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

Sex, Lies, and Firm Value

Today, two of my coauthors, Brandon Cline and Adam Yore, are featured as guest bloggers today talking about a recent paper of ours entitled, The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value.

All the best

Ralph

The Agency Costs of Managerial Indiscretions: Sex, Lies, and Firm Value

 Ethics and codes of conduct are frequently placed at the forefront of corporate policy. Recently, many have even argued that the integrity of management is a factor of production. The notion is that mutual trust between two economic agents reduces transactions costs as it mitigates the need for excessive contracting. However, when trust among economic agents is breached, the offending agent’s reputation is damaged. The penalties resulting from the damaged reputation are often a multiple of the actual harm associated with the offending event.

Many executives face ethical charges in their personal lives unrelated to the firm’s financial or operating decisions. Boeing’s Harry Stonecipher, RadioShack’s David Edmonson, Staples’ Martin Hanika, and Raytheon’s William Swanson were all placed under the spotlight for engaging in alleged extramarital affairs, substance abuse, domestic violence, or public displays of dishonesty.

In a paper just released we examine a sample of executives accused of indiscretions in their personal lives for actions explicitly unrelated to the operations of their firm. These include allegations of violence, substance abuse, dishonesty, and sexual misadventure. The objective of this research is to examine the corporate agency costs associated with alleged indiscretions in executive’s personal life.

The existence of alleged improprieties in an executive’s personal life raises important questions for corporate governance. First, what is the impact of these allegations (if any) on the valuation and operations of the firm, and do these allegations have the potential to signal important managerial qualities to the market? A second set of questions asks whether an executive’s alleged personal indiscretions relate to subsequent questionable or even illegal activities at the firm level including earnings management, actions provoking shareholder lawsuits, or fraud. In essence, are signals suggested by personal indiscretions borne out by successive actions in the corporate setting?

While these actions are personal in nature, we find that they signal significant agency costs for the firm. The data indicates that managerial indiscretions pose a significant risk to the company and inflict substantial agency costs upon shareholders, particularly when the CEO is involved. On average, there is an immediate 3.8% loss in shareholder value at the disclosure of a CEO indiscretion and operating performance suffers an abnormal decline of 1.5% during the same fiscal year. In addition, the firms of these executives experience a long-run abnormal decline in value of 9% to 12% during the year of an indiscretion. These firms are also more likely to be involved in shareholder-initiated lawsuits, DOJ/SEC investigations, and are significantly more likely to manage their earnings. Notably, only 25% of executives face disciplinary turnover for these offenses, despite the fact that a significant fraction of these executives are repeat offenders. In fact, the turnover rate for repeat offenders is almost identical to that of first time offenders. At best, this implies that the typical firm’s board does not feel that that management’s behavior poses a problem. At worst, it implies that boards are ineffective at preventing these events or are simply apathetic to their consequences.

The paper contains many other results. It is authored by Brandon N. Cline of Mississippi State University, Ralph Walkling of Drexel University, and Adam Yore of Northern Illinois. It can be downloaded here.

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

Goodwill Hunting

Unlike the 1997 movie-this story does not have a happy ending. A January 30, 2013 Citi Credit Research note titled "The Goodwill Game" provides some interesting insights into the extent of recent M&A over-payments. Goodwill is the difference between the price paid and the book value of the assets acquired. It represents a proxy, albeit crude, for the premium paid by the acquirer. It is tested in subsequent years for an impairment charge if the value of the assets declines relative to their original carrying value. The valuation methods used are similar to those Ralph has previously outlined. (See, for example, Estimating Value, Part 1). Recent examples of substantial write-downs include HP's $8.8B charge on the Autonomy and Rio Tinto's $3.5B write-down on mining assets. Alarmingly, the report shows that goodwill growth is out-pacing total asset increases.

The write-downs highlight the importance of the three most important things in an acquisition: price, price and price. Over paying, as represented by goodwill, is the reason why most acquisitions fail to create value for the buyer's shareholders. Management often tries to explain write-downs as unimportant non-cash charges. The cash, however was lost when the over-priced acquisition was made. Furthermore, the write-down reduces managerial accountability for the remaining assets-the out-of-sight-out-of-mind effect. Post write-down, the future operating performance can actually appear to improve. Perhaps, we should consider keeping the investment's original value when determining performance reviews?

The problem is worse still for serial acquirers like HP who, while suffering from depressed share prices, continue to make over priced acquisitions to cover-up a declining business model. Shareholders tired of seeing the wealth wasted in high premium-high goodwill acquisitions should insist that Boards pressure management to stop the madness and return the capital to them via dividends. The kingdom may be smaller, but its citizens will be richer.

Investors should keep a close eye on the level of goodwill creation and write-downs as we continue into the earnings-10K season. It provides an insight into the quality of management and their acquisition proposals. It also raises questions concerning Board oversight and governance of the acquisition process.

j

Concentration Ratios: The Case of Anheuser Busch and Modelo

On Friday, the Wall Street Journal reported that

U.S. Sues to Block $20 Billion Beer Merger

WSJ Feb 1, 2013

Picture by WSJ 

When the government thinks of opposing a merger like this, they try to discern whether an industry is overly concentrated, and thus prone to monopoly like behavior; they often use two ratios.  The first is the 4-firm concentration ratio, simply the sum of the four largest producers.  The second ratio is the Herfindahl-Hershman index, the sum of the squared market values of all firms in the industry.  The range of values for this index are close to zero for a highly populated, highly competitive industry (say 100 firms, each with 1% market share)  to a maximum of 10,000 for a case where one firm has 100% of the market.

