Monday, September 28, 2015

Share Repurchases and Agency Costs Revisited

Ralph and I engaged in a debate about the use and abuse of share repurchases here , here and here. I thought it might be useful to revisit the issue as repurchases are on pace to eclipse the pre crisis 2007 record.

First some review. The major motives for share repurchases include:

1)     Reduce Option Dilution: less of an issue once the accounting rules changed and require the expensing of options.
2)     Valuation Signal: useful to close a value gap. Management signifies its belief in future cash flows by return cash to shareholders. Can be strong when debt financed. Usually in response to real or imagined activist threats.
3)     Dividend Alternative: with growth elusive and CAPEX modest free cash flow is building. Firms need to do something with cash piles or face criticism (e.g. Apple and Icahn). Either acquire (M&A is also at a record pace this year) or return the cash thru dividends or repurchases.
4)     Rebalance the Capital Structure: debt financed repurchases are being used to capitalize on cheap debt market conditions. Could achieve the same result using a debt financed special dividend.
5)     Manage EPS (i.e. earn bonuses): hard to increase earnings late in the economic recovery cycle. Thus, incentive to reduce share count via repurchases to achieve EPS target.

Warren Buffett reminds us to repurchase only when the price paid is less than the firm’s intrinsic value; otherwise, remaining shareholders will suffer a value loss. You would expect firms to repurchase shares when their prices are low. The evidence, however, indicates they repurchase when prices are high. This propensity to buy high is consistent with my suspicion repurchases are used to manage EPS, and not because managers are bad market timers. Share prices are also likely to have recovered later in cycle as well (i.e. they are relatively high). Consequently, management is likely to manufacture EPS growth thru repurchases at high prices.

Interesting empirical support for this conjecture is provided by Almeida, et al. They find the probability of repurchases is higher for firms that would have just missed their EPS forecast without the repurchase compared to firms that just beat their forecast. This suggests managers are likely to use repurchases to meet analyst EPS forecasts. Furthermore, they find managers are willing to cut investments in favor of EPS motivated repurchases. It appears late cycle repurchases, just like late cycle M&A, tend to have higher risk of being overpriced. In fact, record repurchases and M&A volumes may suggest the market has peaked (cyclical leading indicators?).

I am all for returning excess cash to shareholders. My concern is over the best method to return the cash-dividends or repurchases. My preference is to keep it simple-use dividends, regular or special, unless management can demonstrate a compelling alternative reason. Taxes may be such a reason. Nonetheless, since most shares are held by institutions this may not as important as you would think. Boards should carefully examine repurchase requests for firms experiencing difficulty in achieving analyst EPS forecasts-there may be an agency cost problem lurking in the request.


Thursday, September 24, 2015

Board Changes and the Director Labor Market: The Case of Mergers

Boards of directors perform the critical tasks of monitoring and advising management and it is logical to suspect that the necessary skills vary with the nature of a particular firm.  That is, a board should be chosen with consideration of the needs associated with advising and monitoring a particular business.  So what happens to boards after a merger?  After all, mergers change the nature of a firm, sometimes in dramatic ways.  Do boards change as well?  

In a recently revised working paper, David Becher, Jared Wilson and I examine this question. However, to ascertain whether board changes around mergers are significantly different from the status quo, we needed a benchmark of normal board changes.  To our surprise, there was little information available in the literature.  Consequently, our work provides evidence on changes around mergers but also provides a benchmark for normal non-merger changes.  

The abstract is below:

Board Changes and the Director Labor Market: The Case of Mergers
David Becher, Ralph Walkling and Jared Wilson

We examine the stability and composition of acquirer boards around mergers, contrasting changes with the same firms in non-merger years and a sample of non-merging firms. Contrary to perceived wisdom, the post-merger board changes substantially and variation is significantly different from both non-merger years and non-merging firms. Adjustments reflect firms upgrading skills associated with executive and deal experience and bargaining between targets and acquirers rather than agency motives. Conversely, director selection in non-merger years is driven by general skills and diversity. Our analyses provide insight into the dynamic nature of board structure and characteristics valued in the director labor market.

The complete paper may be downloaded here.

All the best,


Monday, September 21, 2015

Hewlett Packard‘s 21st Century Adventures: Stupid Is as Stupid Does

Hewlett Packard and its shareholders have suffered during the first 15 years of this century. I previously highlighted the issues here and here. The underlying problem is an attachment by HP’s CEOs starting with Carly Fiorina and continuing with current CEO Meg Whitman to a doomed attempt by a mature low-growth, hardware-based, old tech conglomerate to regain its growth mojo thru acquisition related consolidation. Back in 2013 I recommended an alternative path to grow old gracefully by managing for cash and returning it to shareholders instead of growth. This is a difficult recommendation for most managers to accept; they seem instinctively opposed to shrinking even when it is the right thing to do. I thought it might be interesting to see how HP has progressed as it approaches the split of its PC and printing business from its services group.

