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.

J

Merger Activity - A Record Year?

Tuesday's Wall Street Journal contains a very interesting article on this year's merger activity. (See Merger Activity is on Pace for Record, by Dana Mattioli and Dan Strumpf).  Citing Deal Logic as a source, the authors note that if the current pace of deals continue, it will outpace 2007 - the last record year.  Illustrative of this is Berkshire Hathaway's $32 billion deal to acquire Precision CastParts Corp.  the largest deal in Berkshire's history.

What interests me most about the article are the reasons cited for the large number of deals.  We've covered most all of these in these posts - and also urged caution.  Some of the main issues are noted below:

• Low interest rates - and the fear future rates will rise
• Executive confidence
• Fear of being left behind
• The desire to boost growth through acquisitions (as growth from other sources becomes limited)
• The "economy isn't in free-fall"
• Accumulated cash on acquirer balance sheets

I firmly believe these concepts are on the minds of today's executives and I don't doubt they are driving deal activity.  What concerns me is that with the possible exception of confidence none of the reasons are valid by themselves for doing deals.

Sure, low interest rates are better than high rates, but if a deal doesn't make strategic sense, low rates are not a sound motive for doing deals.  (See Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price).  The same is true of fear of being left behind.  On the face of it, it implies a 'keeping up with the Jones' mentality. It could also imply an 'eat or be eaten' mentality.  While shifting landscapes are certainly catalysts for deals, it is important to understand the economics behind these shifts.  Again, deals that fit the strategic plan of the company are best and sometimes the best deals are those you don't attempt.  In some situations, selling the company is actually the best move for shareholders.

Joe has talked extensively about the attempt to boost growth through acquisitions.  If the benefits don't exceed the costs, the deal is bad, even if it produces a short term boost to earnings.  Unfortunately, it can be easy to get caught up in deal fever and overestimate benefits and understate the difficulty in integration.  (See A Man Hears What He Wants to Hear).

The economy not being in free fall is a good thing, but hardly enthusiastic support for doing deals.  Finally, accumulated cash is absolutely no justification for doing deals.   Each company must ask - can I earn a superior return on this cash for my shareholders.  If not,  it should  be returned to its owners - the shareholders.

So this brings us back to executive confidence.  Confidence can be driven by many desirable qualities - knowledge and experience come to mind.  Confidence can also be driven by emotion and influenced by every one of the other factors in the list.  Bottom line - only attempt deals that make strategic sense and that are justified based on a hard look at the costs and benefits.  Without this step, none of the other items matter.

All the best,

Ralph

Private Equity: Aging Cyclical Business Model?

Private equity is a mature asset class that is enjoying an excellent fund raising cycle. According to Prequin, 1Q15 fund raising topped $104B just $7B shy of a very robust 1Q14. Continued strong equity and IPO markets allowed PE funds to liquidate portfolio holdings at attractive prices and return substantial capital to their limited partner investors. These investors may be chasing yield based on past performance by reinvesting in new funds. For example, they committed $17B to Blacksone's latest fund in just 7 months, among others.

Strong fund raising combined with weak investing prospects have raised the level of PE dry powder to over $1.2T (that is in trillion not billion). PE investments both in number and dollars (excluding the hybrid 3G-Berkshire Hathaway Heinz-Kraft $40B deal) have fallen to their lowest level since the crisis year 0f 2009. PE is being out-bid by strategic acquirers in a buoyant M&A market. Thomson Reuters  reports that domestic M&A is up by over 30% 1Q15 to over $415B-heavily skewed towards larger $5B+ deals. Furthermore average purchase price multiples top 12.5X EBITDA with premiums in excess of 37% in an already frothy stock market.

Remember, PE adds value in one of 4 ways:

1)     Buying Right (i.e. not over paying): this is difficult when strategic acquirers are offering such high premiums.

2)     Financial Engineering (i.e. high leverage): complicated by bank regulator guidance frowning upon FD/EBITDA leverage levels above 6X. Current new deal leverage is stuck at around 6X. The PE math (not risk adjusted) is difficult when you pay 12X and can only leverage lever up 6X.

3)     Multiple Expansion (i.e. sell high): little room for multiple arbitrage (buying cheap in the public market and subsequently selling higher in the M&A takeout market) at current price levels.

4)     Operating Improvements (i.e. grow EBITDA): the easy stuff has already been done; the big payoff requires some special strategic sauce like 3G is doing with Kraft-combining it 3G’s prior Heinz acquisition. This is both difficult and rare for PE.

PE is a mature asset class experiencing a cyclical recovery. GPs will have a difficult time profitably investing. Make no mistake, however, invest it they will (otherwise they forgo substantial fees) leading to some unhappy returns for current LPs. This is just the nature of the pro cyclical boom and bust PE cycle. There is just too much capital to deliver superior risk adjusted performance across the market cycles thru differentiated strategies. The former persistence of superior returns in certain top tier funds has disappeared suggesting just competitive the market has become. LPs should beware of investing at this point of the fund raising cycle.

J

Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J

Lessons Worth Remembering

Warren Buffett’s letters are always worth reading. The 2014 letter is no exception. In this post I will comment on three acquisition related topics raised in that letter. The first topic concerns risk. He highlights that risk is not volatility. Risk is the exposure to consequences from uncertain events leading to permanent capital loss. Academics focus on volatility because it is easier to measure and quantify than the exposure based definition. Nonetheless, putting a probability distribution (usually the highly questionable normal distribution) on an event does not make it less certain. Worse, it can lead to unjustified over confidence leading to Black Swan type surprises. Most of what passes for risk analysis is nothing more than simple extrapolation of recent history. It is experience v exposure based. Furthermore, it ignores perhaps the biggest risk of all in M&A; namely price risk (see next paragraph). We should instead focus on total v systemic risk and use scenario analysis and sensitivity charts to gauge its effect.

Next, is the need to distinguish intrinsic value from price when evaluating acquisitions. Premiums to market and comparable transaction multiples relate to the price you have to pay now. Intrinsic value concerns what you hope to receive in the future. They are not the same thing. Keep in mind the following:

1)     What you pay = pre bid price + premium

2)     What you get = standalone value + synergies

3)     Usually the pre bid price equals the standalone value - if markets are reasonable efficient

4)     Thus, the transaction’s net value added depends on synergies exceeding the premium

Synergies are of course an expectation-hence risky as they may not materialize. The key is to avoid fanciful synergies-leave a margin of error/safety to cushion your downside if something unexpected (risk) occurs. Gauging the validity of synergies considers the following:

1)     Expense cuts are more believable than revenue growth

2)     Acquirer’s track record. An experienced acquirer has better chance of achieving synergies

3)     Expected performance consistent with industry base rate

4)     Acquirer is the best owner of the assets based on business model fit

Last, avoid playing the EPS bootstrapping game. Initially, you can always increase EPS by either acquiring a firm with a lower PE ratio than yours (using your stock as currency) or borrowing to acquire the target’s earnings stream. Post close your PE ratio will adjust to reflect the quality of earnings, growth and risk involved - AKA there” ain’t no free lunch or magic”.

The above represent simple principles to follow when in the heat of a transaction. Although simple to express they can be difficult to apply and seem to be constantly re-learned .

j