What happens when a target and bidding firm share the same auditor?  According to an interesting study by Dhaliwal, Lamoreaux, Litov, and Neyland, targets lose.  Of course, this is a characteristic of the sample and not true for every observation, but certainly something that deserves thinking about.  The abstract is below:

Shared Auditors in Mergers and Acquisitions

Abstract:      

We examine the impact of shared auditors, defined as audit firms that provide audit services to a target and its acquirer firm prior to an acquisition, on transaction outcomes. We find shared auditors are observed in nearly a quarter of all public acquisitions and targets are more likely to receive a bid from a firm that has the same auditor. Moreover, these shared auditor deals are associated with significantly lower deal premiums, lower target event returns, higher bidder event returns, and higher deal completion rates. These results are driven by bids in which targets and acquirers share the same practice office of an audit firm and in which the target is small. Overall, our evidence suggests that bidders benefit from sharing an auditor with the target, and that these results are robust to controls for alternative explanations and for selection bias in the shared-auditor effect.

The complete paper, can be downloaded here.

All the best,

Ralph

Venture Capital Pricing: Bubble or Something Else?

Trying to make sense of current VC pricing is a daunting task. The increased pricing is reflected in VC IRRs for the past year which exceeded 25% according to Prequin-exceeding those of PE for the first time this century. Consequently, fund raising is accelerating as investors chase yield. This is producing ever higher pricing multiples. Is it a bubble, a recovery or something different?

My thoughts, which focus primarily on the ecommerce segment, are as follows:

1)     There are only three ways to profit from ecommerce. Either you sell devices like Apple, sell goods or services such as EBay or Angie’s Page, or sell advertising –Facebook.

2)     The implicit assumption for investors is competition is weak due to something like network effects-hence the need to raise lots of money, invest it quickly and get big quick. Investors flock to the industry and its participants creating a momentum pricing effect lifting pricing multiples-a virtuous circle.

3)     Wild changes in pricing occur once evidence accumulates that the competitive advantage period is unrealistic. Investors are reintroduced to Porter's  five forces which eventually impact industry profitability.

4)     Investors recognize they misread market signals and have misallocated capital, and begin to curtail investments. This triggers a reverse momentum or vicious circle.

Investor errors are understandable given the lack of operating history or clear business model for these firms. The impact of seemingly small changes in investor estimates can have a major valuation effect:

1)     Simple earnings calculation model: P=E/(r-g) were E is a horizon value earnings estimate, r is the risk factor and g is estimated growth.

2)     P/E ratio is then equal to 1/(r-g). If we assume (r-g) =2 at the beginning of the investment then the P/E ratio is 50. If (r-g) increases to 4 due to a combination of changes in r and g then the P/E ratio falls to 25 resulting in a massive value change.

3)     The change in estimated growth, g, is probably the greatest wildcard. Over estimating growth (AKA under estimating competition) results in investors over paying for growth and reduces their margin of safety when something causes a reassessment.

4)     VC markets, especially early stage, are by no means as efficient as established markets. Thus, the price is not always right. Even in efficient markets the price is not always right. Rather, it means it is difficult to exploit any perceived errors.

The above volatility is characteristic of investors “shooting in the dark” given the lack of operating histories and clear business models for many of these new firms-leap of faith investing. Warren Buffet calls this speculation and not investing-different strokes for different folks I guess.  Until new information arrives, investors are left following technical demand factors (e.g. momentum which is heavily dependent on the amount of new capital raised) and guesswork. Momentum and guessing are prone to error and wild corrections as the mean reversion impact of the Five Forces kick-in.

So, keep your safety belts fastened and do not bet the ranch. The path for now is up, but how long this lasts is unknown. When it changes things will get bumpy as is characteristic of the creative destructive process of economic progress.

J

Staples, Office Depot and the New Competitive Landscape

Nearly 20 years ago, Staples tried to acquire Office Depot to find the deal rejected by regulators.  Fast forward to today and we see the two largest office supply stores again seeking to combine.  What has changed and will the deal still be anti-competitive in the eyes of regulators?   How does the market see the prospects of the deal? What are the lessons to be learned?

To answer the last question first, there are many elements that make this an interesting story.  First is the role of activists (hedge fund Starboard Value).  Second, we have noted that a wave of consolidation in an industry is often sparked by some catalyst.  Note the Office Depot and Office Max combination of two years ago reduced the number of main stream office suppliers to two.  This merger would reduce that number to one.  Ironically, although the catalysts here are multifaceted, they led by a string of new competitors with competition for Staples and Office Depot ranging from the big box stores (Walmart and Target) to online behemoth Amazon. 

