right for Your Deal?".  The second component-cost in the event of distress -is much more amorphous and frequently understated if not ignored all together. These included heighten risk of competitor attacks, negative relationship impact on suppliers, customers and employees, and ultimately risk of default and failure. Leveraged firms have simply less room for error. Many firms discovered this fact during the 2008/2009 period.

These firms lost financial market access, were unable to rollover maturing debt, had to curtail investments and dividends, and some ultimately failed. As James Grant has noted all lessons in finance are cyclical and not cumulative. They are continually being rediscovered. What is surprising is how quickly many of the crisis lessons have been forgotten again. They may be painfully rediscovered again.

Financial markets still face considerable macro headwinds which could result in their closure to some firms. This could severely impact their strategic investment programs - their main source of shareholder wealth creation - and especially the flexibility to capitalize on market disorder by profiting from competitor weakness. That is why capital structure decisions must be tied to overall strategy. Also, they must be consistent with an appropriate debt rating and liquidity levels.

Less leverage and more liquidity are not mere redundancies or insurance. Rather, they represent opportunistic investments. Firms sometimes under estimate their liquidity and capital needs during bullish markets. Apart from tax shields (which may be overstated) leverage does not create value-it only magnifies short term results.  In addition, offsetting costs of financial distress are difficult to estimate. See Nassim Taleb’s recent book “Antifragile -Things That Gain from Disorder” (Random House, 2012) for a more philosophical approach to this topic.

Cautious Joe

p.s. Best Buy (original post November 19, 2012 “Not Sold on Best Buy LBO") update: The firm has granted its largest shareholder and founder an extension to next February to make a bid. This another sign of the difficulties associated with the planned buyout. As the saying goes, good deals get done right away, while bad deals don’t.

We won't post next week, but will return Jan 4.  We wish all of you a wonderful holiday season and a fantastic 2013!

Joe and Ralph

Wednesday, December 19, 2012

Speculation Spreads and the Market Pricing of Proposed Acquisitions: Part I

A useful tool in merger analysis is what we have termed the Speculation Spread.  Simply put, it is the percentage difference between an announced bid price and the current market price of a stock.

Speculation Spread = (BP - P1)/P1

where BP is the bid price offered for a target and P1 is the price at some point after the announcement, say one day later.  Let's take a simple example:  Consider a stock trading at 20 euros.  There is a surprise announcement by a bidder offering 30 euros in a deal to be completed in a month (if all goes well).  What happens to the stock price the day after the announcement (or more likely 30 seconds after announcement )?  Typically the stock price would move to 29, 29.50, or even 29.80.  Thus, the Speculation Spread is either 3.4%, 1.7% or 0.7%.  This is the return you would earn if you purchased the stock the day after the announcement and it was completed as announced, without revision in the price.  Your actual return would depend on price revisions, whether the deal was completed and, if you are concerned about the time value of your investment, how long it took to complete the deal.  For example, if the stock price is revised upward by the current bidder or another bidder, your gains would be greater.  (Interestingly, bids are occasionally revised down as well.)  If the deal falls through, your returns would depend on the post deal stock price.  If you add holding costs in the equation, deals that take longer to complete reduce your return.

Some simple examples are illustrative.  First, rule out any possibility of bid revision.  In that hypothetical world movements of the post-announcement price to 25, 27, or 30 euros indicate the probability of deal completion at 50%, 70%, or 100%.  Thus, the market is predicting the probability of deal success.

Jan Jindra and I analyzed these topics in a paper published nearly a decade ago in the Journal of Corporate Finance. A version of the paper can be found at Speculation Spreads and the Market Pricing of Proposed Acquisitions.

In about a fifth of the cash tender offers we analyzed, the price after the announcement exceeded the bid price!  For example, suppose the market price goes to 31 euros after the announcement.  This represents a Speculation Spread of  negative 3.2%.  Why would this occur?  Obviously, the market thinks the deal will be revised to a higher price.

