The Empire Strikes Back: DuPont's Response to Trian

As readers of this blog know, contested offers, proxy fights, and activist campaigns produce heated exchanges between the parties involved.  The latest round in the DuPont/Trian exchange is from DuPont, filed with the SEC yesterday.   This is management's defense of its record and counter claims against Trian and occurs in a letter to shareholders.  See DuPont's response.

As the letter indicates, DuPont has outperformed the market in the last one, three and five year periods.  What remains unclear, however, is what additional value can be obtained through the actions Trian proposes, namely splitting up the company.  It is difficult to defend against projected 'what ifs' and admittedly, the track record of activists in general, is positive in terms of creating value. In many cases where activists attack, however, the target has been underperforming.  That certainly isn't the case with DuPont.  In Star Wars, the Empire represented the villains.  That's not clear here.  Stay tuned.

All the best,

Ralph

Allergan and Valeant - Lessons from the Market for Corporate Control

The current Allergan Inc. case illustrates many points we have made in these posts.  As we start to think about our upcoming Amsterdam class on Structuring the Deal, it is useful to review.  The Allergan situation is an important illustration of the importance of corporate governance and the fact that when internal governance mechanisms (e.g., management and the board) overlook value creating strategies, external governance mechanisms (e.g., hostile bidders, arbitrageurs and the stock market itself) will force that change upon the firm.  It is better to be proactive.

On April 22, 2014 Valeant announced a hostile bid for Allergan, explicitly noting its value creating strategy, with an estimated $80 billion in synergies to be achieved in the first six months.   Allergan rejected the acquisition offer by Valeant but is now implementing many of the same strategies Valeant has proposed.  Specifically, Allergan has focused heavily on research and development while Valeant has focused more on sales.  Valeant said it would cut up to 20% of Allergan employees, primarily in R&D.  Allergan rejected these initiatives but is now following a similar strategy in an attempt to pacify its shareholders.  It has announced that it will lay off about 13% of its workers.  Here are just a few of the lessons from past posts.

The Best Takeover Defense: Don't leave Money on the Table.  Anticipate value creating activities and implement them, however painful.  Continuously evaluate your firm's strategy, particularly in light of a changing environment.  Consider Are You a Takeover Target? Take the corresponding action before external markets force change upon you. Don't wait for a hostile bidder to force you into action.  Indeed, Do Unto Thyself.

Once your firm is in play, the ownership quickly shifts to arbitrageurs.  The Speculation Spread between the offered bid price and the post announcement market price reveals the market's anticipated outcome for the deal (e.g., successful or unsuccessful acquisition and whether the bid will be revised).  Once arbitrageurs are the major owners, a deal is much more likely to happen as their interest coincide with deal completion.  As we noted in April, "The market is predicting a higher, successful bid as the Allergan's stock price on Monday closed well above the $153. value offered by Valeant." Allergan's shares closed at $171.14 on Monday.

This deal is reminiscent of the numerous oil takeovers in the 1980s.  During the late 1970s, many companies began an extensive drilling program searching for more oil.  By the 1980's two factors made that strategy hugely unprofitable.  First, the price of oil fell from $40. a barrel to around $10. a barrel. Second interest rates rose from single to double digits.  Thus, in terms of the present value equation, the numerator declined while the denominator rose.  Not a good combination.  Firms that failed to adjust were subsequently taken over.  

To repeat, it is necessary to always consider if your current strategic course is the best one for maximizing value.  If you get this wrong, you are likely to find out the hard way.

All the best,

Ralph

Are You a Takeover Target?

An improving economy and favorable financial markets have renewed interest in acquisitions as a growth option. We can expect increasing shareholder pressure to grow earnings, or return excess cash to them. The pressure can trigger a hostile bid or shareholder activism. Either you develop options, or you become one.

Targets include both firms suffering from poor performance like HP or well performing firms with large and growing cash holdings such as Apple. Both HP and Apple may be somewhat protected from a hostile bid given their size. They are not, however, immune from shareholder activism as recent events have shown.

