No-This Time is Not Different

Leverage is increasing. YTD 50% of LBOs have FDX (funded debt multiples - Funded Debt/EBITDA) greater than 6X - 15% have FDX greater than 7. Additionally, creditor structural protections like financial covenants are disappearing. The driver is the increase in PPX (purchase price multiples - purchase price/EBITDA). Current LBO PPXs have increased two full turns to 11.5X since 2013. This reflects the increased pressure from competing strategic acquirers, a strong stock market and a recovering M&A market. PPX always increase to absorb any rise in debt capacity. Just as the Cash Burn Rate is important for venture capitalists so is the PPX for private equity sponsors - it represents a LBO burn through of value.

Some believe this time is different and the increasing debt levels are affordable. They believe an improving economy, low rates and low spreads translate into strong interest expense coverage and low default rates. They do, but this is a cyclical business and these pleasant facts can quickly change as we saw during the financial crisis when defaulted or restricted loans rose to double digit levels.

FDX greater than 6X mean you cannot retire principal during the original term of the loan. This means the ultimate repayment source is either a refinancing or trade sale of the company. These depend on markets remaining open and liquid - which is clearly not always the case. We have moved in Minsky terms from a hedged phase (2009-2013) in which debt principal and interest can be serviced from internal cash flow to a speculative phase. During this phase only interest can be covered from internal cash flow. The final Minsky phase before a correction is the Ponzi stage in which neither interest nor principal can be internally covered. Instead they must both be refinanced as was the case the last Ponzi stage of 2007. We are, hopefully, a few years away from this, but no one knows for sure when markets will turn. All we do know is they can and do turn violently when the refinancing wall is hit.

This situation has been noticed by banking regulators. They have strongly signaled that transactions with greater than 6X FD ratios will be subject to greater review. Last year they criticized over 40% of the large syndicated loans, known as shared national credits or SNC, which are heavily weighted towards leveraged transactions. Recently, they have signaled out Credit Suisse for underwriting loans exceeding the 6X guideline. This is understandable as CS is a major LBO loan sponsor with a 13% market share and generating over $400mln in loan fees this year alone. CS will push to defend its market position. Regulators may require CS to hold more capital and criticize banks participating in their loan syndicates via the SNC review. Ultimately, this will push more of origination effort to non banks just as most of the ultimate holders of leveraged loans are now non bank CLOs.

This will not end well. As Hemingway stated about bankruptcy - first it happens slowly, then suddenly. It is difficult for banks like CS to resist getting dragged into the fray. How can you choose not to play the game on the field especially when your competitors are doing so?  Citi’s Chuck Prince noted, as long as the music is playing you have to keep dancing. The regulators are trying to turn down the music. Whether they succeed this time is questionable.

J

There Goes the Nest (Labs) Egg?

Last week Google (GOOG) announced the acquisition of privately owned Nest Labs (Nest) for $3.2B (see Acquisition). The interesting thing for me is not the size, but the eye-popping valuation. I understand Venture Capital (AKA VC or Adventure Capital) is different.  Nonetheless, a multiple of 10-20X sales (depending on which sales figure you use) for a 4 year startup makes me wonder just how different it can be and still make financial sense.

Valuation is based on the higher of cost, going concern (intrinsic or DCF) or third party (multiples) measures. The measure used depends on the life cycle of the firm and its industry. VC projects typically use a form of the third party approach (dependent on what buyers are willing to pay) given the rapidly growing nature of both the firm and its industry and lack of positive cash flow. In fact they frequently have negative cash flow (AKA burn rate) and are dependent on new rounds of financing to exist.

The VC valuation approach involves five steps:

1)   A multiple is selected e.g. sales.

2)   An estimate of the future market size in say 5 years is chosen.

3)   The firm’s future market share in 5 years is used to determine its sales.

4)   The multiple is applied to the sales estimate to determine the future value. Currently for hardware firms 2-4X is used. Software and social media firms receive a higher multiple in the 10-20X range. Yes, I recognize this very imprecise, but that is why VC firms require such high returns.

5)   The quasi future terminal value calculated in # 4 above is then discounted back to the present using a (high-very high) hurdle rate. This value can be used to determine the target’s M&A price or by investors to determine their required ownership percentage for an investment in the firm.

Nest makes “smart” thermostats allowing the remote control of your home temperature.  Additionally, they can be linked with other instruments. This last networking feature seems to be Nest’s value proposition. The 2012 financing round provided an implied value of $800mln based on the approach outlined above. An uncompleted YE 2013 financing round supposedly valued it at $2B.

Its sales are estimated at 50,000 units per month (600,000 p.a.) with an average price of $250 per units. Sales are expected to reach 1,000,000 units p.a. soon. The total market is estimated at around 90mln units. An issue is whether the sales and margins can be achieved once competitors are considered. Remember, you should evaluate companies not industries. As Buffett notes you cannot earn superior returns by investing in economy transforming sectors (e.g. the 1990s Dotcom delusion). Based on the financing rounds or the multiples of future sales for similar firms, Nest received a rich price. They got tomorrow’s price today.

Google with its $57B cash balance could clearly afford the price. The question, however, is should they have paid the price. Google’s growth has been slowing, while its cash pile has been growing. They have become the most acquisitive tech firm with over $17B of acquisitions in the past 2 years. This exceeds the combined value of all acquisitions by Apple, Microsoft, Yahoo, and Amazon over the same period. The common theme is data (AKA the internet of things) to justify the disjointed acquisitions which include the successful YouTube to the less successful Motorola.

This looks to me like another maturing tech firm, Google, trying to regaining its mo-jo thru over priced unfocused acquisitions justified as a long-term strategy. We have seen this movie before-Hewlett Packard. Maybe I am being too harsh, but maybe not. Let’s keep an eye on Google.

J