So will the deal be seen as anti-competitive?  That depends on how regulators view the market for Staples and Office Depot.  To be sure, there is considerable overlap in the geographic location of stores and the closing of duplicate stores is undoubtedly a central factor in any synergies from the deal.  But the question of market is much more complex.  For example a sizable component of the sales of the two firms comes from large quantity orders from businesses.  In addition, we have the big box and online competitors to consider.

Regulators measure anti-competitive behavior by a number of factors, including the 4-firm concentration ratio and the Hirfindahl index.  As we have noted before, the key to determining concentration is defining the market and in today's landscape, that market is widespread but the jury is out on how the regulators will view the world.

As for the market, it seems to be expressing skepticism over completion of the deal.  Office Depot closed yesterday at $9.49 a significant gap below the deal value of $10.91.  That is a quite sizable speculation spread.

(See also Comcast, Time Warner and the Myth of the Cable Industry, Concentration Ratios, the Case of Anheuser Busch and Modelo, and Speculation Spreads and the Market Pricing of Proposed Acquisitions)

All the best,

Ralph

The Swiss Franc (SwF) Surprise and Private Equity Risk

The Swiss National Bank unexpectedly removed its cap/peg limiting the value of SwF on January 15, 2015. The SwF soared and traders who had relied on the peg since its 2011 creation to bet against the rise suffered huge losses. For example, Citi Bank, Deutsche Bank and Barclays lost a combined $300mln. Smaller trading houses like FMCX had to be rescued or failed. The losing parties claimed the situation was an unforeseen BLACK SWAN or 20 standard deviation event (AKA not their fault).

What happened is a classic example of Peso Risk. It reflects exposure-not experience-to a risk event not reflected in the sample period used to gauge risk. The termed was coined by Milton Friedman in the 1970s to describe what happened to traders engaging in a carry trade between the Mexican Peso and USD. The official Peso exchange rate to the USD had been fixed by the Mexican government since the early 1950s. Mexico had higher inflation and interest rates than the United States. Traders were borrowing USD at relatively low rates to spot into Pesos which were then invested in higher yielding  Mexican bonds and pocketing the difference. It looked like a free lunch except for one thing; namely devaluation risk. Sure enough in the early 70s, the Mexican government could no longer the support the Peso, which was promptly devalued. The losses wiped out years of “profits” – the profits were of course illusory. Traders, just as in the SwF case, blamed it on unforeseen events.

Private Equity is sometimes based on the carried trade model involving Peso Risk, and it too suffers from periodic blowups like the one experienced during the recent Financial Crisis. As debt markets overheat PE firms borrow heavily (FD/EBITDA > 6X), cheaply (low debt spreads and at relatively low absolute rates) and with favorable terms (Cov-Lite, back ended amortization and PIK) to acquire firms and achieve a positive carry (i.e. with positive debt service coverage of EBITDA/I >1). Eventually an event occurs and the carry turns negative leading to losses.

Bottom line, make your risk assessments based on exposures and fundamental analysis and not just on recent experience. Past performance is not indicative of future results because the past sample period may be biased by not including a major bad event. Assume a worst case and ask if you are prepared to accept the consequences - if not then walk. Be skeptical of claims that a worst case will never happen -they do.

J

One Sided Activism? A Note on the Symmetry of Market Problems and the Asymmetries of Activists

There are a couple of really interesting articles about activists in the last two Wall Street Journals.  The first is yesterday's "Activists Are On A  Roll With More to Come", which documents the power and success of activists, noting the growth in the number of campaigns and in the number of assets under control.  The article also notes the increased success rate of proxy campaigns.  

The second article, entitled A Radical Idea for Activist Investors presents a provocative question.  If Actists are so smart, why are they one sided in their attacks? As the article notes:

"The vast majority are making similar demands of their targets, delivered with what now feels like a dull percussion: Raise the dividend, buy back shares, cut these costs, spin off that division, sell the company."

Wouldn't we expect a similar pressure by activists encouraging at least some firms to invest more?  Shouldn't we expect at least some activists campaigns to push firms to be less conservative, to invest more, to pursue heretofore missed opportunities?  

The article suggests three reasons for the one-sided attacks.  First, CEOs can be driven by ego and are motivated to expand not contract.  Second, such an attack requires a longer term investment to reap rewards.  Activists tend to be more short term.  Third, it could cause destabilizing investor turnover as one type of investor replaced another.  (I confess to not fully understanding the latter idea.  How does this ever stop value creation?  Don't takeover attempts do the same thing?)

But I'd like to offer a fourth reason that activists are not prone to pushing firms to invest differently and it is simply this:  Activists are not by nature, build it, type individuals.  Also, the expertise it takes to recognize over investment is likely to be more plentiful than the type of expertise it takes to build something.  I'm not saying one of these skills is more valuable than the other, just that it is not surprising that activists don't possess these skills.  Also as the article notes:

"These are the very opportunities that private-equity firms exploit, capitalizing on the market’s impatience for such undertakings."

