Managers, Pigeons and M&A

Nine month 2015 M&A activity is within 2% of the pre-crisis 2007 record. Most of the buyers are strategic corporate. Even LBO volume recovered in 3Q15 driven by large levels of PE dry powder. As Ralph outlined there are many reasons, some good and others not so good, for the increased volume. A sometimes neglected reason for M&A growth is based on B.F. Skinner who influenced animal (pigeons) behavior thru rewards.

Investors have reacted positively to buyer M&A announcements for the last 3 years. This is in contrast to their negative reaction for the 1996-2011period subject to anticipation effect adjustments. Since the end of the great recession, investors have rewarded firms who could profitably reinvest capital; those who could not were rewarded for the return of cash via dividends and repurchases. The initial acquisition, 2012-2014, spurt involved lower prices, both premiums and multiples, strong strategic rationale, and smaller targets. Bottom line they were attractive deals.

Current late in the cycle acquisitions are getting pricey in terms of premiums over bull market inflated stock prices (40 %+) and multiples often exceeding 12 X EBITDA. Furthermore, they are becoming quite large. Although dollar volumes are up the number of transactions is actually down this year. This is reflected in the number of large $10B+ deals, which now total 47. Larger deals combined with higher premiums put more acquirer shareholder value at risk (SVAR). Additionally, larger deals involve increased integration risk. Consequently, investors are justifiably becoming concerned with the recent number of higher risk announced acquisitions. Some managers, like Skinner’s pigeons, have been conditioned to think (all-most?) acquisitions will be positively received by investors, and are sailing full speed ahead.

Just like investors, mangers need to become more discriminating about acquisitions. This means addressing the following issues:

1)     Red Flags: be prepared to sit out current late stage acquisitions that involve SVAR greater than 20% of the acquirer’s pre bid market value due to size and pricing premiums unless you are REALLY REALLY sure.

2)     Timing: remember the best of deals are made during the worst of times; while the worst of deals are made during the best of times-like now.

3)     Growth: not all growth is good. The key is return on invested capital. Overpriced deals relative to value received never work.

4)     Best Owner: unless you are the best owner of the target you are likely to fall prey to the winner’s curse.

5)     Strategic Basis: why are you buying? The best answers include achieving economies of scale or scope, expand geography by expanding into adjacent markets, and to improve operations of a poorly run target.

Managers, just like Skinner’s pigeons, cannot expect positive investor reaction to all acquisitions. Investors are evaluating the fundamentals of each deal based on factors similar to those previously stated. This does not mean all M&A is bad again. Rather, it means managers need to be more selective just like investors and less like pigeons.

J

Rue21: A Deal to Rue

Yield hungry investors have swarmed syndicated leveraged loans this year. It seemed that they were throwing caution to the wind. Anything and everything seemed possible. Then came Rue21-one of the biggest high profile deals to flop in a while. Rue is a rapidly growing value orientated teen apparel fashion retailer. It has added 500 stores over the past years, and is scheduled to reach 1000 stores by year end.

In May, Apax, a UK private equity firm, offered to buy Rue for $1.1B Acquisition with a $62 Mln breakup fee. An affiliated Apax entity already owned 30% of Rue. The offer represented $42 per share- a 23% premium to market, 1.2X sales and 9.2X EBITDA. Comparable multiples were 0.5X sales and 8.4X EBITDA. The premium represented Rue’s rapid growth potential.

Apax would contribute $280 Mln in equity with the balance financed by debt representing a FD/EBITDA multiple over 6X. The debt included a JPMChase, BofA and Goldman $530 Mln syndicated loan. The loan was richly priced at L+ 475 with a 1% LIBOR floor.  During the syndication, Rue announced disappointing sales and earnings due to a “challenging retail environment”. Same store sales fell 9.5% thru 3Q and by 12.8% in September. The syndication struggled, and the agents offered 20-25% discounts without success.  See Syndication.

Some observations:

1)  Aggressive leverage for a rapidly growing firm is always a challenge. Add in fashion retail and the margin for error is razor thin.

2)  The purchase price was rich leading to the need for increased leverage. It only made sense assuming Rue’s growth would continue.

3)  Unexpected performance issues during the syndication are always possible. Nonetheless, I wonder how unexpected this really was. First, simple extrapolation, which appears to be the case here, is dangerous when constructing projections for growth firms. A modest downside case would indicate how problematic the debt service would be if a slowdown occurred.

4)  Basic earnings quality analysis also suggested concern. Earnings are an opinion while cash is a fact. Despite Rue’s growing sales and net income since 2009, their free cash flow peaked in 2011, and fell in FYs 2011 and 2012.  Growth related, rapid CAPEX and inventory increases were part of the problem. This coupled with a performance decline suggests a) Rue must curtail its growth and b) Rue will have difficult time repaying its debt. Loan investors undoubtedly saw this, and declined to participate despite the original rich price and even with the substantial discount -  they would not bite.

