Thursday, March 28, 2013

Catalysts for Merger

We've talked before of motives for merger.  This time let's talk about what causes an entire industry to suddenly be the target of acquisition attempts or similarly why an industry suddenly starts making bids for other firms.

Think of an industry where no firm has been targeted for acquisition and imagine that this situation has prevailed for some time, say at least a year.  Metaphorically, the waters are still, the pond is flat, with no acquisition activity causing disruption.  The first bid for a firm in this industry is going to cause waves, possibly large waves, in this industry - like a rock thrown in the middle of the pond.

What causes this sudden activity?  Presumably some managerial team has decided that the assets of the target firm are worth more to this team than their current market value.  Hence a bid takes place.  Will this signal other bids in the industry?  Perhaps.  In another post we'll talk about merger waves.  For now, let's assume that the first firm to be targeted does indeed signal the possibility of other bids.  What are the reasons for this sudden activity?

The reasons are that something has occurred to cause the value of the target firm to increase in the view of the bidder.  What causes this shift?  In terms of the present value equation some catalyst must have caused an increase in the estimated cash flows or a decrease in the discount rate.  Either (or both) of these will increase value.   

As one example, there were a multitude of oil mergers in the 1980s.  One reason is that exploration and development became a value-losing proposition.  Why did this occur?  Because the price of oil (a fundamental component of cash flows) dropped from over $40 a barrel to $10 a barrel and simultaneously, interest rates rose from single digits to double digits.  As a consequence, the present value changed from a positive cash flow to a loss for each barrel discovered.  For Gulf Oil, the present value impact was about $50. per share.  A popular Harvard case makes these points and others in explaining how Gulf Oil could be trading for $38 today and receive a bid of $80. per share tomorrow.  

So what are these shocks, these catalysts?  Common catalysts include: shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology.

Shifts in regulation cause firms to adjust their behavior.  New regulation increases the costs of operating a firm.  Reduced regulation creates new opportunities.  Both types of shifts can make it more profitable for firms to combine.  In some cases firms reduce costs through economies of scale.  In other cases, firms are able to exploit synergies in situations previously blocked by regulation.  A good example is the banking industry where regulations prohibited growth in a (new) state unless a bank already had a presence in that state.  One way to establish a presence was merger with an existing bank.  

When consumer tastes shift, so do the estimates of future cash flows.  Investments that previously seemed unattractive (or attractive) are reversed.   As as result, targets find it beneficial to merge with other firms to exploit new synergies or merge as an attempt to reduce over-capacity in the industry. Firms that fail to adjust to shifts in tastes (e.g. Chrysler) are forced to merge to avoid bankruptcy (General Motors).  In addition to an industry example like automobile manufacturing, one can think of company specific examples like Dell or Hewlett Packard or Yahoo.  All were dominate within their industry until they failed to keep up with changing times.  

Changes in the factor of production can include changes in the cost of supplies, or changes in the cost of wages, or changes in other elements used in producing or delivering products and services. As one example, some products depend more heavily on oil in their manufacture.  As the price of oil changes, so do the costs of these products.   In many cases, mergers occur to capitalize on these changes.  Vertical mergers will occur as bidders seek to control supply, reducing uncertainties and costs in the process.  Horizontal mergers will occur to erase overcapacity and develop economies of scale

Competition from unexpected sources occurs as new competitors enter what was once a protected business environment.  This could be accompanied by a shift in regulation like increased interstate banking or from the entry of foreign companies into what was primarily a domestic market.  It also happens when products are suddenly put to additional uses that infringe on new territory.  For examples, think of how the various applications for the cell phone have eroded traditional markets.  Garmin once profited by selling stand alone GPS units, now a smart phone application does the same thing.  

Changes in technology cause firms to adapt or become obsolete.  Polaroid and Kodak are good examples.  Banking is facing overcapacity with the advent of the internet.  I sometimes challenge executives to think of the new products and services that have existed only in their lifetime.  They mention Personal Computers, the Internet, Digital Cameras, and even things like Rock and Roll and Viagra!  Each new product and each new technology is a catalyst for change and a potential force for mergers in a particular industry.  (See our related posts on Do Unto Yourself and Anticipation, Acquisitions and Bidder Returns as well as posts on Dell and HP.)

