Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Agency Theory,Corporate Governance and Acquisitions

We’ve mentioned that one of the ways going private creates value is through improved governance.  In fact, governance is strongly linked to mergers and acquisitions.  Consider the following:

Governance involves aligning the interests of owners and managers.  A merger changes the ownership of target and possibly bidding firms.  Thus, it creates possibilities for altering the alignments that previously existed.

Governance issues are called agency problems in the academic literature because they involve agents (the CEO, the board and management) working on behalf of the owners (shareholders).  Agency problems occur naturally because the best interests of owners may not coincide with those of the agents they hire.  Good governance seeks to align these interests. 

In future posts, we’ll spend more time on some of the potential agency conflicts that arise naturally in corporations and in particular in mergers and acquisitions.  They include, but are certainly not limited to:

CEO compensation.  It is natural for an executive to desire more and for owners to want to pay what is justified.

Consumption of perquisites by the executive team.  A sole proprietor may have a Spartan office and fly coach.  If he/she does not, they bear 100% of the costs of any perquisites.  This is not true for the CEO of the typical large corporation who probably owns less than 1% of the equity and hence bears that proportion of the costs of perquisites.  Suddenly the private jet looks more appealing.

Resistance to mergers.  A merger in the best interests of shareholders may nevertheless cost a target CEO his or her job.  Enough said.

Acquiring for the sake of building the empire.  An executive may desire to expand the empire for personal reasons.  After all, the size of a company is linked to measures of ‘prestige’ like being part of the ‘Fortune 500.’  And, of course, there is a strong link between size of the firm and size of the CEO’s pay.

Getting caught up in deal fever and overpaying.  We’ve noted a good deal becomes a bad deal at some price.  Most of us have encountered a bidding situation, on eBay or elsewhere, where we’ve gotten caught up in the momentum of bidding and gone beyond our preset upper limits.  Ego can also becomes a factor in heated bidding wars.  Neither of these situations is best for us as individuals and they certainly aren't best when playing with shareholder's money.

Conflicts between classes of capital.  Less obvious are the conflicts that can exist between equity holders and debt holders.  In a share repurchase, for example, equity holders may gain at debtholders expense.  This can occur when the collateral protecting the debt holders (including cash) is reduced for share repurchase.

These are but a few of the potential conflicts that must be handled carefully in mergers and related transactions.  In a subsequent post, we'll talk about the incentives created when an owner (say an institution) holds both debt and equity in a deal.    

Ralph

International Valuation: Around the World in 80 Steps

Valuation is critical to M&A. If you know the target’s value you can evaluate its price. Most of the MergerProf value discussions have centered upon the developed world-especially the United States. Developed nations use the valuation techniques championed here and taught in most business schools. People from emerging and developing countries sometimes ask if these techniques work in their markets. The answer is yes, but with important implementation caveats. The United States and the developed world are blessed with good quality readily available data. This aids in the implementation of the theory. Nonetheless, for emerging markets it is possible to establish workable cost of capital and other valuation estimates.

All valuation boils down to three questions:

1)     What are the cash flows: use the standard recipe of EBIT(1-t)+depreciation-

       (CAPEX+Working Capital Increases)

2)     When are they paid or received: gets to the time value of money based on a “risk

        free” government bond rate.

3)     How sure are we in the estimates: concerns the risk premium

The combination of 2 and 3 above give us the rate used to discount the cash flows. So for a Chinese company looking at another Chinese firm in a purely domestic transaction the procedure is relatively straightforward. There is a Chinese government rate and betas can be estimated from foreign peers. Damodaran's website provides useful country market risk estimates.

It gets more complicated when looking at cross border transactions involving two or more countries. The following discussion is limited to countries in emerging versus developing markets. The later have  difficult to gauge legal and political risks (e.g. expropriation and limited rule of law). In these countries, use a country risk premium or a modified payback rule-get your investment back ASAP before the local government blocks your returns.

