Corporate Governance, Acquisitions and the Interdisciplinary Connections of Business

Corporate Governance and Acquisitions are two distinct topics that cut across countless other topics - and certainly each other.   Acquisitions, for example, encompass so many different aspects of business.  First and foremost is finance.  We need finance to understand our financial projections, to make sure that the net present values are realistic and that the terminal growth and other assumptions are appropriate.  But that present value model of finance is derived from estimates of every other area of business.  Cash flow projections initially depend on sales projections from marketing.  Logistics are part of the marketing estimates as well.  If projections start with sales, they travel through accounting regulations on their way to cash flow.  Information systems are crucial avenue for decision making before, during and after acquisition.  Legal restrictions (regulatory and deal specific) permeate acquisitions.  Behavioral finance and the decision sciences are crucial for informed and unbiased decisions.

Last - and unfortunately often considered least - is the fact that all projections, all synergies, and ultimately all results,  are driven by people.  Numbers are essential, but without the proper personnel they are meaningless.  A business and hence its cash flow, work only through people.  It is true for the goods and services a firm delivers and it is true for the decisions executives make.  Numbers don't make decisions.  People make decisions.

Which brings us to Corporate Governance.  Corporate Governance involves the alignment of owners and managers and like acquisitions impacts (and is impacted by) virtually every area of a business.  It is certainly true that many deals are driven by an opportunity to increase value through better governance.  In private equity, for example, a firm may be taken private to better align incentives for owner-managers.  In other cases, internal governance structures have failed to maximize value - external governance mechanisms (like acquisitions) rush in to fill the vacuum.  

In (a) separate post(s), I'll write about two of Drexel's premier events held recently in Central Philadelphia.  The first is our 6th Annual Academic Conference on Corporate Governance.  The second is our 5th Annual Director's Dialogue, a program on governance by and for practitioners.

All the best,

Ralph

Dell: The "Really" Real Issue

Holman Jenkins “The Real Dell Issue Is Michael Dell”,  March 13, 2013 Wall Street Journal opinion piece raises the right issue. Michael Dell is under no obligation, legal or moral, to offer shareholders a higher price. The “really” real issue is whether his offer should be accepted despite his having shareholders over a barrel due his inside control position.

Dells’ intrinsic value depends on the strategy employed and the management executing it. The current strategy involves diversifying away from its declining legacy core PC business towards a solutions based model. Unfortunately, others, including IBM, HP, Oracle, EMC, and Cisco, had the same idea years ago, and have established themselves as formable competitors in this sector. Despite years of trying and over $7B of questionable acquisitions, Dell is no closer to achieving its stated goal. Trying to accomplish this task in a highly leveraged capital structure is even more questionable. Hence, the pre bid price accurately reflected the then current intrinsic value based on its currently announced strategy. Nonetheless, all is not lost as Dell has a huge cash pile and still generates considerable free cash flow.

Michael Dell, is a very smart person.  My belief, or should I say suspicion, is that he recognizes the situation, and is prepared to change course towards an alternative higher value strategy. Namely, stop the diversification, manage Dell for cash and utilize the cash pile. This would likely increase Dell’s value. Unfortunately for Dell’s shareholders, Michael Dell understandably does not want to share the upside with them. Conveniently, the Dell Board has concluded that alternatives for sharing the upside, such as a leveraged recapitalization, would be less attractive to Dell shareholders.

This is the “really” real reason behind major shareholder resistance to Dell’s offer by Carl Icahn and others. Jenkins, while acknowledging this issue bemoans, the lack of alternative higher price offers. This issue here, however, is information and timing. Recently, interested parties like Icahn have signed non disclosure agreements giving them access to inside information that previously Michael Dell exclusively enjoyed. I expect that based on this information competing higher priced offers may be forthcoming. We are still in the early innings of this game. So I would suggest to Jenkins that he hold on a little bit longer as good things can come to those who wait.

j

Dell - Icahn: March Madness!

I have expressed fairness concerns about the proposed Dell insider LBO. See the February 8, 2013 post “The dell LBO: Existing Shareholders Lookout Below”. Until recently, it appeared that despite the resistance of minority shareholders like Southeastern, the deal would proceed at the original $13.65 per share offer price. Quite simply, no other bidder could or would challenge the Michael Dell-Silver Lake sponsored deal, which Dell’s board had blessed as the best alternative. Luckily for the minority shareholders, not so lucky for Mr. Dell, et al, Carl Ichan has entered the fray. He is proposing a special $9 per share shareholder distribution funded via use of excess cash and debt. He believes the this combined with the remaining “stub” value of $13.80 per shares offers a better value for all shareholders-not just Michael Dell-Silver Lake.