The Department of Justice website gives more details on the HH index, noting that values in excess of 2500 are considered to have excess concentration.

So what is the HH index for the beer industry and what are the problems with the use of this method?

For the distribution of market shares noted above, the HH index would be equal 2766 before the merger and 3312 after.  The calculations are shown below.

Company	Market Share	Market Sh Squared	Mkt Sh with merger	Mkt. sh with merger sq
Ann Busch	39	1521
Modelo	7	49	46	2116
MillerCoors	26	676	26	676
Heineken	6	36	6	36
Others	22	484	22	484
Sum	100	2766	100	3312

This HH can be  a very useful ratio.  But I want to illustrate some of its problems.  First, note that when we square values, higher numbers produce more extreme values.  Note that the squares associated with, say 1, 2, 3, and 5 produce ever increasing square values of 1, 4, 9 and 25.  Larger market shares produce larger numbers.

So here is a first limitation to note:  I took all the 'other' beer distributors and grouped them in one category, resulting in a 22% market share.  That is, I artificially created a company with a 22% market share.  What is the impact of this?  Well, let's change that assumption.  Let's now assume there are 11 'other' competitors, each with a 2% market share.

Company	Market Share	Market Sh Squared	Mkt Sh with merger	Mkt. sh with merger sq
Ann Busch	39	1521
Modelo	7	49	46	2116
MillerCoors	26	676	26	676
Heineken	6	36	6	36
Others           a	2	4	2	4
b	2	4	2	4
c	2	4	2	4
d	2	4	2	4
e	2	4	2	4
f	2	4	2	4
g	2	4	2	4
h	2	4	2	4
i	2	4	2	4
j	2	4	2	4
k	2	4	2	4
Sum	100	2326	100	2872

The HH index is substantially lower, although the merger is still above the limit of 2500 set by the DOJ.

A second and more fundamental criticism of the HH index concerns the definition of 'market'.  Some natural questions arise.  What is the market?

OK, let's start with geography to define our market.  Is is just International? Domestic?  Within a state?  I'll bet more Red Hook is sold in Seattle than in Philly.  Does that make Red Hook anti-competitive in Seattle?

Perhaps more fundamental, what is a market in terms of the product?  Think of Powerade, a low or zero calorie flavored drink.  What comprises its market?  Flavored drinks?  Bottled water?  Soft Drinks?  Beer?  Okay, I'll give you that one - but other questions have less obvious answers.  Does the market for beer include wine?  How about wine spritzers, etc?

And --- if we turn to technology the answers are even more uncertain.  What is the competitive market for HP calculators?  All calculators?  All calculators and personal computers?  Hand-held personal computers?  Cell phones?  Watches with calculators?   Something not yet invented?

The point is - the HH is a useful measure - once we can agree on the market.  But defining that market sometimes requires heroic assumptions.  Think I'll open my Sierra Nevada and contemplate this some more.

Ralph

Estimating Value: Part 4 Using Comparables in Valuation

Three previous posts have talked about methods of valuation, specifically  the use of discounted cash flow in valuation,  the use of multiples in valuation and the advantages and disadvantages of multiples.  We extend this series with a brief discussion of the Method of Comparables.  

Method of Comparables

If  data is available on firms similar to the one we are trying to value, this data can be used as benchmarks.  In fact, this reliance on comparable firms is at the heart of the multiple method discussed previously.  Here we are looking at the price to earnings, price to book, price to EBITDA or other multiples of comparable firms and trying to derive our own inferences.

Comparables are particularly useful in looking at actual completed transactions.  This method is often used in valuing residential property. In that case, the analyst gathers data on the recent sales of similar property (e.g., a four-bedroom split level house in a particular school district) and uses this average as a point of departure for valuing the property of interest. Subjective adjustments to this estimate are made depending upon perceived differences in the property of interest and the comparables. For example, the estimated value would be lowered if the property had less desirable curb appeal; values would be raised if the property had, say, an updated kitchen.

Similarly, a comparables analysis of a business starts by finding several firms whose value is known.  Given the objective information provided by these comparables, the analyst then makes subjective adjustments based on the differing characteristics between the comparable firms and the one to be valued.  

This type of analysis is particularly useful when we have a set of comparable firms that have recently been sold.  The strength of the comparable method with completed deals is that it relies on market transactions to establish a benchmark price.  The disadvantage is the difficulty in getting recent market data on a meaningful set of truly comparable firms.  Differences in industry, size, geographical location, and accounting techniques are among the difficulties in finding comparables. Moreover, accurate data on privately held companies is often difficult or impossible to obtain.

Finally, we again emphasize  the distinction between using transactions and non-transactions data.  Transactions data are ideal as they reflect selling price information on actual deals that have been completed.  However, adding this restraint to the matching criteria listed above usually severely restricts sample size.  Non-transactions data are also quite useful, but, of course don't reflect actual deals.  Thus, we're looking at a stated market price for our comparables, but not necessarily a price at which the firm would be sold.  Setting the latter value involves not a multitude of factors.  To mention just a few we must consider the strategy, motives and characteristics of the acquiring firm, the target, the way the deal is structured, the bargaining power of the parties, the availability of other bidders, and any premia for control or discount for illiquidity.  

In subsequent post, we'll talk more about control premia and liquidity discounts as well as about some sources of data for comparable transactions.

R