Characteristics that will land you on someone’s takeover or activism target list include the following:

1)     Slow earnings growth but profitable cash positive operations

2)     Returns on equity lagging the cost of equity

3)     Depressed stock price multiples-especially market to book and price to earnings ratios

4)     Growing cash and marketable securities holdings constituting a large portion of your market value

5)     Relatively low dividend payout ratio e.g. less than 30%

6)     Low leverage with debt/cap ratios e.g. below 20%

7)     Multiple SBUs with the sum of the parts value, break-up value, exceeding the current market value of the whole firm

8)     Problematic organic and M&A growth results

So what do you do if you have one or more of these characteristics? Consider the following:

1)     Explore alternative strategic options-code for putting yourself up for sale. Probably not your first choice.

2)     Contact your lawyers to ensure takeover and shareholder activism defenses are in order. This only buys you time. It does not solve the underlying performance issue.

3)     Sell assets and SBUs better owned by someone else. This involves a periodic product portfolio review to transfer those units which have passed their sell by date.

4)     Return excess cash to shareholders through a special dividend or share repurchase

5)     Increase the dividend payout ratio to reduce the future build up of cash

6)     Increase leverage and use the proceeds to fund a special dividend or share repurchase. Probably want to maintain an investment grade rating of at least BBB to ensure financial flexibility. This translates into a maximum debt to capital ratio of around 50% for nonfinancial companies.

7)     Consider taking the firm private-possibly via a management lead LBO

8)     Develop new shareholder friendly organic and M&A growth strategies

As I've written before, the key is to Do Onto Yourself before someone else does onto you. We may be early in the cycle. 

Nonetheless, it never hurts to be prepared.

j

P.S. (See also, Ralph's post on The Best Takeover Defense: Don't Leave Money on the Table.)

Martin Marietta and the Pac Man Defense

Martin Marietta is making acquisition news again, most recently as Martin Marietta Materials.  They were involved in merger discussions with rival gravel and sand supplier Vulcan Materials but talks ended when Martin launched a 'hostile bid' for Vulcan.  Vulcan argued successfully in the Delaware courts that Martin Marietta had unfairly used information it learned in the merger discussions.         Now, according to an article in the Wall Street Journal reported in Reuters, Martin is ready to resume the friendly discussions.  One wonders how friendly they will be.  Certainly with an improved outlook for the construction industry and a successful defense of the hostile offer, Vulcan is now in a strengthened bargaining position.

Ironically, Martin Marietta has been involved in another interesting acquisitions - as a target.  I am referring to their novel defense of an attack by rival Bendix back in 1982.   When Bendix started acquiring shares, MM avowed to stay independent.  Their defense, termed the Pac-Man defense after the popular game at the time,  was to launch an attack against the bidder - going after shares in Bendix.   Thus, the hunted becomes the hunter.  Allied Signal and United Technologies both entered the bidding as allies to MM and Bendix.  At the end of the contest, Bendix held 67% of Martin Marietta, while Martin Marietta held 50% of Bendix!  By the end, Allied had acquired all of Bendix's stock and MM remained free - although with a much higher debt burden.  Shareholders of the targets earned about 38% while Allied's shareholders lost 8.6%. (These and other details are contained in a paper by Michael Jensen, entitled Takeovers: Folklore and Science  The figures for Bendix and Allied are been typical for target returns but the losses for Allied that are much larger than those for bidders.

Martin Marietta ultimately merged with Lockheed in 1995 to become Lockheed Martin.  Martin Marietta Materials was spun off in 1996.

All the best,

Ralph

Netflix and Some Personal History with the Poison Pill

It will be interesting to follow the battle for Netflix.  The company recently adopted a 'poison pill' in response to Carl Icahn's acquisition of a 10% interest in the company.  Some recent details are contained in this link from MSN Money.

Poison pills are so named because they are designed to make a company indigestible to a hostile bidder.  Typically, a poison pill is a 'springing right' giving shareholders the option of either buying shares in their own firm at a bargain price or buying shares in the bidding firm at a bargain price.  (More on this latter option in a moment.)  Conceptually, this seems like a stock split or a stock dividend where under idealized conditions, the wealth of a shareholder isn't affected.  In the case of the poison pill, however, the 'acquiring or bidding party' is excluded from using the pill.  Hence other shareholders gain at the loss of the potential bidder.