So from my perspective, there is nothing unusual about specific types of investors being adept at different approaches.  Both articles offer a lot of food for thought and are well worth reading.  

All the best,

Ralph

Dollar Tree Family Dollar Acquisition: A Rare Win-Win

DG began acquisition discussions with its smaller competitor, FDO, last summer. Another smaller rival, DLTR, emerged with an $8.7B mix of stock and cash offer-representing a 22% premium to its 7/25/14 price. DG responded with a $9.1B all cash offer. Ordinarily, a higher all cash offer would prevail as its value is clear. Nonetheless, DG’s offer contained a substantial risk of not closing due to real antitrust concerns.

DG was the largest of the three major players in the “dollar” retail industry at $4.7B in revenues and 11,700 stores compared to DLTR’s $2.1B and 5200 stores and FDO’s $2.6B and 8100 stores. Whenever the #1 buys the #2 in the same industry- antitrust issues become a real concern. It was estimated DG needed to jettison over 1500+ stores to may be satisfy the FTC; while DLTR with less overlap would close less than 500 stores. Recognizing this- DG offered a $300 mln+ breakup fee. Perhaps, DG wanted to remain the dominant industry participant and prevent the formation of a larger rival.

Last week, FDO shareholders  accepted the lower priced DLTR offer given its greater chance to close. Interestingly, the market was positive for all three firms. The stock price increase for DLTR and FDO is somewhat understandable. It signals belief in the synergy benefits of the combination and removal of uncertainty for FDO’s shareholders. Additionally, DLTR appears to have a better chance of turning around the struggling FDO which had suffered a 47% drop in earnings for the 11/14 quarter end.

Looking at the 3.7% increase in DG’s stock rise one can conjecture the following reasons:

1)     The price was too high relative to the possible benefits it could extract. Another way of saying it is DLTR is the better owner.

2)     Closing 1500+ stores given the premium offered makes you wonder what’s in it for DG’s shareholders. That is a lot to give up relative to DLTR.

3)     DG foregoes the possibility of paying a $300 mln breakup fee if the deal failed to obtain antitrust approval.

Yes, DG is smaller than it would be if the acquisition proceeded, but its shareholders are richer- better off. Yes, DG faces a new and larger combined DLTR-FDO competitor. The new DLTR, however, faces real integration and turn around issues. Furthermore, it will be saddled with a heavy debt load comprised of $5.4B in term debt plus another $2.8B in new senior unsecured notes. Well- in any event the market has spoken. My gut tells me DG’s shareholders dodged a bullet on this one and should thank the FDO shareholders for rejecting their offer and thereby preventing a forced DG managerial error.

J

Earnings Dilution - A Real or Imagined Problem?

A good deal is one that is expected to produce a positive net present value.  That is, it is worth more than it costs.  But what about a deal that has a positive net present value and results in earnings dilution next year?  Is this possible?  If so, is this still a good deal?  Are there any ways to avoid dilution?  In a share for share exchange, how can we tell the maximum number of shares that an acquirer could issue without causing dilution?

Can a deal with a positive net present value cause immediate dilution of earnings?  Absolutely.  If we issue enough shares to acquire a target and the shares are not offset by an appropriate increase in next year's earnings, dilution will occur.  By NPV terms, the deal is still a good one if the expected net present value is positive.  It is just that the value and cash flows appear later in time.  Nevertheless, the dilution in eps creates a very real perception that the firm is declining.  Shareholders without privy to the stream of expected cash flows or NPV calculations can assume that the acquiring firm is in a downward trend.  Hence, dilution creates a very real problem.

How to avoid it?  A first solution is not satisfying: don't acquire targets where dilution would occur.  This results in missing great opportunities if the deal is indeed a positive NPV.  A better approach is to structure the deal so that dilution does not occur.  This is done by issuing fewer shares and substituting cash or debt to complete the payment.  Deferred or contingent payouts can also help in this regard.  

How can we know if dilution will occur?

1.  Estimate projected eps without the deal
2.  Estimate projected total earnings with the deal
3. Divide the projected total earnings by projected eps in step 1.  This tells you the maximum number of shares you can have outstanding without dilution
4. From this maximum number of shares, subtract the current shares outstanding of the acquiring firm.  This tells you the maximum number of shares you could give the target without dilution.
5. Divide the number in item 4 by the number of target shares currently outstanding.  This gives you the maximum exchange ratio without dilution.  

As an advanced concept, you could expand this maximum using free cash flow generated by the target in the first year after acquisition although you'd be giving away some value.  To do this:

6. Calculate how many shares of the acquiring firm you could acquire using the target's first year free cash flow.  Add this to the maximum number in item 4 and recalculate item 5.

All the best,

Ralph