In our analysis, we tested for the information actually contained in the Speculation Spread.  Our results indicated that the market prices not only the probability of completion, but the probability of deal revision and the length of time until offer completion.  Thus, a great deal of information is contained in the Speculation Spread.

Moveover, the  movement of the Speculation Spread over the course of a deal is very informative about the prospects of the deal.  More of that in Part II.  For now, we note that in recent news, the Canadian miner, First Quantum Minerals, LTD. has made a hostile bid for Inmet Mining Corp.  The offer is for C$72 per share or about $73 US.  (The offer is 50% in stock which complicates the analysis a bit.)  The original offer was in October for C$62 per share although it apparently wasn't announced publicly.  Consistent with this, the stock price didn't close above C$60 until the week of November 26.  It is currently trading at US $73.83 off just a bit from its previous close of us $74.11.

After our paper was published, someone became enamored of the potential risk arbitrage opportunities and contacted me about setting up a hedge fund.  Another person, also interested in the concept started a blog,  I've resisted the commercial aspects of the concept.  As the paper notes, and as I warned these individuals, there are considerable risks associated with the concepts inherent in arbitraging the position - risks that deserve much more scrutiny and analysis before committing funds.  Still, the concepts are intriguing, particularly when one considers stock exchange offers.  More on that in Part II of this post which will come out sometime in the next few weeks, but the curious may want to take a look at the MergerFund (MERFX) that has been doing this professionally for some time.

All the best,


Monday, December 17, 2012

Looking for Revenue Growth - Hopefully Not in all the Wrong Places

Firms are struggling with macro headwinds, regulatory and industry changes that have structurally changed their value proposition. They face continued slow growth, margin pressure and higher expenses. Many firms are unable to earn sufficient returns to cover their cost of equity. Consequently, their valuation multiples are under pressure. Understandably, they are searching to diversify revenue sources to reduce vulnerability to a prolonged downturn affecting their profitability. A quick way of achieving this goal is thru acquisitions to gain access to new markets.

Unfortunately, this quest gives rise to increased strategic risk. Strategic risk concerns a firm’s long-term ability to survive due to the incompatibility of its strategy and resources with industry changes. There are numerous examples of near fatal unnoticed strategic risk. A recent one was Hewlett Packard, which was reviewed in my December 12, 2012 post. Some firms, including HP, don't seem to consider risk as an input into strategy. Rather, it becomes an unintended consequence because it is not reflected in the income statement. Furthermore, the strategies of these firms appear inflexible, designed to work only in one state of the world. When that state changed they were unable to adjust.

Strategic risk is likely to increase as a slow recovery continues and firms intensify their search for growth. Some may even be tempted to gamble for redemption by expanding into areas in which they lack the skills to manage. The basic problem is that management target's return-not risk. The traditional response to a challenged core business is to take more risk in pursuit of nominal income return. Return, however, is where the risk is located. This leads to a vicious circle of herding into current popular areas that are already occupied by well entrenched competitors. A predictable erosion of margin follows leading to an escalation of commitment. A framework is needed to manage the risk profile inherent in strategy and business model changes consistent with an organization’s risk tolerance and capital structure. The Board of Directors need to set the strategic direction and risk tolerance and then monitor management to ensure they follow the Board’s wishes.

A key component of this framework is to improve the profitability of legacy business lines. Otherwise, resource demands will expose the firm to new risks the firm will be unable to manage. You cannot transform fast enough to offset the continued deterioration of your historic core business units. This would involve shrinking these business units to a defensible core based on the firm’s identifiable competitive advantages.

Evaluating new strategic acquisitions starts with the review of the new markets the firm seeks to enter. The firm must have real identifiable competitive advantages to succeed against the expected competitor response. If you cannot beat them then why join them? A realistic risk assessment is also required of the risks the firm is willing and able to accept in the pursuit of its strategic initiatives. Next, a capital plan is needed to raise the capital to fund the new risk exposure and consistent with credit rating goals. The firm also must ensure that it has the necessary skills to manage the risks involved. Finally, capital must be allocated to business units based on risk and strategic considerations.