Some of the items I suggested and HP’s reactions are as follows:

1)     Improved Efficiency: lots of cost/job cuts-54,000 with another 30,000 planned. Unfortunately, margins and returns have remained weak as core revenues continue to decline. So “A” for effort but “C” for impact.
2)     Refocus Product Portfolio: still burdened with overly board product lines. Remains a work in process with a grade of “C”.
3)     Improve Focus: the split/spin off of the PC and printer divisions to HP, Inc and the service units to Hewlett Packard Enterprise should improve focus. Additionally, it allows more tailored financial polices-see # 4 and 5 below. Grade “A”.
4)     Improve Balance Sheet: the balance sheet and ratings were weakened by a disastrous series of acquisitions. The company’s net debt position was reduced to “0” prior to the spinoff. Post split, Inc will have a net debt of $2.3B while Enterprise will have $5.5B more cash than debt. Grade “A”.
5)     Improve Capital Discipline (i.e. increase shareholder distributions): dividends have increased, but represent only 13% of free cash flow (FCF) compared to IBM’s over 30%. Post split, however, Inc will payout 50-75% of FCF while Enterprises FCF payout is targeted at 50%. Grade “A”.
6)     Curtail Acquisitions: acquired relatively small Aruba Networks (revenues around $700 Mln) for $2.7B earlier this year. Seems to make strategic sense with manageable integration risk. CEO Whitman recently stated their M&A goal is not to do anything (again?)-sounds like a sensible approach to me. Grade “B”.

Lots of unanswered questions remain for the spun off divisions; overall grade-“A-“ Whitman has done “ok”. My concern is with revenue, margins and returns under pressure as reflected in a stagnating stock price, the HP entities will fall prey to the growth fetish and “do something stupid” again. Initially, Enterprise headed by Whitman will have more financial slack to do something stupid. Let’s hope that HP Inc and Enterprises accept financial reality and maturity by focusing on efficiency and capital disciple instead of growth. Their empires may be smaller, but their shareholders will be richer. Let’s hope the HP entities have fewer future adventures than they had over the first of the 21st century.


Thursday, September 17, 2015

Mylan, Perrigo and the Power of the Board

We've written before about Mylan and takeovers (e.g., Shareholder Centric or Stakeholder Centric and Offense and Defense in the Drug Industry).  This weeks Wall Street Journal contains an excellent article by Ron Barusch updating the Mylan story.  It presents a very interesting contrast between the takeover laws of Ireland, the Netherlands (where we teach the Acquisition Finance Course) and the US.  The facts below are taken from the article.

Mylan is attempting to take over Perrigo in a hostile deal.  Under Irish law, the directors of Perrigo can express their feelings about the deal, but must let shareholders decide on its merits.  If the deal fails, Mylan would have to wait a year before attempting another deal.  But the key is that shareholders - the owners of the firm, decide.

Contrast that with the situation of Mylan itself.  Mylan was a takeover target earlier this year when Teva Pharmaceuticals made a bid for the firm.  Mylan blocked the attempt by forming a "stichting", an independent foundation that is required to consider the interests of all stakeholders before approving a deal.  Giving the stichting voting control effectively blocks hostile takeovers.  Shareholders, the true owners of the company, lose the right to tender their shares for a premium.

Here is where it gets really interesting.  Shareholders can remove directors - but only with two-thirds of the voting shares and even then replacements are named by the board!  If the entire board is removed, "...the former chairman - that's right, the one who was just unseated- gets the powers of the board."

The article also discusses the shift in the US towards a more shareholder friendly governance structure with the elimination of poison pills and staggered boards and concludes by noting that Mylan escaped such moves when it became incorporated in the Netherlands earlier in a tax inversion.

Interesting reading and a warning to shareholders - the residual claimants and owners of the firm.

All the best,


Monday, September 14, 2015

Banks and the Clustering of Mergers and Acquisitions Activity

Industry structural changes are a major M&A catalyst. The changes inhibit incumbent firms’ ability to create shareholder value. This is reflected in the current clustering of M&A activity in the healthcare, technology and oil and gas industries. Banking has also seen increased activity in the number of deals. The deals have been primarily in the smaller community and regional bank segments. Hence, dollar volume is still off pre crisis levels. Larger Too-Big-To-Fail banks are still reluctant to seek regulatory approval. Nonetheless, banking has structurally changed since the financial crisis as reflected in weaker operating performance. Many bank, however, have yet to adjust to the changes.

