Monday, August 17, 2015

M&A Activity and the Precision Cast Parts Deal: All M&A Is Local

Ralph’s previous post focused on some questionable M&A motives driving current M&A activity. My experience suggests M&A waves are driven by managerial risk appetite amplified by leverage. Risk appetite is a function of wealth. Managers feel wealthy when their stock price is high(er) reflecting robust earnings. This wealth based confidence encourages them to use leverage, especially when rates are low, to enhance their buying power i.e. do bigger and more expensive deals. Other factors include the pressure to grow and to match acquiring competitors (no one wants to look wimpy). These characteristics underlie the cyclical and mixed M&A record of most acquirers.

Just as in politics, all M&A is local i.e. deal specific. I previously listed a checklist of factors characteristic of questionable acquisitions. The rest of the post focuses upon using the checklist factors to evaluate Berkshire Hathaway’s (BH) announced Precision Cast Parts (PCP) acquisition.
The application is as follows:

1)     Size: bigger transactions entail more financial and integration risks. PCP, while large in an absolute sense, represents less than 10% of BH’s market value. The SVAR appears reasonable as well given the relatively modest premium paid (more on this later). Integration risk is low given BH’s conglomerate strategy of having PCP operate as an autonomous standalone entity. The enduring wisdom of conglomerates will be tested once the uniquely qualified Buffett is gone. Alternatively, I may have misclassified BH as a conglomerate. It could be a stealth PE firm with permanent capital and extremely long hold periods. PE firms operate their portfolio investments on a standalone basis and thereby have low integration risk.
2)     Consideration: using stock indicates a lack of confidence in the acquisition. Here, BH is offering a 100% cash deal-suggesting lots of confidence
3)     Financing: over leveraged (i.e. non investment grade) transactions limit the flexibility to realize on the target’s potential. BH is funding the deal 2/3rds with equity (excess cash) and the remainder with debt. It will operate under the BH investment grade umbrella as well. Thus, flexibility is high.
4)     Buyer: weak deals involve weak buyers buying out of desperation frequently to cover up operating problems. BH is a strong and experienced buyer.
5)     Deal Type: high risk transactions involve transformational and turnaround aspects. This is more of an opportunistic acquisition of a well performing market leader; albeit one operating under some performance problems in its energy sector. Time will tell if the sector recovers-that is the bet.
6)     Timing: acquisitions made later in the M&A cycle are highly competitive and prone to being overpriced. The current M&A cycle could be view as closer to late stage given its current record volume pace. Nonetheless, even in the later stage, it is still possible for disciplined buyers to avoid overpaying as is the case with PCP with a modest purchase premium.
7)     Price:  it appears BH got a relative bargain-subject to due diligence verification. Investors concerned about PCP’ slumping energy segment dumped the stock causing a 30% price drop from the LTM high since the beginning of the year. BH’s modest 20% premium (well below the 40% red zone) is actually 15% below the LTM high. This is rare as most deals are closed above the LTM high which serves as a pricing anchor. Furthermore, the price represents a modest 12X forward EBITDA and 18X forward earnings-both of which (EBITDA and earnings) are expected to be flat this year. BH pricing is similar to PE not strategic acquirers (perhaps, BH is a PE firm not conglomerate after all). BH is capitalizing on a discrepancy between public and private valuation. The question is why PCP would agree to sell at that price?

 Bottom line, BH remains a disciplined buyer able to make promising acquisitions even in a difficult market following a proven formula. As with most things Buffett does-it is easy to understand, but difficult to copy. Unfortunately, many acquirers are prone to the dubious M&A rationales outlined in Ralph’s post.


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