Let’s turn to a simple situation of a U.S. firm buying a Brazilian firm. Two approaches as follows:

1)     Local Approach

     a)     Forecast local Brazilian Real cash flows
     b)     Determine local discount rates using project specific betas and capital structures
     c)     Calculate discounted Real cash flows using local Real rates
     d)     Spot the discounted Brazilian Real cash flows back into USDs in the FX market

2)     Centralized Approach

     a)     Forecast local cash flows
     b)     Convert the local Real cash flows into USDs using Interest Rate Parity
     c)     Discount the converted cash flows with USD home currency rates using project

             specific betas and capital structures into a USD project present value

The second approach is more common. Executives prefer to think in home currency terms, and accounting considerations favor this approach as well.

Taxes are a major consideration in structuring cross border transactions. Shifting taxable income to low rate countries thru various tax structures is a major reason U.S. firms have so much cash “trapped” offshore. Taxes also impact the repatriation of cash thru withholding taxes. My advice-get good legal and accounting tax experts.

As my favorite philosopher Yogi Berra noted-in theory there is no difference between theory and practice, but in practice there is. The same is true for international valuation. Get the cash flows right, and then think about the specific cross border risks that could block the receipt of those cash flows.

j

Do Bad Bidders Become Good Targets?

We all have our favorites, from food to songs and so it is with titles to academic articles.  Today’s post features one of my favorites, “Do Bad Bidders Become Good Targets?”  The answer, in a very interesting article by Mark Mitchell and Ken Lehn, is yes. 

We’ve argued before that the best takeover defense is to not leave money on the table.  The analysis of this article follows this logic.  Companies that lose money through bad acquisitions are wasting shareholder value and are likely to be targets themselves.  The complete article can be downloaded here.  The abstract is shown below.

“Do Bad Bidders Become Good Targets?”

by Mark Mitchell and Ken Lehn

This paper empirically examines one motive for takeovers: to change control of firms that make acquisitions that diminish the value of their equity. Firms that subsequently become takeover targets make acquisitions that significantly reduce their equity value, and firms that do not become takeover targets make acquisitions that raise their equity value. Within the sample of acquisitions by targets, the acquisitions that reduce equity value the most are those that are later divested either in bust-up takeovers or restructuring programs to thwart the takeover. This evidence is consistent with theories advanced by Robin Marris (1963), Henry G. Manne (1965), and Michael C. Jensen (1986) concerning the disciplinary role played by takeovers. 

All the best,

Ralph

Comcast-Time Warner Cable Acquisition and The Whole Deal Concept

The Comcast (COM) Time Warner Cable (TWC) Acquisition illustrates the importance of looking beyond just price to the whole deal when evaluating M&A. As Ralph likes to note, you can name the price if I can name the other terms, and I will win every time. As such, this complements Ralph's Post on the Comcast-Time Warner transaction by focusing on the tradeoff between deal price and non price terms.

TWC had been pursued by Charter Communications (CC) for months resisting three unsolicited bids-the last being a cash and stock offer valued at $132.50 per share. This February, COM surfaced as a White Knight with an all stock deal then valued at $158.82 per share for a total of $45.2B. That price was close to the $160 mentioned by TWC’s management as full value. Since that announcement, COM’s stock price has dropped almost 10% reducing the per share price to $143.55 per share-just 8% above CC’s last bid.

The COM deal is a Fixed Exchange Ratio (FXR) offer-2.875 shares for each TWC share.TWC shareholders will own 23% of the combined firm. Under a FXR the number of shares is fixed, but their value, and hence the transaction’s value, is not determined until closing. The seller bears the risk of a drop in the buyer’s share price until that time. It can gain, however, should the buyer’s stock appreciate. FXR are more common, as opposed to floating exchange ratio structures.

