Excess Cash, Leftover Wine, and Acquisitions

Quiz:

When a company has excess cash, what is the optimal thing to do?

a) return the cash to shareholders via dividends or repurchases

b) make acquisitions

c) return cash to shareholders only when they have a better use of the funds than the company

d) retire debt

e) save the cash, rainy days are ahead

(f) increased CAPEX.

With some explanation, the only correct answer is (a).

First, let's look at (e) and (c) and (f) which could be the best answers if we hadn't specified  the phrase 'exess cash'.  By definition, 'excess cash' occurs after consideration of the safety and usage reasons for holding cash.  The term 'excess' also implies that management has already taken all positive NPV projects which would seem to rule out any reason for management to keep cash for safety reasons (e) or as in (b) make acquisitions.  If there were good acquisitions to make, the cash would not be 'excess'. The same is true of increased CAPEX. 

Retiring debt (d) might make sense if a firm was over-leveraged and/or interest rates were high, but in general only makes sense if the cost of debt is less than the return shareholders can earn on their funds at risks typical to those of this firm. Typically, this is the cost of equity for the firm which exceeds the cost of debt and especially the after tax cost of debt.  Rule out (d).  

Now lets give greater credence to (b).  Sometimes it is argued that when a firm's stock price is inflated, it makes sense to use that over-priced currency to acquire hard assets.  When the firm's stock price adjusts to reality, the firm will still have acquired the hard assets at inexpensive prices.  This argument may explain why the number and dollar volume of mergers is strongly correlated with the stock market.   When stock prices are high, more deals get done.  The problem with this argument is that the target's stock price is also  likely to be high so the acquiring firm could be purchasing overpriced assets.  

Thus, when a firm truly has 'excess cash' the only correct answer is (a). Nevertheless, when faced with a decision to relinquish cash or build the empire, many managements choose the later. 

And it is well known that deals increase with stock prices.  

Currently stock prices are at or near record highs.  

So are the number of deals being completed.  This graph from Jesse Solomon in  CNN Money reveals that the number of deals completed in the first half of this year outpaces the total number of recent years and is on pace to surpass the all time highs of 2007.  

Why?  Certainly some deals make sense - and the conditions in many industries are demanding consolidation, but for many firms, one can suspect that excess cash, like excess wine is just not that apparent when it is in your hand.  

All the best,

Ralph

Rhyming or Repeating?

M&A volume is up substantially in 1H14. Some are worried the market may be overheating just as it did prior to financial crisis in 2006 and 2007. My view is this market is in a different stage than the 2006-2007 period. M&A has been depressed following the crisis. Current activity appears more like a return to normal than overheating. Keep in mind, the stock market increased over 30% last year while M&A was flat. The two are usually correlated.

Especially interesting is the increased activity of activist and hostile bids. In fact we are seeing a potentially new development of a combined activist-hostile bid with the Pershing Square-Valeant-Allergan Drama. Shareholders are putting increased pressure on management to do something. You survived the crisis-now do something beyond share repurchases with our excess cash. Thus,they are positively reacting to many announced deals. This factor plus an improving economy, cheap debt and a rising stock market are contributing factors.

Additional observations include:

1)   Deal Quality: deal quality is high. It is primarily larger consolidating and synergistic industrial transactions like 1990s versus the 2006-2007 private equity going private transactions. The deals are concentrated in the telecom and healthcare industries which are undergoing structural changes.

2)   Financial Structure: although debt remains plentiful and cheap strategic acquirers are primarily funding transactions with equity. The percentage of debt financed cash deals has fallen from over 65% in 2006-2007 to around 45%. This helps lower deal risk as sellers are participating in the future prospects of the new entity, and leverage levels remain modest. Sellers are willing to accept buyer stock given increased confidence in markets. They see the potential for a double dip price increase for an appreciating buyer stock post close.

3)   Private Equity (PE): LBO activity remains far below its 25% pre crisis percentage of total M&A. This reflects current high M&A prices and stiff competition from strategic buyers who have better synergy prospects than PE. PE has responded by using increased leverage to help offset higher purchase prices.