Obviously, many of these catalysts are interrelated.  New smartphone applications that reveal calorie counts on specific food items can lead to shifts in consumer tastes.  Similarly, scanners on smart phones may lead customers to buy online, a new source of competition.

Any of these or other catalysts can lead to merger either for a particular firm or for an entire industry.  We'll follow up down the road with a related post on merger waves.  

All the best,


Monday, March 25, 2013

Are You a Takeover Target?

An improving economy and favorable financial markets have renewed interest in acquisitions as a growth option. We can expect increasing shareholder pressure to grow earnings, or return excess cash to them. The pressure can trigger a hostile bid or shareholder activism. Either you develop options, or you become one.

Targets include both firms suffering from poor performance like HP or well performing firms with large and growing cash holdings such as Apple. Both HP and Apple may be somewhat protected from a hostile bid given their size. They are not, however, immune from shareholder activism as recent events have shown.

Characteristics that will land you on someone’s takeover or activism target list include the following:

1)     Slow earnings growth but profitable cash positive operations
2)     Returns on equity lagging the cost of equity
3)     Depressed stock price multiples-especially market to book and price to earnings ratios
4)     Growing cash and marketable securities holdings constituting a large portion of your market value
5)     Relatively low dividend payout ratio e.g. less than 30%
6)     Low leverage with debt/cap ratios e.g. below 20%
7)     Multiple SBUs with the sum of the parts value, break-up value, exceeding the current market value of the whole firm
8)     Problematic organic and M&A growth results

So what do you do if you have one or more of these characteristics? Consider the following:

1)     Explore alternative strategic options-code for putting yourself up for sale. Probably not your first choice.
2)     Contact your lawyers to ensure takeover and shareholder activism defenses are in order. This only buys you time. It does not solve the underlying performance issue.
3)     Sell assets and SBUs better owned by someone else. This involves a periodic product portfolio review to transfer those units which have passed their sell by date.
4)     Return excess cash to shareholders through a special dividend or share repurchase
5)     Increase the dividend payout ratio to reduce the future build up of cash
6)     Increase leverage and use the proceeds to fund a special dividend or share repurchase. Probably want to maintain an investment grade rating of at least BBB to ensure financial flexibility. This translates into a maximum debt to capital ratio of around 50% for nonfinancial companies.
7)     Consider taking the firm private-possibly via a management lead LBO
8)     Develop new shareholder friendly organic and M&A growth strategies

As I've written before, the key is to Do Onto Yourself before someone else does onto you. We may be early in the cycle. 

Nonetheless, it never hurts to be prepared.


P.S. (See also, Ralph's post on The Best Takeover Defense: Don't Leave Money on the Table.)

Thursday, March 21, 2013

European M&A

During our Acquisition Finance class, Joe and I spend considerable time discussing European deals.  European deals come with their own strengths, weaknesses  opportunities (and yes, even threats).  It is important to understand these differences when considering and structuring a deal.  

A recent analysis of European deals by CMS provides some interesting findings including:

·      MAC clauses are much more popular in the US (being used in 93% of deals) than in Europe where they only appear in 14%. Another sizeable difference exists in the use of working capital adjustments as a criterion for purchase price adjustment, used in 77% of cases in the US as opposed to just 34% in Europe.The explanation for this may simply be the diversity that one sees in 50 different countries as opposed to 50 different states in one country.

·      Earn-out deals are more popular in the US. 38% of US deals had an earn-out component compared with just 16% in Europe in 2012.

·      Not only are baskets much more prevalent in the US, but the basis of recovery is different. In the US, 62% of relevant deals are based on ‘excess only’ recovery as opposed to ‘first dollar’ recovery compared with only 29% in Europe in 2012 for ‘excess only’ recovery.

·       Basket thresholds tend to be lower in the US with 88% being less than 1% of the purchase price compared with 49% in Europe and that is probably because there is less payback for purchasers because of the prevalence of "excess only" recovery.