This is reflected in lower economic returns, ROE less cost of equity, and consequently lower pricing multiples like price to book.  Pricing multiples reflect underlying operating performance. Pressure is building, primarily from activists, to improve returns. Banks who “get it” will enjoy improved returns and values e.g. Warren Buffet’s favorite bank Wells Fargo. They will likely force changes upon weaker banks that “don’t get it” like Bank of America which trades below book value. This will spur increased banking M&A-initially smaller transactions until a larger deal is pushed thru the regulatory log jam. My thoughts on this matter are outlined in my attached American Banker BankThink comment.


Thursday, September 10, 2015

Competition, Consolidation and the FTC: The Staples and Office Depot Deal

The Staples and Office Depot Merger is in the news.  Today's WSJ reports that the FTC is seeking sworn legal statements about the impact of the merger from those potentially impacted.  Here are a few quick thoughts:

  • Catalysts for merger include changes in technology.  In this case, the internet has had at least two impacts on the office supply market.  First, we are using less paper than before, shifting to a less-paper if not paperless economy.  Second, the internet has given rise to rivals like Amazon and Walmart.
  • These changes suggest the need for consolidation.  Both firms have closed hundreds of stores and two years ago Office Depot acquired Office Max.
  • Competition brought about the need to consolidate.  Ironically, the FTC worries that too little competition will remain if the deal goes through.  This, of course, depends on how one views the market and which products, competitors and regions are included in the analysis.
  • The Speculation Spread on this deal is huge.  The journal quotes the deal value for Office Depot at $10.35 with the current price of $7.64.  That's a 35% spread!  If the deal closes in three months that suggests a 142% gain on an annualized basis.  Of course, the spread is a direct indication that the market is highly skeptical the deal will be completed.
One thing is certain.  Something will change in this market.  Too few dollars chasing too many goods - combined with the fixed costs of the physical presence of the stores, insures this will happen.  We'll know more in October when the deadline for FTC action occurs.

All the best,


Monday, September 7, 2015

The Great Lie: Syngenta’s Rejection of Monsanto’s Bid

Hostile takeovers are a struggle by competing management groups over the control of the target’s assets. It involves a valuation dispute over which group has the best strategy yielding the highest value. The target’s management and investors frequently have different agendas. Management seeks job preservation; while shareholders want value. Consequently, the usual management response to an unsolicited bid, when supported by a compliant board, is to say no. The “no” characterizes the bid as undervalued and inadequate.  Of course, sometimes this is just a “play hard” tactic to negotiate a better price. More often than not it is just no especially when management lacks a substantial ownership in the target and has little to gain from the takeover.

Syngenta’s  rejection of Monsanto’s twice revised unsolicited $47B takeover is a prime example of management self interest trumping shareholder desires. Monsanto’s offer represented a 45% premium to Syngenta’s pre bid share price. Also, it included a $3B breakup fee (about 10% of Syngenta market cap) should the deal not receive anti-trust approval  (a real concern) within 18 months. When Monsanto finally gave up and withdrew its offer Syngenta’s shares dropped 18% while Monsanto’s rose 8.5%. Syngenta, facing angry shareholders subsequently announced a $2B share repurchase funded thru a combination of asset sales and debt.

Legally, it is very difficult to overcome the inadequate offer defense. All management and the board need to do is to get a report from a credible independent third party, for a fee of course, that places a higher value on the standalone target than the offer. Shareholders are then left with trying to replace the board and ultimately management at either the next shareholders meeting or a special meeting.
Now let’s look at some reasons why Syngenta’s management should be challenged:

1)     Fact versus belief: Monsanto’s offer is a fact while management’s value estimate is a belief. The belief seems a stretch give the size of improvements needed to equal the upfront 45% premium.
2)     Why now? Why hasn’t Syngenta achieved the improvements already? If a new team is involved why should they be any different than prior management?
3)     Why haven’t investors (the market) bought into the plan as reflected in a higher stock price? Are investors stupid or may be Syngenta’s investor relations group hasn’t explained it well enough? Alternatively, management’s plan may not represent the highest value for investors.
4)     Commitment: Where is management’s commitment i.e. betting their jobs on achieving the plan? Shouldn’t they post the plan’s metrics and timing and agree to fall on their sword if they fail to achieve it?
5)     Time Value and risk: Monsanto’s offer is now while management’s plan is to be achieved in the future and is subject to execution risk.

In my view, this case represents a brazen agency conflict between management and shareholders. As one investor put it-management needs to be reminded that shareholders and not management own the company. Hopefully management will be so reminded at the next shareholder meeting.