Acquisitions are a means of implementing strategy. They are not strategy itself. You have to get the strategy right before acquiring. This demands active Board involvement. They need to balance the need for management experimentation, grounded in facts against delusional adventures. They must pay particular attention to large scale transformational acquisitions not based on identifiable competitive advantages. Such actions usually contain hidden exposures to remote risk. Equally important is not to force a change if you lack the ability or resources to implement it successfully. Instead consider accepting  low growth, manage the business for cash and return the excess capital generated to shareholders. Not everyone can or should transform and grow. Everyone must, however, adapt to the changed economic and industry environment. Just like with love-you have to stop looking for growth in all the wrong places.


Friday, December 14, 2012

Herding Cats - Bank Governance

A recurrent theme in this blog is the need for strong governance from the Board of Directors in the acquisition process. The banking industry has suffered from poor governance for years. Directors are chosen by senior management and are more like puppy dogs than guard dogs. That is one of the reasons why bank stocks, big banks in particular, lag in valuation post crisis. Their balance sheets are opaque and difficult to understand from the outside. If regulators cannot figure it out, then investors do not have a chance. In banking, you never have excess capital for too long. The question is how they will lose it-bad loans or bad acquisitions, and sometimes it is both e.g. Citi. One of the best ways to increase bank value is through better governance and transparency - just what the regulators want and just what shareholder need.  Barbara Rehm makes this point in an interesting article in yesterday's American Banker: Big Banks Flunk OCC Risk Tests.


Wednesday, December 12, 2012

De Ja Vu All Over Again-The Return Of The Spring Menu

Numerous Federal Reserve actions, including QE3 and Operation Twist, have flooded the markets with liquidity, depressed interest rates and flattened the yield curve. Domestic banks, unlike those in Europe, are well capitalized and have the capacity and willingness to lend. Investors searching for yield, but unwilling to assume equity tail risk have a large appetite for debt securities. Investment grade securities have priced so aggressively that more investors are marching up the risk curve.

The demand for noninvestment grade firms and higher 'risk structured' credit product is growing at a rapid rate. It is starting to feel like the pre-crisis 2005-2007 period. It is a good time to be an issuer/borrower. Hence we are seeing the return of bull/spring market debt capacity enhancing products as outlined in my prior post Back in Fashion Again. These include PIK, second lien loans and covenant lite.

High yield bond issuance (non-investment grade issuers with ratings below BBB-) is up 35%+ over 2011.The inflow of new investor funds into high yield bond funds is driving the demand for these instruments. Equally important is the growth in leveraged (non-investment) borrowers. Volumes are up 25% over the prior. They have reached their highest level since the crisis and the third highest level in history.

The majority of leveraged loans are structured as term loan “B” and sold to nonbank institutional investors. These investors are attracted to the asset because of the high yields LIBOR + 450-525 basis points with LIBOR floors of 125 basis point for the Bs and LIBOR + 900 on second lien loans. Additionally, they like senior secured floating rate features.

The return of collateralized loan obligations (CLO) is another development increasing the demand for leveraged loans. CLO are securitization vehicles that purchase and pool leveraged loans. They then tranche instruments used to fund their investments with lower rated tranches serving as enhancement for the higher rated tranches. CLO volume has increased to over $50B this year compared to just $12B in 2011. This is yet another sign of increased investor risk appetite.

M&A volume is highly dependent on credit. If credit is available bidders will use. This is reflected in rising M&A volumes, elevated purchase pricing and larger transactions. A current example is Freeport-McMoRan’s combined $10B acquisitions of two oil and gas firms at significant premiums. Although remaining marginally investment grade at BBB/negative outlook and a stock market beta of 2.3, JPMorgan felt comfortable enough to act as sole initial underwriter for $9.5B of loans.

