Thursday, January 30, 2014

Agency Costs and Corporate Governance, A Quick Overview: Part 1

We've written a lot about corporate governance in these posts including ways in which mergers can be caused by faulty corporate governance and value (in mergers and private equity) can be created by better corporate governance.  In the paragraphs below, I'll explore a few of the basic concepts of corporate governance.  All of this material can be attributed to the academic father of corporate governance, Michael Jensen.  (For a video interviews I did with Mike Jensen see this link.)  

Mike Jensen and William Meckling wrote the modern treatise on Corporate Governance entitled Agency Theory, in 1976.  The ideas are related to work by Alchian, Demsetz, Berle and Means and others.  In fact, ideas of corporate governance can also be traced to Adam Smith and undoubtedly much further back in history.  But Jensen and Meckling created the modern excitement about the field and showed, in an elegant model, how value is created and destroyed by good and bad governance.   Thousands of articles have since built on and tested the concepts of their pioneering work and the practice of corporate governance has been materially improved by these ideas.  The subject can and has filled volumes.  Here is an overview.

First, corporate governance involves the alignment of the interests of owners and managers.  In the modern corporation, the owners are the shareholders and the executives are the managers.  There are tremendous advantages of owners hiring professional managers, for example, not all (many) owners have the expertise or time to run the business.  However, the second a professional manager is hired, the potential for agency problems (that is, corporate governance problems) is created.  Why?  Because rational (and irrational) people will pursue their own self interests and the best interests of the executives can deviate from those of the owners.  

Here are two easy examples.  First, consider executive compensation.  CEOs want to be paid more, while owners may want to pay less.  The same can be said of executive perquisites.  The entrepreneur running his or her own firm may not even have an office, instead choosing to stroll the plant on the lookout for situations that can be improved.  After all, any office accrutements come at direct cost to the owners.  Now consider the same situation when a manager (owning just a small fraction of the firm) is hired to run the business.  And remember,  the CEO of major corporations typically owns a fraction of one percent of the business.  Suddenly, the benefits of a more comfortable office outweigh their actual costs to the person in charge, the CEO.  The corporate jet that would cost $20 million to the owners, costs a fraction of a percent to the modern CEO.  Decisions are made that would not have been made under a 100% owner.  Not all of these different decisions are bad - the situation is different, but all require careful analysis.

As a second example, consider the situation when a sale of the business is best for the owners.  It may not be best for the CEO who may loose his or her job.  Related to this, acquisitions that expand the empire may benefit the executives, but not the owners.

All of these situations can create Agency Problems or problems.  In part 2 of this post, next Thursday, we'll consider some ways to mitigage Agency Problems.

All the best,


Monday, January 27, 2014

Share Repurchases 2014

Share Repurchases reached post crisis record levels in 2013. This occurred while the S&P 500 rose over 30% for the year. Thus, it is becoming less likely shares are undervalued. Repurchases are justified, versus alternative distributions like dividends, only when the current share price is below the firm’s intrinsic value, which is based on the capitalized value of management’s forward plan. Consequently, 2014 repurchase volume should decline. My concern is some managers will maintain unjustified over priced repurchases to maintain their bonuses or enhance their stock option values. The focus of this post is on the return of excess cash as dividend substitutes and not debt financed capital structure repurchase alternatives.

Corporate liquidity reflected in excess cash balances continues to rise based on two factors. First, cash earnings improvements based on enhanced productivity continued their post crisis trend. Next, managers have been reluctant to reinvest in growth through either increased CAPEX or M&A. Excess cash should be returned to shareholders to reduce possible agency cost problems. This concern underlies shareholder activists like Carl Icahn’s request to Apple. The question is how that cash should be returned.

The basic choices for the return of excess liquidity include dividends, either special or regular, and share repurchases. As previously discussed Debate Part I and Part II, I have concerns that managers may misuse repurchases. Essentially, rather than invest in risky CAPEX and M&A with a delayed payback, some managers  such as those at IBM may opt for “safer” repurchases to manufacture incentive compensation relation EPS gains.

Cash rich firms with limited reinvestment opportunities should favor dividends over repurchases absent strong evidence that their shares are undervalued. The dividends can either be special or regular depending on management’s future earnings views. If EPS must be raised for some reason it can always be achieved via a reverse split. Tax issues should be second order consideration given institutional ownership at the majority of firms and other means to structure around the issue.

Either use it, return it but do not abuse excess cash by engaging in over priced share repurchases. Directors need to carefully monitor management repurchase recommendation.