Of course, things can change quickly. The impact of the unwinding of the Fed’s quantitative easing program remains an issue. PE, with its large level of dry powder, could become more aggressive and drive up prices and debt levels. Thus, caution is warranted and disciplined bidding is needed by both strategic and PE acquirers. Nevertheless, the current market feels like it is in the early growth phase-not the later overheated stage. History appears to be rhyming - not repeating the overheated 2006-2007 period at this time.

j

Unique Synergies and the Tyson Foods/Hillshire Merger

The Tyson Foods/Hillshire merger provides an excellent illustration of Joe's Blog regarding the gains to merger (see Chance Favors the Prepared Mind).  Joe wrote that:

 Net Value Added to Acquiring Firm = (Unique Synergies + Common Synergies) -  (Market Cycle Premium/Discount + Common Synergies)  = Unique Synergies - Market   Cycle Premium/Discount

The basic idea behind this equation is simple.  Value added is the difference between what you get and what you pay.  The amount you pay is the premium over the pre-market value of the target.  This premium is driven by the competitive position of the bidder/target and also the competitive pressure of other bidders.  Hence the winning bidder will pay at least the common synergies.  

Now normally, we don't know what the unique synergies are in a merger.  But in this case there were multiple bidders for Hillshire and we know that the second highest bidder ( Pilgrim's Pride) offered $55./share.  Tyson "won" the contest by offering $63. per share.  

In this case, we can estimate the common synergies as the difference between the final bid price of the losing bidder (i.e., the $55 offered by Pilgrim) and Hillshire's $37.  stock price on May 9, the day before the merger activity began.  Thus, the common synergies of $18. (= 55 - 37) are included in the price paid by the "winning" bidder (Tyson).  Tyson paid $8. per share more than the common synergies to acquire Hillshire offering a final bid price of $63. 

 So how much must Tyson earn in unique synergies for the contest to be worthwhile?  Enough so the net value added exceed zero. 

Thus, for Tyson to succeed the deal must ultimately be worth over $8. per share in unique synergies.

Net Value Added to Acquiring Firm 

= (Unique Synergies + Common Synergies) -  (Market Cycle Premium/Discount + Common Synergies)  

= (      ?                      +       18          ) -  (                  8                           +          18          )

Which implies Unique Synergies must be at least $8.  to succeed.

But that's not all.  To succeed, Tyson must earn greater than the $8. premium and  successfully earn the common synergies of $18.  

Also note, we estimate the market cycle premium or discount as the difference between the highest and second highest bids.  The actual value is more complex than this and depends in part on whether the target's pre-market value was already over or under inflated.  That is, we are assuming here that Hillshire's pre-merger value of $37. per share was a fair value of the company as a stand alone.

The bids for Hillshire illustrate many important points about mergers and acquisitions:

• When multiple bidders compete, target shareholders win.
• Multiple bidders will emerge when there are common synergies, available to multiple parties.
• Bidders are likely to earn higher returns in cases without common synergies and in cases where the combination of this bidder/target produces unique gains unattainable by other bidders.
• Bidders face a tension between paying too little and losing the deal, and overpaying and reducing their rate of return.
• Unique synergies can also include precluding a rival (like Pilgrim) from establishing a competitive position.  That is, one motivation for Tyson's purchase is likely to be preventing Pilgrim from occupying the same space.
• Synergies that look good on paper may fail to materialize because of misestimation or problems of integration.  
• The Winner's Curse is a distinct possibility.

All the best,

Ralph

Chance Favors the Prepared Mind

M&A is opportunistic. You cannot buy if the availability of suitable targets is poor, the prices are too high or the sellers are unwilling to sell. These factors are dynamic. Thus, potential acquirers must be prepared to move quickly when opportunities present themselves. For example, during the financial crisis a large number of motivated sellers at modest prices appeared. Buyers like Warren Buffett executed attractive transactions during the period.