It is important to remember that these market windows of financing opportunity can close abruptly-especially for lower rated firms and higher risk structures. Significant macro headwinds including the fiscal cliff, slow growth and Europe still remain. Therefore, I strongly suggest the following:

  •  Locking in your financing with as few lender outs as possible. Borrower bargaining power has increased.
  •  Be prepared to assume pricing and structure flex clauses in commitment letters. These allow lenders to increase pricing and reallocate portions of the loan if market condition change to clear the market.
  •  Try to build financial flexibility into your merger agreements.

You can only take what the market offers. Currently the credit markets are in a holiday mood and offering a lot. So take it while you can, but be prepared should conditions change.


Monday, December 10, 2012

Position, Flexibility, Power, and Knowledge: Chess Moves for Acquisition Success

Sunday's New York Times contains an interesting discussion about bargaining by Robert H. Frank.  The context of the discussion is politics and how, in Frank's view, the Republicans are in a weakened position to bargain.  While one might take issue with some of the political viewpoints, the discussion of bargaining is unassailable.  Knowing the bargaining strengths and weaknesses of each side is crucial in negotiations.  In particular, know the BATNA - the Best Alternative To a Negotiated Agreement.  

Frank writes:

"The Warner Brothers 1999 hit comedy 'Analyze This' portrays a mob boss (Robert De Niro) and his psychiatrist (Billy Crystal), who share a passion for the recordings of Tony Bennett. With the film almost completed — and with Mr. Bennett already an integral part of the plot — the studio finally got around to approaching the crooner with an offer of $15,000 to sing 'I’ve Got the World on a String' in the movie’s closing scene. But as Danny Bennett, the singer’s son and business manager, later explained, the executives made a fatal mistake by not scheduling this conversation sooner: 'Hey, they shot the whole film around Tony being the end gag and they’re offering me $15,000?'

Had studio officials made their offer at the outset, they would have had much more leverage. If the Bennetts demanded an unreasonable sum, the filmmakers could have rewritten the script and used some other singer. At the 11th hour, however, Warner Brothers’ best alternative to a negotiated agreement was to spend hundreds of thousands of dollars reshooting the film. In the end, the studio paid Tony Bennett $200,000 for a brief cameo appearance."

The same thing occurs in mergers and acquisitions.  When we know the strengths and weaknesses of both sides of a deal, we are better able to strike favorable terms.  In part, this ties back to synergies, strategies and necessity.  What are the synergies in this deal?  How many are unique?  That is, how many are available to one particular bidder?  To the extent this occurs, that bidder is in a stronger bargaining position.  In situations where any bidder can achieve synergies, the power flows back to the target.  

What are the strategic needs of both sides?  Does one side need the deal to prosper - or to survive?  The bargaining power of each side increases with their own BATNAs. 

There are numerous implications for this.  We'll mention just a few.  First, always be thinking strategically.  Strive to be 'anticipating and acting' - thinking proactively rather than 'reacting' to some exogenous shock to your firm.  Thinking ahead could have reduced the amount paid to Tony Bennett.  It can also result in more favorable terms in acquisitions.  Try to place your firm in a position of strength.  Second, enter the negotiations with as much information as possible.  As we've written elsewhere, negotiate on multiple fronts, not just price.  

The essence of a BATNA is simple - it is our opportunity cost - what we could be doing if we were not doing this deal.  Position, Flexibility, Power, and Knowledge.  They work in chess - and in acquisitions.

Friday, December 7, 2012

Hewlett Packard: A Failed Growth Strategy

HP was already a master serial value destroyer before its latest disaster with Autonomy. Consider that since 2006 it spent $38B in ill-fated acquisitions like Autonomy, EDS, Palm, and Compaq of which it has written off $26B. The write-offs exceed HP’s current $23B market value, which in turn, is now less than one third of its 2001 market value. Putting aside Autonomy’s alleged accounting and due diligence issues - there is a clear pattern of inept acquisitions over an extended time period, and under several different management teams. This suggests an institutional strategic flaw at HP, which makes it incapable of doing successful acquisitions. Consequently, the focus of this post is on the strategic issues in HP’s broader growth model. See Aswath Damodaran’s 11/26/12 post on “HP’s Deal from Hell” for an alternative financial review of the Autonomy acquisition on a standalone basis.