The nub of the issue is related party LBOs is always prone to abuse. The proposed Dell deal is especially suspect given its large cash position. Undoubtedly, as 4Q12 results indicate, Dell’s legacy PC business continues to decline. Nonetheless, it remains cash positive and has large liquid resources. The offer price, although representing a substantial premium over the pre-offer trading price, is at a large discount to Dell’s 52 week high price-a usual selling shareholder reference point. Furthermore, based publicly available information, a higher fundamentals based price could be reasonably crafted. Dell’s share price has increased following the mounting pressure by about $1 per share as investors sense that the offer price needs to raise to avoid Ichan’s ‘years of litigation’ threat.

Some lessons I see from this unfolding sequence of events are as follows:

1)     Honesty is still the best policy: The Dell “short sighted market doesn’t understand” the reason for going private which was never very convincing. Trying to complete a turnaround in a highly leveraged LBO structure would complicate not simplify the prospects. The real reason was to capture the upside benefits for the buyout group-in particular the large net $7.4B available cash position. Interestingly, the Dell group plans to bring the foreign cash home and pay the tax penalties after years of saying it could or would not return the cash due to tax considerations.

2)     Sharing is nice: Consider sharing the upside with Dell’s long suffering shareholders rather than trying to keep it all. A special shareholder distribution involving utilization of available net cash and a debt financed share repurchase would have allowed shareholders to participate in the transaction. Also, it could have avoided the auction requirements in a going private transaction. I would love to see the Board’s analysis in rejecting this alternative.

3)     Don’t be a pig: Absent sharing, at least offer a price that does not embarrass existing shareholders like Southeastern who has a $15-16 investment basis. Let them walk away- if not happy –at least not mad.

4)     Over disclose to increase the trust level: Provide valuation information to an independent third party like The Shareholder Forum, Inc with appropriate confidentially safeguards. This would supplement the less independent traditional fairness opinion provided by the company hired investment bank.

5)     The Michael Dell Rule: When he is buying you should not be selling. He does not appear to be minority shareholder friendly.

Ultimately, the next steps in the drama include Dell dropping the deal, increasing the price, providing more information, or letting the shareholders share in the deal. God bless Carl Ichan-he is doing God’s work here-of course for a fee, but that is ok.

J

The Dell LBO: Existing Shareholders Lookout Below ?

                                                      

Details on the recently announced Dell LBO are interesting. First the deal is creditworthy. Michael Dell ($4.50B) and Silver Lake (1.4B) are investing almost $6B in equity thru rollover and new equity. This is supplemented by junior capital of $4B provided $2B each by Microsoft and de facto subordinated existing bondholders. The remaining $15, or so, of new bank provided senior debt will be supported by a strong 40% junior capital position. Add to this excess cash of over $7B being repatriated from overseas at a substantial tax penalty, and  projected annual $3B of cash flow, albeit declining, should comfortably cover annual debt service. Estimated credit ratings in the BB range reflect these facts.

Just because something can be done does not mean it should be done. Something still does not make sense. The transaction is justified as accelerating the transition from PCs to services by removing Dell from the distracting spotlight of the short term public market. The question is how? The increased debt, while supportable, reduces flexibility. Debt service requirements, unlike discretionary dividends and share repurchases, combined with new debt covenants will hamper Dell’s transition strategy implementation-especially if something goes wrong and new investments are needed. This is a key concern as Dell faces deep pocket investment grade competitors like IBM as it repositions itself. Already, HP has announced they will go after Dell’s PC customer given Dell’s increased financial vulnerability.

Next, and perhaps most importantly for Dell’s existing shareholders, the Dell investor group has yet to disclose what it will do differently, and more successfully, as a private firm than it has done as a public firm. Dell has been trying for years to reposition itself all with mixed results. This is the reason for Dell’s sagging share price. The market may not be short sighted as much as it is skeptical, given existing performance. So what is different once Dell goes private? Is there some secret sauce that has yet to be disclosed, and if so, why has it not yet been disclosed? If they have a new secret and credible, turnaround sauce, then disclose it and the market will reward the firm with a higher valuation. Of course, under that approach, Michael Dell and his investor group have to share the upside with existing shareholders instead of capturing all of it for themselves.

Could it be the investor group is planning to immediately dispose of the ailing PC business? Another possibility could be a planned special dividend to the investor group after the deal closes using some or all of the repatriated cash. This would effectively reduce the investor group’s investment basis thereby giving them a free upside option.  Perhaps, there is a good reason for the shareholder class action suits filed upon the LBO announcement.