Thursday, January 23, 2014

Merger Wave in the Publishing Industry

We've written quite a bit in these posts about the motives for merger and merger waves.  In general, some catalyst shakes up an industry and creates opportunities for some firms and solutions to problems for others.  We have specifically mentioned shifts in regulation, shifts in consumer tastes, competition from unexpected sources, changes in the factors of production and changes in technology, (see our post Catalysts for Merger).   It is self evident to readers of this or any blog, that change has been afoot in the publishing industry.

 I read an interesting article today by Jeremy Greenfield in that makes these points very well for the publishing industry and I thought I would share the link.  The author argues, and I agree, that the publishing industry is currently in a merger wave.  He discusses the specific catalysts that are involved in the publishing wave and gives examples of each.  I hope you enjoy it.  See "Get Ready For More Mergers and Acquisition in Book Publishing".

All the best,


Monday, January 20, 2014

There Goes the Nest (Labs) Egg?

Last week Google (GOOG) announced the acquisition of privately owned Nest Labs (Nest) for $3.2B (see Acquisition). The interesting thing for me is not the size, but the eye-popping valuation. I understand Venture Capital (AKA VC or Adventure Capital) is different.  Nonetheless, a multiple of 10-20X sales (depending on which sales figure you use) for a 4 year startup makes me wonder just how different it can be and still make financial sense.

Valuation is based on the higher of cost, going concern (intrinsic or DCF) or third party (multiples) measures. The measure used depends on the life cycle of the firm and its industry. VC projects typically use a form of the third party approach (dependent on what buyers are willing to pay) given the rapidly growing nature of both the firm and its industry and lack of positive cash flow. In fact they frequently have negative cash flow (AKA burn rate) and are dependent on new rounds of financing to exist.
The VC valuation approach involves five steps:

1)   A multiple is selected e.g. sales.
2)   An estimate of the future market size in say 5 years is chosen.
3)   The firm’s future market share in 5 years is used to determine its sales.
4)   The multiple is applied to the sales estimate to determine the future value. Currently for hardware firms 2-4X is used. Software and social media firms receive a higher multiple in the 10-20X range. Yes, I recognize this very imprecise, but that is why VC firms require such high returns.
5)   The quasi future terminal value calculated in # 4 above is then discounted back to the present using a (high-very high) hurdle rate. This value can be used to determine the target’s M&A price or by investors to determine their required ownership percentage for an investment in the firm.

Nest makes “smart” thermostats allowing the remote control of your home temperature.  Additionally, they can be linked with other instruments. This last networking feature seems to be Nest’s value proposition. The 2012 financing round provided an implied value of $800mln based on the approach outlined above. An uncompleted YE 2013 financing round supposedly valued it at $2B.
Its sales are estimated at 50,000 units per month (600,000 p.a.) with an average price of $250 per units. Sales are expected to reach 1,000,000 units p.a. soon. The total market is estimated at around 90mln units. An issue is whether the sales and margins can be achieved once competitors are considered. Remember, you should evaluate companies not industries. As Buffett notes you cannot earn superior returns by investing in economy transforming sectors (e.g. the 1990s Dotcom delusion). Based on the financing rounds or the multiples of future sales for similar firms, Nest received a rich price. They got tomorrow’s price today.

Google with its $57B cash balance could clearly afford the price. The question, however, is should they have paid the price. Google’s growth has been slowing, while its cash pile has been growing. They have become the most acquisitive tech firm with over $17B of acquisitions in the past 2 years. This exceeds the combined value of all acquisitions by Apple, Microsoft, Yahoo, and Amazon over the same period. The common theme is data (AKA the internet of things) to justify the disjointed acquisitions which include the successful YouTube to the less successful Motorola.
This looks to me like another maturing tech firm, Google, trying to regaining its mo-jo thru over priced unfocused acquisitions justified as a long-term strategy. We have seen this movie before-Hewlett Packard. Maybe I am being too harsh, but maybe not. Let’s keep an eye on Google.


Thursday, January 16, 2014

Beam Me Up: Jim Beam to be sold to Suntory

Today's  Wall Street Journal reports interesting details of the proposed Jim Beam acquisition by Suntory:  a $13.6 billion dollar deal, ($16 billion, including debt), the deal is all cash and represents a 25% premia over Jim Beam's recent closing stock price.  Will this deal be successful for Suntory?  It is too soon to tell, but there are many elements of this deal that make it interesting for students of mergers.

A deal creates value when the present value of future cash flows exceeds the costs.  Three big elements of cash flows and costs are:

Bid Premia- 25% is the cost, plus all of the integration fees.  While this is in the range of typical bid premia, a much more detailed analysis is needed to determine if it is excessive. At about 20 times EBITDA, it seems pricey.  Moreover, if the market price had already anticipated the bid, the real premia could be higher.