HP’s acquisition strategy was based on buying increased earnings through transformational deals. Management would not accept its maturing low growth business profile. Nor would it consider returning excess cash flow to shareholders instead of overpaying for strategic targets. Once a target is deemed strategic by a CEO, it will be supported by endless strategic studies and supporting financial analysis supplied by top named advisors.

The Autonomy deal - priced at 11X revenues, 24X EBITDA, 3X assets, and a 60%+ pre-bid stock price premium - was DOA at close. There was no way it could work, even without the alleged accounting irregularities, except in the eyes of the CEO who proposed the deal and was subsequently fired. A real question is where was the board, including the current CEO who was a board member supporting the deal? Why didn’t it raise questions? They could have chosen to exit up to the day of close by paying the $100mm break-up fee - cheap relative to value loss incurred. Apparently, the board was infected by the same growth delusion as management.

Most likely, the root of the problem was HP’s strategy of buying growth to offset weak core operations. This is based on the mistaken belief that investors value nominal earnings increases. GAAP earnings are an incomplete profitability measure. They ignore the cost of capital needed to generate earnings. Markets do not passively respond to reported earnings with a constant valuation multiple. Rather the multiple changes to reflect the quality of the earnings generated given the level of capital employed. Firms need to distinguish between adding value with residual earnings, and earnings after a capital charge from nominal earnings. Value is created only when asset returns exceed their cost of capital. Expansion with subpar returns may make the corporate kingdom larger, but its citizen shareholders will be poorer.

The pressure to expand is among the greatest threats to effective acquisitions. Expansions consume capital to fund the growth. Capital efficiency, not earnings alone, creates value. A simple example illustrates this fact. Assume you double an investment in a certificate of deposit at the same rate. Earnings will double, but clearly no one should receive a bonus on the increase as the residual income, earnings after the capital charge (the CD rate) for the increased investment, is unchanged. This highlights that simply employing more capital in investments with positive GAAP earnings can always create earnings, but doesn’t necessarily increase value.

Improving returns by making existing operations more efficient and returning excess capital to shareholders has a larger value impact than asset expansion for maturing firms. Despite this fact, growth strategies remain popular as they fit the conventional wisdom that bigger is better. Also, it reflects how management performance is evaluated and rewarded. Unlike most investment proposals, which reflect a capital cost, many performance and incentive systems are largely earnings based. Thus, they can be gamed to favor management through unwarranted expansion. Mature firms like HP should temper their ambitions to fit industry opportunities instead of trying to create opportunities to match their ambitions.

Size matters, but not necessarily in the way many think. Getting bigger can be a means to improving intrinsic value. It is not, however, an end in itself. The paradox of expansion is that increased earnings can be hazardous to shareholder wealth. The preferred near term strategy for a mature firm like HP, is to manage for returns by curtailing expansion, especially large transformational acquisitions, and then give the excess capital back to shareholders.

HP’s board and management should pledge not to acquire anything regardless of size for the next 5 years to stop further write-offs. Moreover, they should consider strategic alternatives. This could include the break-up of its services and software units through spin-offs, divestment or carve-outs.  See Bill George DealBook 11/28/12 “To Save HP, Break It n Two” for a further discussion. Ultimately, this may mean putting HP up for sale to someone who can better utilize its assets. Bad bidders like HP eventually become good targets. That time may have come. HP’s shareholders deserve nothing else. HP illustrates the importance of getting the strategy right before acquiring -as ‘there ain’t no right way to do the wrong thing’.