Being prepared means the following:

1)     Knowing what you want to achieve: what is your end game - a financial or strategic transaction? If    strategic-what is the strategic rationale basis-consolidation, market share or products?

2)     What are the key target characteristics: size, location or performance?

3)     Buyer capability: do you have the skills to execute and operate?

4)     Financial resources: have sufficient debt capacity and liquidity to acquire?

5)     Strength of character: hard to be buying when everyone else is selling. Most managers are pro-     

         cyclical. Yet the best deals tend to be made in the worst of times e.g. Wells/Wachovia.

Equally important is making sure you are the Best Owner of the target. Best owners can obtain the highest risk adjusted cash flows from the target’s assets. No business has a unique fixed value. It varies over time depending on industry conditions, the strategy employed and operating efficiency of the management-owner team in charge. Best owners can obtain the highest value by employing new strategies and better execution to maximize risk adjusted cash flows. Simply put - best owners can extract the most synergies from an acquisition by bringing more than money to the table. Recent examples of this concept are being played out in the Big Pharma Industry.

Winning bidders usually pay a price close to the next highest bidder in a competitive bid situation. Whether the deal adds value depends on the value of the synergy improvement exceeding the premium paid. It is not enough to create synergies. You must create more synergies than the other bidders to avoid the Winner's Curse.

Synergies come in two flavors. The first are common synergies available to multiple bidders. An example is unused debt capacity. Common synergies typically are captured by the seller in the premium paid. Unique synergies are those that can be achieved bidders who are the best owner. Unique synergies are retained by the buyer.

The above can be reflected as follows:

1)     Deal Price = Target Pre Bid Price + Common Synergies +/- Market Cycle Premium/Discount

2)     Deal Value = Target Standalone Cash Flows + Synergies

3)     Value Added to Acquiring Firm =  Synergies - Premium

a)     Premium = Common Synergies +/- Market Cycle Premium/Discount

b)     Market Cycle Premium/Discount factors: financing liquidity + market momentum

c)     Synergies = Common + Unique

4)     Net Value Added to Acquiring Firm = (Unique Synergies + Common Synergies) -  (Market Cycle Premium/Discount + Common Synergies)  = Unique Synergies - Market   Cycle Premium/Discount

Thus, over priced late market cycle deals by bidders lacking unique synergies tend to be losers. Buyers need to know where they are in the M&A and Industry market cycles and whether they are the best owner of a target before bidding. So be prepared.

J

GM, Product Risk and Corporate Governance

We've written many times of the importance of corporate governance.  It becomes readily apparent when something like the GM ignition switch crisis occurs.  The product problem relates to a faulty switch which would turn the engine off with a slight nudge of the knee or when heavy objects (other keys?)  dangled from the keychain.  The company problem is much more complex.  The company links 13 deaths to the problem.  Plaintiffs attorneys suggest a figure considerably higher.  Even one known injury is too many.

The obvious questions to be asked are ones without any suitable answers: Who knew what when?  Top management?  The board?  If they did know, what actions were taken?  If they didn't know why not?  The board states that they were not aware of the problem, yet numerous customer complaints began pouring into the firm as early as 2005.  Press reports assert that some engineers knew of the problem in 2001.  Why wasn't management aware of these problems?  Why wasn't the board informed?  At the time of this writing, GM has recalled over 2.6 million cars costing more than $1.7 billion dollars. This doesn't begin to measure the cost of liabilities facing the firm, nor can it ever measure the human loss.  Why did it take so long to begin the recall?

It apparently would have cost about fifty seven cents to improve the switch.  Instead of doing so, the company tried makeshift solutions, shipping modified key inserts and writing to customers to be aware of hanging heavy objects from their keys.  When the part was finally improved, the company kept the same part number, providing further confusion.

The other solution the company took when at least some managers were made aware of the problem is to form two committees - not committees of the board - but committees of employees - and the board was never made aware of the situation.

To be fair, the current board is largely new, but it is not enough to say 'We weren't there.'  The board needs to understand if this is a systemic governance problem within the company.  They must assure themselves, as well as investors and customers that something like this could not happen again.  Those steps must begin with a thorough analysis of the process of risk management and the process by which the board is informed of problems.  