More detail on the report can be found at:  European M&A.

All the best,


Monday, March 18, 2013

Dell: The "Really" Real Issue

Holman Jenkins “The Real Dell Issue Is Michael Dell”,  March 13, 2013 Wall Street Journal opinion piece raises the right issue. Michael Dell is under no obligation, legal or moral, to offer shareholders a higher price. The “really” real issue is whether his offer should be accepted despite his having shareholders over a barrel due his inside control position.

Dells’ intrinsic value depends on the strategy employed and the management executing it. The current strategy involves diversifying away from its declining legacy core PC business towards a solutions based model. Unfortunately, others, including IBM, HP, Oracle, EMC, and Cisco, had the same idea years ago, and have established themselves as formable competitors in this sector. Despite years of trying and over $7B of questionable acquisitions, Dell is no closer to achieving its stated goal. Trying to accomplish this task in a highly leveraged capital structure is even more questionable. Hence, the pre bid price accurately reflected the then current intrinsic value based on its currently announced strategy. Nonetheless, all is not lost as Dell has a huge cash pile and still generates considerable free cash flow.
Michael Dell, is a very smart person.  My belief, or should I say suspicion, is that he recognizes the situation, and is prepared to change course towards an alternative higher value strategy. Namely, stop the diversification, manage Dell for cash and utilize the cash pile. This would likely increase Dell’s value. Unfortunately for Dell’s shareholders, Michael Dell understandably does not want to share the upside with them. Conveniently, the Dell Board has concluded that alternatives for sharing the upside, such as a leveraged recapitalization, would be less attractive to Dell shareholders.

This is the “really” real reason behind major shareholder resistance to Dell’s offer by Carl Icahn and others. Jenkins, while acknowledging this issue bemoans, the lack of alternative higher price offers. This issue here, however, is information and timing. Recently, interested parties like Icahn have signed non disclosure agreements giving them access to inside information that previously Michael Dell exclusively enjoyed. I expect that based on this information competing higher priced offers may be forthcoming. We are still in the early innings of this game. So I would suggest to Jenkins that he hold on a little bit longer as good things can come to those who wait.


Thursday, March 14, 2013

Say on Pay in the US: The Early Evidence

Joe and I have been debating the merits of the new Swiss Say on Pay regulation.   (See Mad as Hell and I'm Not Going to Take This and Swiss Say on Pay - The Dangers

The US now has it's own, non-binding Say on Pay legislation, but it is a relatively new development.  A few years ago, my colleague Jay Cai and I performed the first empirical analysis of Say on Pay in the United States in the academic literature.

The starting point for our analysis was April 20, 2007, when underdog Presidential Candidate Barack Obama introduced the legislation into the Senate.  It had just passed the house on the same day.  Thinking about the impact of this legislation on shareholder wealth you can immediately envision three possible impacts.

First, it could be beneficial, prodding boards to rein in excessive pay and to be more careful in the compensation packages they offer.  In this case, the share price of firms would increase with the bill.

Second, such a law could be detrimental to shareholders.  Boards are responsible for executive compensation and can always hire additional expertise to advise them as needed.  Outside pressures from shareholders, some of whom may have narrow agendas, could produce unnecessary complications within the boardroom which could reduce shareholder wealth.

Finally, we might find that the mere introduction of the bill in the Senate (and it's passage in the house) have no impact on shareholder wealth.  After all, we are talking about the introduction of a bill, not its passage.  Moreover, even if it passed the Senate, then-President Bush said he would veto it.  Besides, it is an advisory vote - boards don't have to do anything even if a majority of shareholders disagree with the level of executive compensation.  (In this regard, I note that previous evidence on advisory votes finds them to have little impact on shareholder wealth.)  So in my mind, the probabilities were stacked towards no impact.  

What did we find?  Some interesting results.

First, we find that one size doesn't fit all with this legislation.  Our results indicate that situations where the law appears beneficial and situations where shareholder votes are likely to be seriously considered are associated with increases in shareholder wealth.  In other situations, the bill would appear to reduce shareholder wealth.  