Synergies -   should be present in the increased market power of Suntory (jumping from 15th to 3rd in market share), and from Suntory's ability to expand distribution of Jim Beam internationally.

Projected cash flows - could benefit from an increased worldwide demand for Bourbon.  A separate journal article notes that as we grow older our appreciation of more complex tastes increases.  This bodes well for the sale of bourbon and the synergies mentioned above.

It is also of interest to note the importance of ownership structure in acquisitions

The Role of Activists- Bill Ackerman's Pershing Square Hedge fund was reportedly instrumental in getting Fortune Brands to spin off Jim Beam.  Ackerman should now earn a sizeable return as the fund reportedly owns about 12% of the stock.  According to a report in The Guardian, the successful sale of Jim Beam will result in a return of 106% since the time of the spinoff.

 Ownership structure - Jim Bean isn't family controlled and is publicly listed. Both facts facilitate acquisition.  This is in contrast to Brown-Forman and others with concentrated family ownership. Concentrated ownership works to block acquisitions when the block (say, a family) is against a sale, or to facilitate acquisition when the block is in favor of the sale (presumably Pershing Square).

However, an element of caution is in order when one considers

Suntory's buying spree- Suntory has made several acquisitions in the past year.  A more careful analysis of the motives of Suntory is needed before drawing conclusions.  The spree could represent a carefully planned expansion or an attempt to increase size without adequate consideration of integration and value.  The companies acquired, however, do play to Suntory's strength in soft drinks, energy drinks, and alcoholic beverages.

So what is the market saying about the prospects of the deal being completed?

Speculation spread- after a deal is announced, the market price jumps to something closer to the bid price.  How close?  This depends on the probability the deal will be completed and the probability of deal revision.  We call the percentage difference between the market price after the deal (P1) and the bid price (BP) the speculation spread.  In this case the market price rose Monday to $83.42 just slightly below the bid price of $83.50.  The resulting speculation spread is 0.1% which is much less than the typical spread of 2%.  The Jim Beam spread is signalling a successfully completed deal.  It also suggests that the deal is less likely to be revised by Suntory or other bidders.  (See our post on Speculation Spreads.)

Two reasons for this are:

Antitrust issues- according to the journal the four biggest spirits companies only control 9% of the global market.  This is in contrast to the beer industry where the four largest companies control 49% of the market.  Antitrust issues should not be a major factor here.  
Termination fees- the termination fee of $425 million represents 3% of the deal.  While not unusual, it could still  represent an obstacle for other bidders.

Will this deal, create value for Suntory?  As we mentioned, it is too early to tell.  The positive signs are certainly the potential synergies from distribution, the improved market power of Suntory, and the demographic trends suggesting increased demand for bourbon in the future.  Whether this is enough to offset a 25% premia is still to be seen.  As for now, however, I'd drink to this one.

All the best,


Monday, January 13, 2014

M&A Red Flags

It may be useful to review some M&A red flags as the M&A market continues to improve. These signals are frequently ignored once the deal process starts. My on-going list is as follows:

1)    Do you believe in magic? Aggressive revenue based synergies are always questionable. Failure to consider competitor response to revenue gains renders the estimates useless.
2)    It is a great target: It may be, but it is still a bad acquisition if you overpay. For me, premiums greater than 40% over the pre bid target stock price are delusional.
3)    Trust me: New CEOs still in their honeymoon period can get some strange deals approved.
4)    Trying to get my mo-jo back: Underperforming firms seeking to regain their old growth status usually violate the first law of holes-when you are in a hole-stop digging. Such firms are not the best owner of the target’s assets and make the acquisition for the wrong reasons i.e. weak strategic rationale.
5)    Bid’em up: Revising upward your pre bid walk away price once the bidding begins. Frequently based on some newly discovered synergy, but always fatal.
6)    Don’t worry about it: Large transformational trophy deals with high levels of shareholder value at risk (SVAR). SVAR is the premium expressed as a % of the acquirer’s pre bid market value. Sometimes known as the “bet your company” acquisition strategy.
7)    What- me worry?  Coupling a large high business risk acquisition with a highly leveraged capital structure is questionable. Flexibility is needed to successfully implement the acquisition and withstand possible competitor responses.
8)    All the other kids have one: Late cycle acquisitions to catch up with peers.
9)    It has to work: Vague existential integration plans.
10)  Don’t confuse me with the facts: Weak or ignored due diligence.
11)  Tunnel vision: Ignoring alternatives such as doing nothing or selling out.
12)  We can trust them: Dealing with sellers who have questionable motives is always dangerous. Make sure you listen to your lawyers by including risk mitigation clauses in your documentation. If the seller objects-ask why.

The presence of any one of the above should be a cause of concern for investors and directors. Two or more should be enough to reject the transaction.

