Thursday, July 30, 2015

Shareholder Centric vs. Stakeholder Centric - Mylan and Teva

So let me ask you a question?  As a person or institution about to invest in common stock, what do you expect of the board and management?  I'll give you my own answer: I expect them to maximize the value of my shares.  If I didn't have that expectation, I'd never invest.

My response reveals a shareholder centric attitude - that management works first and foremost for shareholders.  While such a view is overwhelmingly favored by independent experts in  corporate governance, it is by no means without some legal, management and even some academic dissent.  The alternative view is stakeholder centric - that management must consider the well being of all of its stakeholders when making decisions.  Stakeholders other than shareholders include employees, bondholders, customers, and even the community in which a firm operates.

Stakeholder centric requirements in the United States vary with State Law and Corporate Charters.  Different countries around the world take different viewpoints with some (Ireland) being more shareholder friendly and others (The Netherlands) being more stakeholder centric.

This was borne out with Mylan's recent rejection of a $40 billion takeover by Teva.  (For interesting details, see Mylan). Mylan, formerly a Pennsylvania corporation became dutch based in February as part of an inversion - where companies merge with other companies to change the location of their headquarters.  Typically this is done for more favorable tax treatments but it also has other repercussions for shareholders - in this case enabling management to espouse a stakeholder approach to the takeover and find support under Dutch law.  What are the repercussions of a stakeholder centric view?  I'll mention three:

First, companies that could be run more efficiently under new management are protected under existing management.  It can be cost advantageous - and beneficial to society as a whole to have the company acquired.  In some cases it is beneficial to society as a whole to lay off employees and focus the company in more efficient ways.  Companies protecting employees may resist such change.

To be sure, communities can be harmed when companies close plants, lay off employees and perhaps move their location.  But community or state or country protectionism is harmful in the long run.  Subsidizing inefficient operations may prolong the inevitable, but it avoids the obvious - uncompetitive companies will ultimately die and shareholders and ultimately all stakeholders will suffer.  Protectionism and cross-subsidization will ultimately fail.  The employees,  companies and communities that thrive are those that embrace change and continually adapt - keeping themselves competitive in a global marketplace.

Second, situations that can benefit shareholders - the residual claimants in a company can be rejected.  Not only is this unfair to the owners of a company, it is again ultimately destructive.  Few investors would invest in a company that doesn't look out for their own best interests.

To be clear, stakeholders are important and they deserve every consideration by management.  Even under a shareholder centric view, the best companies are conscious of the needs and obligations of their stakeholders and fulfill these claims in consideration of the competitive marketplace.  Usually the claims of stakeholders are also defended by other means including contracts, union, and laws.  Shareholders are not provided the same contractual certainties that stakeholders enjoy.  They are the residual claimant of a firm's profits.  They are entitled to everything that is left after all other expenses and claims have been paid - if there is anything left.  Shareholders are not guaranteed a profit, but have the benefit of knowing management and the board are looking out for their best interests.

Third, boards that take a stakeholder centric approach are answering to more than one master - not an optimal situation.  It is never clear whose interests should be pursued or which direction to follow.  The typical result is stagnation.

To be sure, laws that permit boards to reject takeovers based on stakeholder theory can also insulate management from needed change.

Thus, Mylan's shareholders have lost the opportunity to sell their shares at a substantial premium.  Share prices fell 14%.

All the best,


Monday, July 27, 2015

Mature Tech: Valuation and Pricing Lessons

Apple’s large price drop and the Google’s large price jump occurred within days of each other. They highlight how challenging tech valuation and pricing can be in a normal trading context let alone in an M&A setting. I find it useful to distinguish the different stages of tech firms to understand the economic dynamics. My scheme is as follows:

1)     Seed: idea stage with no established business model or revenues; private market valuation set by handful of optimists of questionable reliability.
2)     Early: established business model and revenues -profits hopefully to follow e.g. Square; price based on relative value compared to “peers”.
3)     Mature: great returns/profits but growth leveling off e.g. Apple and Google; key drivers are growth and returns.
4)     Old: declining returns with limited if any growth e.g. Hewlett Packard and IBM; focus on shareholder distributions and breakup asset values.