So where was it beneficial?  In firms with high, abnormal CEO compensation, those with low pay for performance sensitivity and for those firms that had been responsive to shareholder votes in the past.  The latter result is in line with the fact that firms don't have to implement changes, even if a majority of shareholders disagree with pay packages.  

But Say on Pay could have been voluntarily implemented by boards if they deemed it beneficial.  They didn't need legislation to do this.  Moreover, shareholders themselves could have proposed Say on Pay to their boards.  In fact, this did happen.  We found numerous cases where activists (primarily unions) had sponsored Say on Pay proposals.  Unfortunately, they appeared to target the wrong firms.  The firms they targeted were large firms that, on average, appeared to have reasonable performance, governance and pay characteristics. As a result, the share price dropped for firms targeted in this way.  Our research suggests that say-on-pay creates value for companies with inefficient compensation, but can destroy value for others. 

The complete paper can be downloaded here: Shareholders’ Say on Pay: Does It Create Value? 

Monday, March 11, 2013

Dell - Icahn: March Madness!

I have expressed fairness concerns about the proposed Dell insider LBO. See the February 8, 2013 post “The dell LBO: Existing Shareholders Lookout Below”. Until recently, it appeared that despite the resistance of minority shareholders like Southeastern, the deal would proceed at the original $13.65 per share offer price. Quite simply, no other bidder could or would challenge the Michael Dell-Silver Lake sponsored deal, which Dell’s board had blessed as the best alternative. Luckily for the minority shareholders, not so lucky for Mr. Dell, et al, Carl Ichan has entered the fray. He is proposing a special $9 per share shareholder distribution funded via use of excess cash and debt. He believes the this combined with the remaining “stub” value of $13.80 per shares offers a better value for all shareholders-not just Michael Dell-Silver Lake.

The nub of the issue is related party LBOs is always prone to abuse. The proposed Dell deal is especially suspect given its large cash position. Undoubtedly, as 4Q12 results indicate, Dell’s legacy PC business continues to decline. Nonetheless, it remains cash positive and has large liquid resources. The offer price, although representing a substantial premium over the pre-offer trading price, is at a large discount to Dell’s 52 week high price-a usual selling shareholder reference point. Furthermore, based publicly available information, a higher fundamentals based price could be reasonably crafted. Dell’s share price has increased following the mounting pressure by about $1 per share as investors sense that the offer price needs to raise to avoid Ichan’s ‘years of litigation’ threat.

Some lessons I see from this unfolding sequence of events are as follows:

1)     Honesty is still the best policy: The Dell “short sighted market doesn’t understand” the reason for going private which was never very convincing. Trying to complete a turnaround in a highly leveraged LBO structure would complicate not simplify the prospects. The real reason was to capture the upside benefits for the buyout group-in particular the large net $7.4B available cash position. Interestingly, the Dell group plans to bring the foreign cash home and pay the tax penalties after years of saying it could or would not return the cash due to tax considerations.

2)     Sharing is nice: Consider sharing the upside with Dell’s long suffering shareholders rather than trying to keep it all. A special shareholder distribution involving utilization of available net cash and a debt financed share repurchase would have allowed shareholders to participate in the transaction. Also, it could have avoided the auction requirements in a going private transaction. I would love to see the Board’s analysis in rejecting this alternative.

3)     Don’t be a pig: Absent sharing, at least offer a price that does not embarrass existing shareholders like Southeastern who has a $15-16 investment basis. Let them walk away- if not happy –at least not mad.

4)     Over disclose to increase the trust level: Provide valuation information to an independent third party like The Shareholder Forum, Inc with appropriate confidentially safeguards. This would supplement the less independent traditional fairness opinion provided by the company hired investment bank.

5)     The Michael Dell Rule: When he is buying you should not be selling. He does not appear to be minority shareholder friendly.

Ultimately, the next steps in the drama include Dell dropping the deal, increasing the price, providing more information, or letting the shareholders share in the deal. God bless Carl Ichan-he is doing God’s work here-of course for a fee, but that is ok.