Diminished growth means the purchase price and capitalization rationales are no longer valid. Apax should consider renegotiating the deal or walking away after paying the breakup fee. The banks would be happy. Rue’s current shareholders, of course, would be upset, but would still be $62 Mln richer. Discretion is sometimes the better part of valor.

J

PS - Just over two months until Acquisition Finance in Amsterdam (see side note or click here)

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

Tech Wreck - Dell, Apple and HP: A Developing Story

Technology based firms like HP (transformational M&A), Dell (Management led LBO) and Apple (huge cash reserves) have generated plenty of recent headlines. What they have in common is a maturing industry, slower growth and increasing over capacity that is common to the creative destructive process is dynamic economies. The consequences of these developments are pressured margins and falling stock prices. This has created a strategy-value gap. Essentially, the current strategy no longer creates the highest and best results because it no longer fits evolving market opportunities. This presents a huge governance challenge for boards facing management teams unable or unwilling to change.

The competitive advantage period these firms previously enjoyed has shrunk to zero as their markets and products became commoditized. Thus, the source of value has shifted from growth opportunities to assets in place. The emphasis is no longer growth but returns and profitability. This shift gives rise to the following fundamental changes:

1) Increased emphasis on capital allocation as free cash flows rise due to falling investment requirements. This produces significant agency issues as management may be tempted to waste resources in over-priced acquisitions as occurred at HP.

2) Ownership and management changes in the areas of consolidation based M&A, LBOs by frustrated management and spin-offs and divestment of SBUs that no longer fit.

3) Increased shareholder distribution thru dividends and stock repurchases of excess free cash flow.

4) Higher leverage to maximize tax benefits and increase managerial discipline over cash flows and balances.

5) Improved focus reflected in the reduced number of SBUs. This reduces cross subsidies and improves capital allocation.

6) New incentives added to improve accountability.

7) Enhanced governance through new more active and experienced board members.

All of the above will be driven by heightened shareholder activism by investors,such as Einhorn at Apple, seeking to improve shareholder value. Some of this will be ugly-proxy fights, litigation, transaction challenges, and ultimately possible hostile take-over attempts.

The net result will be the tech industry as the new hotbed of deal activity going forward. Firms, management and boards will struggle to adapt to an evolving industry environment. Not everyone can succeed, but for those who can the rewards will huge. In the meantime, investment bankers, lawyers and bloggers will be busy. Much more to follow.

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

Dell LBO: The Beat Goes On

Part 2 of our discussion of using multiples in valuation will appear Wednesday.  We wanted to get this timely post on Dell out today.

R

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The potential Dell LBO continues to develop. Microsoft is considering a $3B convertible preferred stock investment. This would greatly strengthen the outlook for the transaction. Besides improving the capital structure, it provides a deep-pocket strategic partner. This is crucial to provide comfort to debt providers as a secondary repayment source should Dell experience financial problems.

Microsoft has a strong interest in seeing Dell, a major customer, survive. An out-right Dell purchase might pose concerns with some of Microsoft's existing suppliers and Window's allies. The joint venture with Silver Lake, the lead PE firm, provides a toehold investment with the implicit option for an additional follow-on acquisition. Should Dell falter, then Microsoft could elect to support Dell by increasing its ownership under the cover of protecting its investment. If Dell prospers, then Microsoft could serve as a strategic exit partner. Bottom line, they obtain an inexpensive option for a subsequent acquisition, reduce initial supplier and allies concerns and avoid having to consolidate Dell on its balance sheet.

Next to consider is the value transfer from Dell's bondholders to the transaction.  Like most investment grade bondholders, Dell is currently rated A2/A- by Moody’s and S&P respectively.  Dell's bondholders have minimal covenant protection and cannot force Dell to repay them once Dell goes private. Thus, Dell avoids having to refund the low rate bonds with more expensive buyout debt.  The existing bondholders continue to receive an investment grade coupon on their investment, which is now non-investment grade-most likely BB post close. Worse yet, the bonds will become effectively subordinate to the buyout debt. Consequently it comes as no surprise that Dell's bonds have plunged in price since the LBO discussions began.

I still question the wisdom of a highly leveraged Dell trying to adjust to its strategic challenges in a maturing and highly competitive industry facing substantial competitors who are unburdened by high leverage. Nonetheless, the potential for financial engineering related magic may just make the transaction possible even if it remains unwise. The Dell Silver Lake guys are good.

More to follow I am sure.

J