Monday, November 24, 2014

Audacity of Hope: Halliburton - Baker Hughes Acquisition

The energy sector is under immense pressure due the collapse in oil prices. This will drive M&A activity as firms seek to adjust. Halliburton, the oil services industry  #2, made a $35B Bid for Baker Hughes, the #3 player, in an attempt to close the operating and valuation gap with industry leader Schlumberger. It represents a large, richly priced and risky transaction.

Ordinarily, the buyer’s price falls following a bid reflecting investor concerns with the deal such as being over priced. Usually, the pro forma value of the combined entity, however, increases. In the Halliburton situation, the combined value actually fell. It reflects both a 10%+ drop in Halliburton’ stock price and Baker Hughes trading at $66 p/s compared to the $78 p/s offer price-which illustrates investor concern with the deal’s large antitrust hurdles.

My issues with acquisition are as follows:

1)     Size: the target is almost the same size as the acquirer. This raises integration issues.
2)     Premium: the 50%. My belief is anything over 40% for a major transaction is difficult to justify.
3)     Shareholder Value at Risk (SVaR): SVaR, combination of premium and size, is huge making this a potential “bet-your-company” type of deal. Halliburton’s management is risking 50% of its shareholders’ pre bid value on this deal.
4)     Antitrust Risk: Halliburton will pay Baker Hughes a $3.5B breakup fee if the deals fails to obtain antitrust approval. This is a significant issue given the combination of the industry’s #2 and #3 firms. Some estimate divestments representing $7.5B of sales may be needed to obtain approval.
5)     Consideration: the deal is 25% cash. Halliburton is using its stock, which trades near its 52 week low, to fund the remaining 75%. The use of potentially depressed under valued stock constitutes another source of over payment.
6)     Synergies: the estimated $2B in cost cuts exceed what observers had estimated-especially in a down market. Projections should reflect reality. Here, I wonder if reality is not being reshaped to fit the projections.

The deal is being justified as strategic, and it may well be. Nonetheless, it must still make financial sense. I am reminded of my former boss who used to say “strategic” is a code word for “over priced”.

Halliburton must have been influenced by President Obama’s book-The Audacity of Hope”. Hope, however, is never a good M&A strategy. Hewlett Packard is the current poster boy of bad acquisitions. I think Halliburton is making a strong move for that dubious honor with the Baker Hughes transaction. No wonder why their shareholders are so concerned.


PS  We will not publish Thursday in observance of the American Thanksgiving Holiday.  To all of our friends worldwide, we wish you peace and happiness with your families. 

Thursday, November 20, 2014

Actavis, Allergan, and Ackerman's 2 Billion Dollar Day

The Allergan saga repeats many common themes of mergers:

  • An activist sees ways to improve share-value and targets a company.  In this case Ackerman and Valeant thought Allergan could maximize value by slashing R&D
  • The target management disagrees and then takes defensive actions including a) seeking a white knight b) threatening legal action and c) doing many of the same things the activist proposed anyway.
  • A white knight arrives touting great synergies and offering more than the activist.  Shareholders of the target (Allergan) gain.   (This step is often missing and shareholder welfare might not be maximized.)
  • The activist gains on increased value of the toehold position in the target.  (See Bill Ackerman's $2.2 billion day.)
Often in these situations there is another theme: the winning bidder overpays (i.e, the winner's curse).   In this case, the CEO of Activis "admitted Actavis paid up for Allergan. ‘But in the midst of doing that, we got a company and a team that shouldn’t have been up for sale,’ he said during an interview. ‘This is a once-in-a-lifetime, a unique opportunity to transform our industry.’" See Actavis Agrees)

We’ll see.  In fairness, the stock price of Activis rose on the announcement.  A win-win-win for target shareholders-activists-acquiring shareholders?  That usually doesn’t happen.

All the best,


Monday, November 17, 2014

When Numbers Get Serious

As the Paul Simon song goes “… when times are mysterious serious numbers will always be heard…after all is said and done… two becomes one.” This may explain what is happening in the Venture Capital driven tech world with its current nose bleed valuations/pricing. Venture Capital, like its related deal market cousins-Real Estate and Private Equity, is cyclical. Venture Investing is based on funding capacity not fundamentals as investors, especially limited partners, chase past yields.

