Shareholder Centric vs. Stakeholder Centric - Mylan and Teva

So let me ask you a question?  As a person or institution about to invest in common stock, what do you expect of the board and management?  I'll give you my own answer: I expect them to maximize the value of my shares.  If I didn't have that expectation, I'd never invest.

My response reveals a shareholder centric attitude - that management works first and foremost for shareholders.  While such a view is overwhelmingly favored by independent experts in  corporate governance, it is by no means without some legal, management and even some academic dissent.  The alternative view is stakeholder centric - that management must consider the well being of all of its stakeholders when making decisions.  Stakeholders other than shareholders include employees, bondholders, customers, and even the community in which a firm operates.

Stakeholder centric requirements in the United States vary with State Law and Corporate Charters.  Different countries around the world take different viewpoints with some (Ireland) being more shareholder friendly and others (The Netherlands) being more stakeholder centric.

This was borne out with Mylan's recent rejection of a $40 billion takeover by Teva.  (For interesting details, see Mylan). Mylan, formerly a Pennsylvania corporation became dutch based in February as part of an inversion - where companies merge with other companies to change the location of their headquarters.  Typically this is done for more favorable tax treatments but it also has other repercussions for shareholders - in this case enabling management to espouse a stakeholder approach to the takeover and find support under Dutch law.  What are the repercussions of a stakeholder centric view?  I'll mention three:

First, companies that could be run more efficiently under new management are protected under existing management.  It can be cost advantageous - and beneficial to society as a whole to have the company acquired.  In some cases it is beneficial to society as a whole to lay off employees and focus the company in more efficient ways.  Companies protecting employees may resist such change.

To be sure, communities can be harmed when companies close plants, lay off employees and perhaps move their location.  But community or state or country protectionism is harmful in the long run.  Subsidizing inefficient operations may prolong the inevitable, but it avoids the obvious - uncompetitive companies will ultimately die and shareholders and ultimately all stakeholders will suffer.  Protectionism and cross-subsidization will ultimately fail.  The employees,  companies and communities that thrive are those that embrace change and continually adapt - keeping themselves competitive in a global marketplace.

Second, situations that can benefit shareholders - the residual claimants in a company can be rejected.  Not only is this unfair to the owners of a company, it is again ultimately destructive.  Few investors would invest in a company that doesn't look out for their own best interests.

To be clear, stakeholders are important and they deserve every consideration by management.  Even under a shareholder centric view, the best companies are conscious of the needs and obligations of their stakeholders and fulfill these claims in consideration of the competitive marketplace.  Usually the claims of stakeholders are also defended by other means including contracts, union, and laws.  Shareholders are not provided the same contractual certainties that stakeholders enjoy.  They are the residual claimant of a firm's profits.  They are entitled to everything that is left after all other expenses and claims have been paid - if there is anything left.  Shareholders are not guaranteed a profit, but have the benefit of knowing management and the board are looking out for their best interests.

Third, boards that take a stakeholder centric approach are answering to more than one master - not an optimal situation.  It is never clear whose interests should be pursued or which direction to follow.  The typical result is stagnation.

To be sure, laws that permit boards to reject takeovers based on stakeholder theory can also insulate management from needed change.

Thus, Mylan's shareholders have lost the opportunity to sell their shares at a substantial premium.  Share prices fell 14%.

All the best,

Ralph

The Evolution of Takeover Defenses and Managerial Entrenchment

In the wake of the DuPont - Trian outcome (DuPont retaining all 12 board seats), it is interesting to examine the impact of takeover defenses and outcomes in general.  Here is an interesting article examining the subject.  The article, refers to takeover attempts instead of activist proxy fights but is nonetheless interesting.

Have changing takeover defense rules and strategies entrenched

management and damaged shareholders? The case of defeated

takeover bids

by

Michael Ryngaert , Ralph Scholten 

"Using the Delaware Supreme Court's Time-Warner decision of July 1989 as a focal point,we study

defeated takeover bids before and after July 1989 to assess the direct effects of stronger takeover

impediments on takeover defense tactics used to defeat bids and the resulting shareholder wealth

outcomes and managerial turnover. We find that firms that defeated takeover bids after July 1989

shifted away from the use of active takeover defenses (repurchases, special dividends, greenmail,

and leverage increases). Nevertheless, shareholders of firms that defeat a takeover experienced

slightly better wealth outcomes in the 1990s than in the 1980s.We also find increased managerial

turnover rates after defeating a takeover bid post Time-Warner, suggesting that managers

that defeat hostile takeover bids did not become more entrenched due to greater takeover

impediments relative to prior years."