The first poison pill was issued by Enstar in 1982.  By early 1985, there were 12 in existence.  I know, because I was a young assistant professor at the time, visiting at the University of Washington in Seattle.  My colleague, Paul Malatesta and I were intrigued by a Wall Street Journal article describing the pill and we conducted the first empirical examination of their characteristics.  (The original article that came out of this is now dated but for those interested it was published in the Journal of Financial Economics.  It can be viewed here and downloaded at the top left of the page).

Of particular interest to us was the concept that you could 'buy stock in the acquiring party's firm at a reduced rate'.  The last time I checked, I couldn't give you the right to buy someone else's car at a bargain rate.  We wondered how this could work with stock and decided to investigate.  We called Marty Lipton, regarded as the father of the poison pill and he informed us that, yes, the article was correct and that there were now 14 such pills - he had done them all.  So we began our analysis with that small sample.  Soon the sample grew to 30.  By that time, the legality of the pill was being decided in the Delaware Courts.   The courts upheld the legality of the Household International pill in November 1985 and our sample quickly grew to over 120.  By the end of 1986 there were over 300 in existence.

Our main findings at the time:

• Firms that issued pills had been less profitable than their peers
• Shareholders of Firms that issued pills suffered wealth losses
• Executives of these firms owned smaller amounts of shares and hence, were more insulated from the losses

The announcement of a pill can send two messages.  First - wow, the firm's in play!  This would boost stock prices.  Second, is the deterrent effect of the pill itself.  For the very earliest pills, we found the wealth losses to be negative.  In fact the wealth losses were 1% for firms not in play, but if we restricted our analysis to those already in play at the time the pill was announced, (so the positive 'in play' hit was already in the price) the wealth losses were 4%.

The impact and efficacy of the pill has continued to be debated over the past 30 years.  Throughout the rest of the 1980s and 1990s thousands of companies adopted them.  As they became more anticipated, the price reaction was muted.  Advocates argued that they effectively prevented so called 'raiders' from stealing the company.  The pills, it is argued, increase bargaining power.  Detractors counter that the pills can be used to entrench mangement at the expense of shareholders.   It is still felt that the combination of a poison pill with a staggered board (i.e., electing say a third of the directors each year) is a powerful deterrent to acquisition.  The combination is important because pills can be rescinded by the board, so a proxy fight resulting in a takeover of the board would remove the pill.  However, few acquiring firms would be so patient as to wait two or more years to get control of the entire board.  Over the past decade there has been a movement by activists to remove poison pills and staggered boards. Many boards have agreed.

The specific details of Netflix's pill can be found here.  Note: Netflix has a staggered board.  It will be interesting to see how the directors react and whether the pill is used to negotiate or thwart Icahn's bid.

Do Unto Yourself

Ralph’s suggestion to leave nothing on the table to reduce hostile takeover risk is a wise one. Hostile bids are a struggle by competing management groups over the control of corporate assets and strategies. Firms compete in two different markets. The first is the product market for customers and revenues. The second is in the capital markets for capital. Product market changes, such as new regulation, impact firm performance. It requires management and strategic adjustments. However, organizational inertia keeps management from changing strategies that have previously  been  successful. The delayed adjustment depresses returns on equity and equity values relative to underlying asset values. Furthermore, management continues to invest despite the unattractive returns believing the poor operating situation is only temporary, which worsens the problem. The depressed returns and weakening stock price attract bidders who believe they operate the firm more efficiently.

The key characteristics of takeover risk include

•  Fundamental structural change as opposed to cyclical industry change
•  ROE less than cost of equity
•  Sum of the parts exceeds the firm’s market value

Firms operating with these characteristics have two choices. Either adapt yourself or someone else will do it for you. A good example of this was provided by the 2007 takeover of ABN AMRO by a banking consortium of Royal Bank of Scotland (RBS), Banco Stantander (BST) and Fortis (FT). The trigger was an on-going war of words initiated by TCI (The Children’s Investment Fund) a UK hedge fund. TCI had been complaining of ABN’s subpar returns Also, TCI demanded in February, 2007, that bank management should consider a break up the bank as the sum of its parts was worth more that the bank’s current market value. TCI deemed ABN’s response as unsatisfactory and threatened action. TCI lacked the capacity to take over a bank of ABN’s size.They hoped other strategic bidders would join, and they did.