Recently, Apple and Google experienced large stock price swings. GOOGLE increased by 16%+ or $65B on July 17 while Apple fell 7% or $60B four days later. Ralph correctly notes stock prices are based on expectations not actual results.

Expectations are frequently based on extrapolations-sometimes sophisticated, but still extrapolations based on beliefs not facts. Once a new signal (which could be information or noise) is received, investors revise their prior beliefs regarding future operating performance-Bayesian updating or learning. Tech firms are inherently volatile given short product life cycles and their uncertain operating environment. Relatively small changes in expected growth rates can have a huge valuation impact.

Apple, although it had a great quarter, gave revenue guidance that shook investor growth expectations. Specifically, concerns over iPhone, iPad, iWatch and the next “big thing” caused investors to markdown growth estimates. It is still a great firm but was priced too high based on new growth estimates. This raises another issue-will Apple’s management try regain its growth “mojo” through expensive unfocused new product R&D and acquisitions? Remember they have a huge $200B+ cash pile and could do lots of damage. Hopefully activists like Icahn will keep pressuring them to return more cash to shareholders. Interesting to see how their management reacts. The record of aging tech firms refusing to age gracefully like HP is not a happy one.

Google benefited from a “twofer”. They had a better than expected second quarter. They also provided information on improving growth prospects for mobile ads. Equally important, their new CFO provided comforting words on expense and capital discipline. The problem with maturing tech is the discipline to manage the transition from high growth to more modest growth. Managing the transition has an important impact on expectations. Whether Google’s management can deliver on these raised expectations remains to be seen. If they disappoint then expect a subsequent large downward pricing adjustment.

My take is mature tech firms are fraught with agency cost issues which make them difficult to value. They will try to fight the transition to slower growth and try to manufacture growth through undisciplined capital allocation at the expense of returns and value. New management teams unburdened by legacy culture will be needed to avoid Microsoft-Nokia type M&A misadventures.


Thursday, July 23, 2015

Apple Profits Surge 38%; Price Drops 7%

The headline above, paraphrasing results in today's WSJ drives home a reality of the market.  It is not enough to outperform your past, you must outperform expectations. In an efficient market, past performance and future expectations are already discounted (i.e., reflected in price).  What matters is how you perform relative to those future expectations.  Indeed, in the case of Apple, sales of iphones were 35% higher than the same quarter a year before.  And sales more than doubled in China.  Not enough.  The market expected more.

A firm's stock price will always be forward looking, reflecting future expectations.  Deviations from those expectations, either up or down, will move the stock price.  Thus, prices move based on new not historic information.

So how does this relate to mergers.  In pricing a deal bidders (should) establish a walk away price based on their expectation about the present value of future cash flows once a target is under their control.  That walk away price represents the maximum the acquiring firm should pay.  But what is the minimum price the bidder can get away paying?

For a publicly traded firm, this minimum is generally above the prevailing stock price.  But here is where expectations come to play.  What if the prevailing stock price anticipates acquisition.  In this case the market price of the target is already inflated.  It doesn't represent the value of the target's assets in place but the value of those assets under new management.  Bidders need to be aware of this when setting bid premia.  Flatly paying a fixed premia over an inflated market price raises bidder cost, giving a bonus over values already incorporated in target prices due to the bidder's subsequent actions.  

Yet this is precisely what one influential analysis of bid premia implies.  Bill Schwert, in his paper Mark Up Pricing in Mergers and Acquisitions finds little correlation between previous run-ups and subsequent premia, implying that the runup (anticipation) is an added cost to the bidder.  Note that this does not necessarily imply that this is optimal or sub-optimal practice as we don't know the lowest price at which the bidder actually could have purchased the target.

It does imply, at least to me, the importance of keeping deals quiet before a bid is made.  It also suggests a psychological element to target shareholder behavior.