The cycle runs as follows:

1)     High returns from successful exits triggers more fund raising
2)     Funds scammer to invest raised funds leading to increased deal competition and pricing
3)     Higher pricing producers lower returns and accidents which reduces fund raising
4)     Less funding capacity leads to reduced pricing, better deals and higher returns
5)     Repeat cycle

Funds are unable to resist due the Prisoner's Dilemma problem. We last saw this in the 1990s with the dotcom boom and bust. The bust lasted until 2012 as funds worked thru their problems and investor memories dissipated. In 2013, Venture Capital enjoyed its highest return since 1999 according to Cambridge Assoc due to some highly successful IPOs. Investors rushed in to invest and fund raising exploded. Tech pricings have followed suit.

Venture funds have developed a new approach to invest this embarrassment of riches accelerated funding. It follows from the observation that the highest returns (note-NOT risk adjusted) are from the largest exits. In this winner- take- all environment (first mover advantage?) it pays to identify winners (start-ups on the verge of breaking out) early and bet/invest heavily in them regardless of current prices. This, of course pre-supposes you can identify those winners before anyone else. This seems like a stretch given the hundreds of firms looking for such winners.

Essentially what is happening, in my view, given the lack of a fundamentals based valuation anchor, is the former series A seed capital financing round is morphing into a hybrid series B growth financing round. Series B, however, had required an externally based proof of concept with a viable revenue model. This seems to missing in the application of the accelerated funding model.  The impact of this development is pricing for IPOs and related M&A is skyrocketing as no one wants to avoid missing the next Facebook. This assumes Facebook ‘s success is based on repeatable skill not luck. The result is great for founders, but scary for investors.

Eventually, prices fall and IPOs fail - leading to a quick re pricing when serious numbers return leading to 2 becoming 1. Paul Simon was very perceptive and may offer some cautionary lessons for tech investors. Venture Capitalist must be attentive of cycles and beware extrapolating recent positive trends.

Sorry to rain on the parade.

Thursday, November 13, 2014

Ownership and Control

I read an interesting blog recently about ownership and control.  The post (available here) was written entirely from a legal perspective and dealt with courts deciding if there was a controlling shareholder. This makes a difference in legal standards regarding fairness in mergers and acquisitions.  Certainly, one has control of the firm with ownership exceeding 50%. In most of the cases considered, the shareholders held sizeable blocks of shares, often close to, but just below 50% and the courts were trying to decide if there was de facto control.

If we are talking economic reality, there is considerable evidence that even very small  levels of ownership can influence board decisions and corporate behavior.  In fact, the literature is so large, that I couldn't begin to do justice to it in this blog.  Suffice it to say, that it is standard to control for insider and blockholder ownership in analyses of corporate events and substantial research has shown that even small levels of concentrated ownership can affect decisions.   Indeed, even twenty years ago, one article involving executive ownership showed a different relation between CEO turnover and performance in cases where the ownership level exceeded 1%.  Above this level, there was an insignificant relationship between turnover and performance.  The article also found that turnover rates were higher in firms with unaffiliated blockholders and lower in firms where blockholders were associated with management.

In an even older article by the author, we compared resisted and unresisted mergers and asked the question, "Why does management resist?"  It wasn't the bid premia - they were insignificantly different across contested and uncontested deals.  It wasn't the other terms of the deal, they were also similar.  The only factor that differentiated the cases was managerial ownership.  Consider the potential conflicts, if a deal succeeds management is much more likely to lose their jobs.  From a personal standpoint (as opposed to shareholder welfare) it may be optimal to resist.   In cases where management resisted, the only significant differentiating factor was managerial ownership.  Where management had even slightly higher levels of ownership, and hence stood to gain more from the deal in selling their shares, they were significantly less likely to resist.  In other work, we have shown that managerial resistance is the single most important factor in predicting whether a deal is completed

Since the time of thoses article, there have been scores of papers finding links between ownership, control and corporate decisions in general.  So yes, ownership matters and it can affect control at levels substantially below any 50% threshold.