ABN’s suffered for years. It was an unfocused global conglomerate with little synergy among the countries in which it operated. Management was aware of the problem and making some incremental progress. They could not, however, make the difficult psychological choice to break up the bank. 

The consortium was a novel approach to handle the size and complexity of ABN’s business. RBS essentially took the international network (with the exception of Brazil and Italy which went to BST). The Benelux business went to FT. ABN tried to bring in Barclays as a white knight and sold their regional Bank, LaSalle, to B of A as a crown jewel defense to defeat the consortium. It failed and ABN was sold in October 2007 at a substantial premium to its pre TCI price.

One could argue that RBS and FT over paid and conducted inadequate due diligence. The market timing was also unfortunate as the transaction closed shortly before the great financial crisis of 2008 and both RBS and FT failed. Nonetheless, ABN’s sale released billions in trapped shareholder value. Additionally, the consortium did in the end what ABN managers should have done in the beginning-namely break up the bank. This illustrates the principle of doing onto yourself before others do unto you.

Joe

The Best Takeover Defense - Don't Leave Money on the Table

Publicly traded firms can be targets for acquisition bids.  Sometimes the bids are welcome and target managements try to understand how to maximize the bid price.  Other times bids are unwelcome and target management seeks to avoid a hostile acquisition.  In both of these cases, target management has a better chance of achieving its objectives if it will follow a simple rule:  maximize value.  In particular, don't leave easy money on the table. Maximize firm value by every means possible.  If target management does seek to sell the firm, this strategy will raise the floor from which premia are added.  If the target firm is trying to avoid takeover, this takes the easy money off the table and makes the firm a less attractive target.

Acquiring firms launch takeover bids for numerous reasons, but most, if not all, reasons can be classified into two broad areas: shareholder welfare and managerial welfare.  The latter set of motives deal with empire building, with overbidding due to hubris and other problems often associated with corporate governance.  We'll have more to say about that in another blog.

In terms of shareholder welfare, one firm bids for another when they believe it is in the best interest of their own shareholders.  In short, the expected net present value from completing the deal is expected to be positive.  Just as there are numerous motives for mergers, there are numerous ways a deal can create value.  For example, gains could accrue because of greater market share and the power associated with that market share or because of synergies that exist between the combined firms.

When the potential acquirer thinks about a bid, they envision the value of the firm under their control.  They also imagine the least amount they could offer for the target to acquire control.  For publicly traded firms, this minimum amount is  the current stock price.  Absent extreme liquidity concerns, rational shareholders would not sell their shares for less than they could get on the open market.  Thus, that market price becomes the floor from which bidders begin their pricing.  If the anticipated gains are insufficient to warrant the risks of the deal, a bid will not materialize.

Maximizing value won't prevent an acquisition bid, but it will put management in the strongest possible position should a bid materialize and in terms of hostile bids, it will discourage bidders looking for easy money left on the table.  Bids that do materialize are more likely to occur because of the synergistic potential of the combination rather than a failure of target management to follow the best value maximizing strategies.  In this regard, one should not disregard the disciplinary force of the takeover market.  In numerous situations, target management faced with a bid decided to implement changes similar to those that would have followed a 'takeover'.  These changes include things like focusing the firm, eliminating redundant assets, spinning off a division that doesn't fit the strategic mission and finding ways to reduce overhead costs.  In other words, taking the easy money off the table.  But it is better to be proactive than reactive.   Don't wait for a hostile bid to force value increasing change.

Incidentally, managements often complain that they are forced to behave in myopic ways to meet quarterly earnings estimates.  But myopic behavior implies overemphasizing the short run and hence producing lower firm value.  Rather than discouraging acquisition, this type of behavior is likely to do the opposite.  Failing to run the firm optimally leaves easy money on the table, inviting acquisition by a management with the proper long term perspective.