A dramatic audit of the firms governance structures is needed.  What governance structures led to this situation?  How must they be improved?  What was/is the process by which the board monitors product risk?   What whistleblower functions are in place and more importantly, what is the corporate culture with regards to reporting and addressing problems - even if they appear costly.

Moreover, it is not sufficient to make changes that could have prevented known problems.  The board needs to have a process for anticipating and eliminating future problems.  Again, this begins with having the right processes in place, and monitoring the corporate culture.  It begins with management developing the right tone for the firm and with the board continually probing and asking leading and open ended questions.  Board experience in working with other problems of risk management at other firms is essential, especially in pointing to weaknesses in current processes and in anticipating the unexpected.  

We'll know more about what happened soon as the firm has hired Anton Valukas to provide a detailed report on the situation.  Valukas was also the person who provided an analysis of the Lehman Brothers bankruptcy.  It should present a good start for reform and for recognition that safety of the customer has to be the highest priority.  Lack of safety is not an option.

All the best,

Ralph

Fantasy Finance: Funding the Fully Priced Deal

Private equity firms are facing increasing deal multiples. EBITDA purchase price multiples now exceed 9X-almost equal to the pre crisis 2007 level of 9.5X. Some factors underlying the increase include:

1)   Return of strategic buyers: corporate buyers have returned with M&A volumes continuing to climb.

2)   Rich IPO prices: sellers can point to higher IPO prices as a credible alternative to a buyout, which buyers must match.

3)   Dry powder: PE firms have raised $95B in 1Q14.This is the highest amount since the heady pre-crisis days. Consequently, the fund raising tail will once again wag the PE dog as the money needs to be invested.

4)   Recaps: sellers can obtain interim liquidity thru a recap in the wide open debt markets.

5)   Strong stock market: sellers feel they can wait. This reduces the current availability of targets.

Not surprisingly, debt markets have responded with increased appetite for leverage to support increased buyer funding needs. Debt multiples have risen to over 5.6X EBITDA. This compares to the pre-crisis peak of 6.1X. Perhaps more important, the percentage of deals with funded debt multiples greater than 6X is 40% versus pre-crisis 50% level. This is important as U.S banking regulators have expressed concern over the growth of highly leveraged transactions exceeding 6X leverage. This could damper further bank funded leverage increases.

The current back-of-the- envelope funding gap, PPX of 9 less a debt capacity multiple of 6, now exceeds 3X EBITDA. As the London subway signs state-mind the gap. PE funds are attempting to mind the gap in the following ways:

1)   Operating improvements to increase EBITDA: there are credibility issues on size of improvements. There has to be some strategic basis to the expertise the PE firm brings other than just money. Pay particular attention to pro-forma deals which translate into EBITDA without the bad stuff.

2)   Asset sales: these can be tricky. The market can dry up. Thus, a bridge facility is needed. Also, the sale EBITDA X must be greater than the deal’s PPX. Otherwise, the EBITDA stream will be diluted and remaining debt capacity will decrease.

3)   Assuming your takeout multiple will exceed the purchase multiple. This is questionable given today’s high PPXs. Typically you need to fundamentally improve the target to justify a higher exit multiple, which gets back to point 1 above.

4)   Increase debt capacity thru financial engineering - but we may be reaching a limit at least for banking regulators.

We are approaching the fantasy finance stage in deal pricing as reflected below:

PE funds will continue to be funded by yield hungry investors into the stupid state. Nonetheless, just because you can do something does not mean you should. These types of situations usually do not end well for LPs as reflected in my wheel of misfortunate:

We appear to be in the “capital chasing deals” stage. Like riding a tiger, it is difficult to get off. As noted before in MergerProf the single biggest inhibitor of PE fund returns is overpaying for portfolio investments. This means paying a premium of 40%+ over the target’s pre-bid price. Compensating with an aggressive capital structure from an accommodating debt market further reduces the chances of success.

j