Wednesday, December 5, 2012

Martin Marietta and the Pac Man Defense

Martin Marietta is making acquisition news again, most recently as Martin Marietta Materials.  They were involved in merger discussions with rival gravel and sand supplier Vulcan Materials but talks ended when Martin launched a 'hostile bid' for Vulcan.  Vulcan argued successfully in the Delaware courts that Martin Marietta had unfairly used information it learned in the merger discussions.         Now, according to an article in the Wall Street Journal reported in Reuters, Martin is ready to resume the friendly discussions.  One wonders how friendly they will be.  Certainly with an improved outlook for the construction industry and a successful defense of the hostile offer, Vulcan is now in a strengthened bargaining position.

Ironically, Martin Marietta has been involved in another interesting acquisitions - as a target.  I am referring to their novel defense of an attack by rival Bendix back in 1982.   When Bendix started acquiring shares, MM avowed to stay independent.  Their defense, termed the Pac-Man defense after the popular game at the time,  was to launch an attack against the bidder - going after shares in Bendix.   Thus, the hunted becomes the hunter.  Allied Signal and United Technologies both entered the bidding as allies to MM and Bendix.  At the end of the contest, Bendix held 67% of Martin Marietta, while Martin Marietta held 50% of Bendix!  By the end, Allied had acquired all of Bendix's stock and MM remained free - although with a much higher debt burden.  Shareholders of the targets earned about 38% while Allied's shareholders lost 8.6%. (These and other details are contained in a paper by Michael Jensen, entitled Takeovers: Folklore and Science  The figures for Bendix and Allied are been typical for target returns but the losses for Allied that are much larger than those for bidders.

Martin Marietta ultimately merged with Lockheed in 1995 to become Lockheed Martin.  Martin Marietta Materials was spun off in 1996.

All the best,


Monday, December 3, 2012

Synergies and Anticipating the Competition

  Today's post continues the discussion of the 14 Keys to Acquisition Success that we posted in early September.  We are actually combining points five through nine in that earlier post.

5.   Beware of unrealistic projections.  Understand the source of synergies.  Why are these synergies available to you and not other buyers?

6.     Beware the winners curse – you win the auction not because you are the smartest, but because – you paid the highest price.

7.     Most deals fail to reach their full potential because of issues in integration. Don’t underestimate the costs and problems of integration.

8.     In mergers, 2+2 can equal 5, (3 is also a distinct possibility)!

9.     Think strategically, but understand that your competition is doing the same.

Mergers can be wonderful opportunities for value creation through synergies.  But synergies can also be negative (point 8).  When that happens it is usually because of unrealistic projections on the front end, inadequate due diligence, or poor integration (point 7).  Destruction of value also occurs when bidders overpay and Joe and I have warned repeatedly about hubris and the winner's curse (point 6).  That is, you 'won' the deal not because it creates value but because - you paid the most for it.  And given a world of smart, competitive bidders, this likely means you won not because you were smarter than the other bright lights in the room, but simply because you were willing to pay the most.  

But synergies do occur and mergers on average, create wealth for the target shareholders and even for the combination of target/bidder shareholders.  So how do you know where to look for synergies and how do you avoid overestimation?  The key is to look for your own sustainable, competitive advantage.  What is it that your company can do better than anyone else in the near future?  The point about the near future gets at the sustainable part.  Having a sustainable advantage in the long run, is of course, even better - but in the long run, most strategies and abilities can be copied or learned or acquired.

So we have to continually ask ourselves:  where do these synergies come from?  And, at least as important - why is no one else able to achieve the same synergies?  What is it that makes them unique between our firm and the firm we are acquiring.  Remember that if the synergies were not unique to our firm, it is likely that other firms would be bidding as well.

Finally, and related to all of the above - think strategically.  It is simply not good enough to anticipate your next moves or acquisitions assuming that the status quo in your industry is maintained.  There is a tendency to project our cash flows assuming our competitors are not also anticipating and adapting to the future.  So think strategically, but understand that your competition is doing the same (point 9).

All the best,