TWC could have mitigated its COM price risk by negotiating for a Collar specifying a range around the initial value within which the price could move. Collars are used in 15-20% of FXR deals. Another interesting feature is the absence of a break-up fee from COM to TWC should the deal not receive anti-trust clearance-which is a real concern here given the size of the firms.  My observations are:

1)     TWC wanted to get as close as possible to its stated full value of $160 per share to distance           itself from CC’s “inadequate” $132.50 price.

2)     Collar and break-up features are valuable options. COM’s offer price would have been                   negatively impacted had TWC insisted upon these protective provisions.

3)     TWC willingly gave up the protection to achieve a higher nominal share price.

4)     TWC’s bet has not worked out and the deal may be endangered. COM is increasing the size of         its share repurchase from $3B to $5.5B post close to support its stock price. Who knows -  the         stock may actually increase in value before the close.

The bottom line is to focus on the whole deal when evaluating transactions. TWC and COM used non price features to help close a price gap. COM could top-up its bid by offering more shares and suffer the resulting dilution. This depends on how concerned COM is with losing the upcoming TWC shareholder approval of the deal due to its falling stock price.

J

Acquisition Risk, Collars and the Comcast Time Warner Deal

An article in yesterday’s Wall Street Journal illustrates one of the risks in stock swap acquisitions – by the time the deal closes the stock price of either target or bidder could change, sometimes dramatically.  What once looked like a good deal could now fall apart.  In this case, the article notes that Comcast’s stock price has dropped nearly 10% since the deal was announced, reducing the value to Time Warner shareholders from $159 per share to $144 per share.  The deal is set to close in the summer.   By that time Comcast’s price could recover – or it could drop further.  Meanwhile Charter Communications waits in the wings with threats to renew its own bids for Time Warner.

One of the topics that always draws considerable interest in our Acquisition Course in Amsterdam is how to mitigate risk in acquisitions.  In the case of the Comcast – Time Warner deal, the risk associated with the change in stock prices could be mitigated through the use of collars.   A collar, comes in various forms, but basically outlines how the value of an offer must change with variations in stock price at deal completion.

The two basic forms of a collar are illustrated below in a chart from an article by Micah Officer.   The formal names of Fixed Exchange Collar and Fixed Price Collar are illustrated graphically by the diagrams and humorously by Micah’s nicknames of Travolta’s and Egyptian’s, respectively.  (Presumably, one can imagine John Travolta striking a similar pose as panel A in Saturday Night Fever.)

Panel A shows the fixed exchange-ratio collar.  This is the most basic collar, setting a minimum and maximum share price at which a deal would be completed.  Imagine striking a deal somewhere in the middle of the chart on the sloped portion of the payoff line.  Small deviations in the bidders stock price produce deviations in the value received (paid) by target (bidding) shareholders at deal completion.  Both sets of shareholders receive some protection from extreme swings in stock price, however. If the bidder’s stock price has increased at deal completion, target shareholders gain and bidding shareholders pay more, but only up to a pre-determined threshold.  Beyond that threshold, the maximum price is reached, illustrated by the upper, horizontal line.   

Conversely, a drop in the bidder’s stock price at deal completion results in target shareholders receiving less and bidding shareholders paying less, but again, only to the point of a pre-determined threshold.  In this case, the lower barrier identifies the minimum value that target shareholders would receive.  Thus, bidders are protected on the upside and target shareholders are protected on the downside.

Perhaps more difficult to understand is the fixed price collar.  In this case the amount received and paid is fixed within a given middle range but varies at the extremes.  Thus, target and bidder are certain of the deal price in some (perhaps plausible) range.   Beyond the thresholds, however, target and bidding stockholders share upside gains and downside losses in response to changes in the bidder’s stock price at closing.   (Still, it is hard to imagine target shareholders suffering extreme losses on the downside without at least trying to walk away from the deal.)

In the case of Time Warner shareholders, there is currently no collar in place.  It will be interesting to watch the vote for approval in the summer if Comcast’s stock price remains low.

All the best,

Ralph