All the best,


Monday, November 10, 2014

Choose Wisely

I am fascinated with the technology industry-not because of the technology itself, but the pace of industry change. Company life cycles are measured in years compared to decades in other industries. The half life of T (The competitive advantage period) is frequently less than 5 years. This allows us to observe and study how firms are handling maturity. The basic choice is to grow old gracefully by curtailing investments and returning excess cash to shareholders, or try to spend your way back growth.

This was best put by Google’s Larry Page FT who stated his firm, although still growing, risks irrelevancy if it is unable to keep pace with market developments. He hinted at setting up a holding company structure to make diversifying bets (acquisitions) like Warren Buffett’s Berkshire Hathaway. Firms like IBM and Microsoft have chosen to age gracefully and return cash to shareholders who are then free to find the next tech generation of winners. Others, such as Facebook, are seeking transformational M&A to retain their growth status. The problem firms like Google and Facebook who chose to fight aging is they risk an arms race with other cash rich tech competitors battling for supremacy in an evolving digital environment. This leads to ill advised over priced transactions like Hewlett Packard experienced in its 14 year computer adventure which it recently decided to end thru a spin-off of its disparate divisions.

Tech firms considering reinventing themselves by acquiring should consider the following:

1)     What is strategic motivation? Growth alone should be a consequence of strategy not a strategy itself. What competitive advantage in terms of products, technology, market extension, pricing power, or cost advantages are to be gained?
2)     Are there alternatives to acquiring (i.e. internal development)?
3)     Can you identify appropriate targets? These include targets that can exploit market developments-quickly and efficiently scale operations. You acquire firms not technology.
4)     Can you acquire at a reasonable price (i.e. not overpay relative to value)?

It is difficult to value early stage or rapidly growing targets, which often lack an intrinsic value. Rather, their price is determined by what buyers are willing to pay based on current, potentially overheated, market conditions. The lack of an intrinsic value anchor makes such transactions prone to be over priced. Buffett believes firms lacking an intrinsic value are worth only what some other buyer is willing to pay for them. Hence he believes they are speculative and not long term investments. This is the reason he avoids tech firms now just as he did during the 1990s dotcom boom.

You can inject an element of discipline thru a reverse engineering process. This involves solving for the level of sales and profits needed in 5-10 years to justify the offer price. Keep in mind the caveats. First growth requires investments (CAPEX, R&D and working capital). This investment reduces free cash flows and ultimate value. Second time is not your friend. The more distant the cash flows either initially planned or due to delays, the lower the value. See my previous post applying this approach to the Facebook-Whatsapp Acquisition. Whatsapp reported 1H14 sales of around $15mm and a loss of $235mm. They claim the potential still remains, but realization is delayed. The potential growth needed is huge and preliminary results are not encouraging.


Thursday, November 6, 2014

ZOPAs, Zones of Potential Agreements, Oil Prices as a Catalyst

Deals exist because buyers and sellers place different valuations on assets.   More to the point, when buyers place higher values on a company than sellers, deals can be made.  In theory, a necessary condition for deals to occur is a ZOPA, a zone of potential agreement between buyers and sellers.  For example a seller thinks a company is worth at least 30 euros per share and a buyer is willing to pay 35 euros.   The ZOPA is between 30 and 35 euros.  Where will the deal occur?  If it does occur, it should happen between 30 and 35, the exact value depending on the bargaining power of the two sides.

But a deal won't always happen in a ZOPA.  In fact, evidence indicates that often deals occur outside a ZOPA and fail to happen inside a ZOPA.  Negotiations can be complicated and influenced by all sorts of behavioral and economic factors beside the raw numbers.  A seller may be turned off by the aggressive nature of a bidder, even when an agreement could be reached. A buyer may turn against a deal in the face of increased uncertainty in the economy.

The latter seems to be the case in the oil industry.  A report in the Dallas Morning news reports that deal are in limbo after the recent drop in oil prices.  In our terms, the ZOPAs have disappeared.

All the best,