Good hunting, but be careful-it is dangerous out there.


Thursday, January 9, 2014

European Mergers in 2013

Joe and I have recently been commenting about merger activity or lack thereof.   In his most recent post (viewed here) Joe notes, "Overall Volume is a Tale of Two Continents: U.S. volume is up over 11% over 2012 to over $1T-a post crisis high.  Europe, however, continues to lag, reflecting its structural problems." In the post before that (viewed here) I discussed deals of the year for 2013.  Combining these two streams, today's post deals with European Mergers in 2013, drawing on the note, Cross Market Commentary: European Merger Activity Falls in 2013.  

While aggregate deal activity was down in Europe in 2013, an analysis of quarterly activity reveals interesting and juxtaposed trends: the dollar volume of activity increased each quarter while the number of deals decreased each quarter.  Obviously, the average deal size was increasing by quarter as well.  The largest European Merger deal of the year was the 19 million dollar deal by Brazilian telecommunications firm Oi SA to acquire Portugal Teleccom SGPS S.A.  

Some of the Trends noted in the European Report are also borne out by Thompson Reuters.  Here we find that US merger activity accounted for the largest percentage of world activity since 2001 while European Activity hit a ten year low.  This reflects Joe's comment about the tale of two continents.

Regardless of the trends it is certain that mergers will continue to be important in the US, in Europe and in the World.  Why?  Because The forces that drive mergers will continue to be dominant in all of these markets, specifically changes in: technology, consumer tastes, regulation, competition, and factors of production.  The size and volume of activity will ebb and flow, but the fundamental factors driving deals are ever present.  More detail is contained in our post on Catalysts for Merger.

All the best,


Monday, January 6, 2014

2013 M&A Observations

2013 was an interesting year. The stock and credit markets boomed as investor risk appetite increased. M&A, at least in the U.S., continued to improve (see Thompson). Some of my not so profound observations on 2013 are as follows:

1)     Overall Volume is a Tale of Two Continents: U.S. volume is up over 11% over 2012 to over $1T-a post crisis high.  Europe, however, continues to lag, reflecting its structural problems. The difference is also reflected in pricing with U.S. EBITDA multiples and bid premiums of 12.8 X and 40% respective compared to Euro stats of 10.8 X and 28%. The U.S. market benefits from an accommodating Fed, leading to easy financing and an increased confidence from a booming stock market, which also provides buyers with an attractive acquisition currency.
2)     Shareholder Activism: It seems that activism has become the 21st Century hostile takeover. Additionally, activists are acting as M&A headwind (see Activists). They are focusing more on return of capital through repurchase than M&A. Watch for shifts in this area to spur activity.
3)     The M&A Paradox: Bidder M&A share performance are problematic at best. Yet M&A continues. Is management stupid or unaware of this fact? Recent research by Ralph highlights that the problem may have more to do with faulty methodology than faulty management (see Ralph). Failure to include the anticipation effect negatively skews M&A performance.
4)     Recent Shareholder M&A Response: Even without making the anticipation adjustments, recent shareholder response to M&A announcement has been positive. This reflects investors rewarding smart M&A. Of course, managers failing to deliver the promised returns will have to pay the piper.
5)     Beware the Aging Acquirer: Aging acquirers seeking to regain their growth are likely to make bad acquirers. We are seeing this is the tech industry where firms like Yahoo and others are acquiring to cover over business model problems. This is unlikely to work as these types of firms are rarely the best owners of the acquired firms.

Predictions are always tricky-especially when about the future. Nonetheless, often wrong, but never in doubt, here are a few:

1)     The market will continue to improve in 2014-both in the U.S. and to a less extent in Europe. Economic and political uncertainty seems to be declining. Additionally, large amounts of private equity dry powder, some from heavy fund raising, will provide heightened acquisition demand. This will put upward pressure on acquisition prices.
2)     Possible concerns are the traditional “black swans” of overheating financial markets, major unexpected defaults, and Asian and Middle Eastern geopolitical uncertainty.

Happy New Year


Thursday, January 2, 2014

Deals of the Year for 2013

Deal activity was much higher this year than last, but not at the pace we expected.  See Joe's recent post 'Something is happening here, what it is ain't exactly clear.'  Still, the years is over and we can look back at the highlights.

Investor Place gives a nice tally of the ten biggest deals of the year.  There's an interesting set of stories here, from bankruptcy and regulatory issues (US Air/American Airlines),  private equity (Silverlake and Dell)  Warren Buffett (H. J. Heinz), industry consolidations (Publicis Groupe/Omnicom Group and Applied Materials/Tokyo Electron) and size - the third largest transaction of all time (Verizon and Vodaphone).  See the complete list and more detail here.

All the best,