All the best,


Monday, July 20, 2015

Leveraged Lending Envy: Banks and Non Banks

Bankers and their supporters continue to object to regulatory leveraged loan leverage limits. The limits raise concern whenever transaction related Funded Debt to EBITDA ratios exceeds 6X. The usual complaints include:

1)     The Market and Bankers know what is best-not regulators
2)     Regulators are keeping banks from lucrative lending opportunities
3)     The lucrative opportunities will be picked up by less regulated non banks like business development companies (BDC)
4)     The restrictions are inhibiting the LBO market development and growth

Let’s take a look at these complaints:

1)     Market knows best: The tragedy of commons shows that some market equilibrium can lead to suboptimal results. Look at the concentrations(leveraged loan commitments YE 2007):
Merrill: $97B
Citigroup: $97B
JPMorgan: $95B
Goldman: $95B

2)     Loss of lucrative loans: lucrative loans usually have more risk than acknowledged. Consider leveraged loan 1Q08 provisions and charges for some of the major players:

Merrill Lynch: $1B; contributor in its forced sale to BofA
Citigroup: $2.6B; contributor in its subsequent failure and rescue
BofA: $700Mln; contributor to its need to be rescued
JPMorgan Chase: $1.4B
Wachovia: $500MLn; contributor to forced sale to Wells

3)     As I previously discussed-this is really a work in process whose outcome remains to be seen. Nonetheless, just because someone else is doing something stupid doesn’t mean tax payer guaranteed banks should follow them off the cliff. Private capital not subsidized by tax payers should be free to invest at whatever leverage levels they chose. Furthermore, bankers seeking BDC lending flexibility should keep in mind it comes with BDC capitalization levels which have substantially less leverage than banks. Sorry boys, you cannot pick and chose the good BDC features without taking the bad.

4)     Restricting the LBO Market: PE may complain that the restrictions reduce the availability of under priced bank loans. The response- is that so bad? Also, remember the restrictions focus on leverage greater than 6X. If you need more than 6X to make the deal work, then maybe the deal is overpriced.

The leveraged loan market, like other deal markets, such as real estate, is prone to boom and bust cycles. Lenders fixate on nominal not risk adjusted return as they are driven by incentive compensation to maximize their bonuses. Regulators trying to stop them face the same plight as someone trying to stop an individual from playing Russian Roulette who is on a winning streak. When that individual is subsidized by tax payers, as banks are, then it does not seem too much to ask to place some restrictions on leverage levels. The banks should be thanking the regulators for stopping them from hurting themselves.


Thursday, July 16, 2015

“Board Walk or Parked Place? Acquiring Firms and the Director Labor Market”

A lot of attention has been given to the composition of a firm's board of directors.  Much less attention has been directed to changes in the board of directors, particularly around major events.  An important literature does address changes around mergers, but concentrates on target firms.  What about acquiring firms?  After all, mergers can represent dramatic shifts in the evolution of a firm.  It makes sense that monitoring and advising needs of boards should evolve as well.  The only evidence we do have on acquiring board changes around mergers suggests relative stability with few changes.  This evidence comes from the examination of target firms which finds that target directors are not often retained by the acquiring firm.  If these are the only changes, general stability of the acquiring board is implied.

In recent research with my colleagues David Becher and Jared Wilson, we find that stability is far from common with acquiring firm boards.  There are significant and substantial changes of boards over time and the changes are significantly different around mergers.  As just one indication the post-merger board typically consists of 7% target directors, but 11% of new directors unaffiliated with either target or bidder before the deal.  In addition, board size often changes either increasing or decreasing


"This paper examines the stability and composition of acquirer boards around mergers.  Contrary to perceived wisdom, composition of the post-merger board changes substantially and these variations are significantly different from both non-merger years and non-merging firms.  These adjustments reflect firms upgrading skills associated with executive and deal experience.  Board changes also reflect bargaining between targets and acquirers rather than CEOs seeking a more friendly board.  Conversely, director selection in non-merger years is driven by general skills and diversity.  Overall, our analyses provide insight into the dynamic nature of board structure around mergers and characteristics valued in the director labor market."

All the best,