Perhaps, I am just a confused skeptic. Alternatively, I smell a rat. Given Michael Dell past actions, when he is buying, you do not want to be selling. So for existing shareholders, the Dell LBO may indeed mean lookout below.

Your confused skeptic -Joe

The Dell Stock Repurchases Program - Hmmmmmmmmmmm

Ralph and I have an on-going debate on the merits (Ralph) and demerits (me) of share repurchases. My point is not all repurchases are the same. Some may be value enhancing. Others, however, are not. They can be used by executives to manipulate earnings per share (EPS) to improve their option values.

Floyd Norris' January 18,2013 New York Times article on the misuse of repurchases at Dell provides a cautionary tale for shareholders. He analyzed Dell's long running approximately $ 40 B program. He concludes over priced repurchases benefited corporate executives at the expense of long term shareholders. Michael Dell, Dell’s founder and largest shareholder, was a substantial option recipient. His gain is estimated at over $650 MM. Executives would profit if Dell stock price increased following a decline in the number of outstanding shares post repurchase compared to a dividend. This encouraged repurchases to offset potential stock price weakening by increasing EPS as operations began to mature. This occurred despite the negative impact on long-term non-tendering shareholders. This occurred because the repurchases, being over priced, transferred value from remaining shareholders to those tendering. Michael Dell's losses were offset by his option gains, which were unavailable to non-executive shareholders, plus the gain on any shares he tendered. Dell paid an average repurchase price over the years of $ 19 per share compared to the current price of $ 12. A general observation is firms facing a challenging operating environment who have stock option programs may be prone to questionable repurchases.

The current low share price due to concerns over the firm's business model has increased the interest in taking Dell private. Michael Dell is rumored to contribute his shares into the potential LBO. This raises conflict issues as to who he represents-the firm's shareholders or himself in the buyout negotiations. Given his record on the repurchase program we can only guess hmmmmmmmm.

I promise this will be the last post on repurchases for a while. There will be more posts on Dell as the story develops.

j

Gin Rummy LBO Screening: The Case of Dell

My previous Best Buy post highlighted why I considered it to be a poor LBO candidate. Best Buy's big box retail model was rapidly losing out to on line firms like Amazon. Firms suffering from declining operations due to industry structural changes, which put their existing business into question, involve too much business risk. They have poor prospects of turning themselves around in a highly leveraged state.

Now another structurally challenged firm, Dell, is considering an LBO. Dell's shares declined 30% last year despite an overall rise in the stock market. Its core direct order PC business has fallen prey to retail stores and new products like smart phones and tablets. The result is that sales declined 19% and profits fell 47% last year. They have been trying to offset the decline by repositioning the firm through almost $13B in new initiatives (including acquisitions) for some time.

Dell's market value exceeds $20 B. Applying a reasonable premium suggests a transaction price around $24B. A 40% equity requirement generates a $9.5B equity need.  Assuming the rollover of Michael Dell's ownership reduces the new equity need to $6B. This is a large amount and would probably be split among multiple private equity sponsors as had occurred during the 2003/2007 LBO boom. Shared deals like this can be tricky if something goes wrong as it is difficult to know who is in charge.

Debt in excess of $13B would be needed. Dell has a sizable cash position. Unfortunately, it is largely overseas, and probably subject to substantial taxes if returned to the U.S. to support the proposed LBO. The key impediment to the debt levels is Dell's declining core earnings and market share-despite years of continued turnaround efforts by Michael Dell. How can you build a realistic capital structure if you are unsure about your cash flow?

Michael Dell is likely to continue in a senior role in the LBO. Thus, it is difficult to see what new turnaround efforts he will employ in a highly leveraged firm that will be more successful than past efforts. It is difficult to reinvent and implement a new business model in a leveraged firm. There is little room for delay or error. The fact that this project can even be seriously considered is a testament the current highly receptive bank and capital markets.

I understand Dell's frustration given the market's response to their existing turnaround efforts. Nevertheless, an ill-advised LBO is not the best alternative choice of action. Absent a strategic buyer, a more realistic option is to manage the firm for cash, and return the cash to shareholders. Part of the disappointing stock market performance may be due to shareholder concerns that Dell is over investing in low return activities, or overpaying for acquisitions.

The high financial risk in LBOs requires a stable operating environment with predictable cash flows. It is difficult at best to try a high-wire business turnaround in leveraged firm. A concern is banks and other investors in search for high returns will proceed with the transaction despite its size and risk. Wilbur Ross gives the proposal a 50% chance of proceeding. Investors should beware of LBO candidates representing weak discarded cards as in gin rummy.

J