The complete article can be downloaded here.

All the best,

Ralph

PE Magic

One of the merger motives touted during the 1960's was PE Magic.  The concept was simple: you have Firm A with a PE of 20 acquiring Firm B for cash with a PE of 10.  Suppose both firms have an EPS of 1 and 10 shares outstanding.  The market price and market value of firm A is 20 and 200, respectively.  The corresponding values for Firm B are 10 and 100.  So without synergy, if the firms joined, the market value should be 300.  

Here is where PE magic comes in.  According to PE magic, when firm A acquires firm B the market attributes Firm A's superior PE of 20 to the combined EPS of 2.  Hence the market value of the merged firm is 40 and the total market value is 400.  Voila!  100 of market value by PE magic!

This concept was used to explain the conglomerate merger wave of the 1960s.  You know, when a cement company acquired an ice cream manufacturer - not much synergy there unless you can use the cement trucks to mix the ice cream!

Ahem.  There are obvious problems with PE magic.  There are reasons that firms trade for various PEs.  The PE of firm B is only 10 for reasons related to risk, managerial talent, growth and all the factors that relate to future projected cash flows and the variability of those cash flows.  Unless Firm A is able to alter those factors there is absolutely no reason to believe the PE of the combined firm will not settle somewhere in between 10 and 20 to reflect the realities of the new firm.  If nothing  changed after merger, the combined market value would be 300, the combined EPS would be 2 and the PE would be 15.  If you adjust for the costs of integration, the PE and market values would be reduced.

Now, Firm A may  be able to alter the characteristics of the cash flow stream - but that is synergy, not magic.  The moral of the story is to beware of any explanation for merger that implies something for nothing.   See our related posts on merger motives, synergies and the power of subtraction.

All the best,

Ralph

The Price is Right?

Ralph and I have previously mentioned the difference between price as a fact and value as an opinion.  (See, for example, Value is Estimated, Price is Paid.)  Nonetheless, many remain rightfully confused by a firm whose stock is trading at $20 p/s receiving a takeover offer for $30 p/s.  Specifically, was the $20 price wrong or is the $30 offer a mistake? While it is possible for either the market price or offer to be wrong-it is also possible they are both right, but under different circumstances.

As an opinion, value is truly in the eyes of the beholder. Equally true, there is no one true intrinsic value based on a firm’s cash flows (magnitude and timing) and risk. Think of valuation as an attempt to price expected operating performance. This in turn depends on the firm’s market environment and the strategy and asset-liability combinations employed by management in the execution of their chosen strategy. Thus, different owner-manager teams can different results from the same firm.

Changes in the industry environment from technology and regulation shifts for example can render existing strategies obsolete. Existing management may be unable or reluctant to change, thinking the changes to be cyclical not structural. Performance under these conditions starts to decline and the firm’s stock price begins to decline as passive minority shareholders begin to vote with their feet by selling their shares. These selling shareholders have priced downward from say $30 p/s to $20 the firm’s expected operating performance based on its current strategies in a changed market. They no longer share management’s expectations.

The price decline attracts the attention of others who see profit opportunities from shifting to alternative higher value strategies, asset -liability combinations and improved management execution of the strategies. These investors are active control shareholders seeking to force a change. This in turn requires a significant ownership position or majority to implement their plans. These investors are prepared to obtain this position by offering a premium to existing shareholders of $30.  Their price is not based on the firm’s expected operating performance as currently configured. Rather, it reflects their view of operating performance under a new higher value strategy and management team.

This illustrates that firms trade in two different financial markets, and at two different prices. The first represents the passive minority interest market, for example, the firm’s current Bloomberg terminal price, based on existing strategies and management. The other is a potentially higher price to alternative owners employing different strategies and management; this price is available in the market for corporate control. Of course, the new investors can be wrong. They are, however, willing to back up their beliefs with real capital. Thus, their position can have more credibility than a simple existing management denial – a management who may be more interested in keeping their jobs than in creating shareholder value.

So next time before assuming the share price is right first make sure you specify which price you mean. The right price depends on the right combination of owners, strategies and management, and this combination changes over time.

J