Gin Rummy LBO Screening: The Case of Dell

My previous Best Buy post highlighted why I considered it to be a poor LBO candidate. Best Buy's big box retail model was rapidly losing out to on line firms like Amazon. Firms suffering from declining operations due to industry structural changes, which put their existing business into question, involve too much business risk. They have poor prospects of turning themselves around in a highly leveraged state.

Now another structurally challenged firm, Dell, is considering an LBO. Dell's shares declined 30% last year despite an overall rise in the stock market. Its core direct order PC business has fallen prey to retail stores and new products like smart phones and tablets. The result is that sales declined 19% and profits fell 47% last year. They have been trying to offset the decline by repositioning the firm through almost $13B in new initiatives (including acquisitions) for some time.

Dell's market value exceeds $20 B. Applying a reasonable premium suggests a transaction price around $24B. A 40% equity requirement generates a $9.5B equity need.  Assuming the rollover of Michael Dell's ownership reduces the new equity need to $6B. This is a large amount and would probably be split among multiple private equity sponsors as had occurred during the 2003/2007 LBO boom. Shared deals like this can be tricky if something goes wrong as it is difficult to know who is in charge.

Debt in excess of $13B would be needed. Dell has a sizable cash position. Unfortunately, it is largely overseas, and probably subject to substantial taxes if returned to the U.S. to support the proposed LBO. The key impediment to the debt levels is Dell's declining core earnings and market share-despite years of continued turnaround efforts by Michael Dell. How can you build a realistic capital structure if you are unsure about your cash flow?

Michael Dell is likely to continue in a senior role in the LBO. Thus, it is difficult to see what new turnaround efforts he will employ in a highly leveraged firm that will be more successful than past efforts. It is difficult to reinvent and implement a new business model in a leveraged firm. There is little room for delay or error. The fact that this project can even be seriously considered is a testament the current highly receptive bank and capital markets.

I understand Dell's frustration given the market's response to their existing turnaround efforts. Nevertheless, an ill-advised LBO is not the best alternative choice of action. Absent a strategic buyer, a more realistic option is to manage the firm for cash, and return the cash to shareholders. Part of the disappointing stock market performance may be due to shareholder concerns that Dell is over investing in low return activities, or overpaying for acquisitions.

The high financial risk in LBOs requires a stable operating environment with predictable cash flows. It is difficult at best to try a high-wire business turnaround in leveraged firm. A concern is banks and other investors in search for high returns will proceed with the transaction despite its size and risk. Wilbur Ross gives the proposal a 50% chance of proceeding. Investors should beware of LBO candidates representing weak discarded cards as in gin rummy.

J

Repurchases Part 4: Some Concluding Remarks

In three previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side,  and Repurchases, Part 3: Joe Responds, Joe and I have debated the merits of repurchases.  Today's blog contains Part 4 where we continue the debate and try to summarize.  

Thanks to all for your comments.  You are also welcome to post them here.

Joe and Ralph

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Ralph:

Joe, your Repurchases Part 3 contains some great comments.  Maybe I'm being picky but I still kinda disagree with two points.  

First,  and this is technical, share repurchases can alter the capital structure and as they increase leverage, the tax shield increases.  This can create value if it doesn't increase risk excessively.   For many repurchases, this can be a minor effect.  However, a company can increase its leverage quickly by borrowing and using the proceeds to repurchase stock.

Also, while I agree you can replicate repurchases with special dividends, your shareholders will suffer much higher taxes.

Joe:

Yes, but you can get same leverage impact thru debt financed special dividend.

Regarding taxes - it depends on the shareholder base-clientele.

Ralph:

OK, I agree you can get the same leverage impact, good point, but still think either approach can create value.  It might be that we disagree whether leverage can 'create' value.

On taxes, yes, but capital gains  are taxed at a substantially lower rate than ordinary income (dividends).

Joe:

Taxes are not an issue for investors like untaxed pension funds

Microsoft’s 2004 32B special dividend is counterfactual.  If the tax

disadvantage is key,  then why didn't they use a repurchase?

Ralph:

I agree with your comments about untaxed pension funds - and institutional ownership is quite high in corporate America.  To other investors it would matter.

Regarding Microsoft, I don't know the answer.  I do note that in addition to the special dividend, they also repurchased shares.  So they actually did both.  As far as I know, Steve Ballmer and Bill Gates do pay taxes, so the mystery remains.  (Bill Gates was reported to donate the proceeds he received to his charity but I still think repurchases would have saved taxes.)

I do think we can agree that:

Share repurchases can be controversial!  And, while they offer tax advantages over dividends, they can be abused.  Two possibilities for this abuse are a) the apparent, but misleading, increase of earnings through repurchases and b) companies that overpay in repurchases harm existing shareholders. 

Dividends don’t produce the overpayment problem, but force shareholders to accept the distribution, while repurchases give them the option to defer.

Also, since it is difficult to precisely estimate the value of one’s shares, companies should proceed cautiously with repurchases. 

Finally, companies that cannot put cash to use at rates higher than those demanded by shareholders should return it in some form.  If you increase regular dividends make sure they can be sustained.  Otherwise, consider share repurchases and special dividends.

Repurchases, Part 3: Joe responds

In two previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side, Joe and I have debated the merits of repurchases.  Today's blog contains Part 3, Joe's response.  We'll conclude (maybe) our current discussion on repurchases on Wednesday.  We'll both respond to these points and try to summarize.

R

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Joe:

Perhaps, I was overly critical of share repurchases in my previous post. Ralph raised several good points to which I would like to offer some clarifying comments.

1) Shareholder distributions, dividends and repurchases, do not increase value since they do not affect firm cash flows. They are, however, correlated with value changes.

2) Not all repurchases are created the same. Their impact depends on their size, premium offered, execution method, and funding. Small, excess cash funded, low premium open market repurchases are associated with small effects.

3) Everything that can be done with a repurchase can be done with a combination special dividend and reverse split. My point is to understand what is driving management's choice of a repurchase over a dividend, and whether it serves the best interests of continuing shareholders. A possible motivation  may be that while most stock option plans adjust for repurchases, they do not adjust for dividends. Thus, stock options are worth more to executives when cash is returned through repurchases v dividends. Interestingly, Berkshire Hathaway, which recently announced a repurchase, does not grant large levels of options and restricted shares to its executives thereby avoiding this issue.

4) The danger of a value transfer from continuing to selling shareholders exists when management overpays relative to the stock's intrinsic value for the repurchase. Berkshire provides an excellent example of pricing discipline in its repurchase policy. They state repurchases will be approved only to return excess cash when its shares are trading for less than 120% of their net asset value,  i.e. intrinsic value.

Bottom line, trust, but verify. Repurchases are more complex than they first appear. The FT's 1/2/13  Lex Column put it best: "Companies should manage cash carefully so a payout is sustainable across the cycle. Failing that, special dividends work just fine, thanks. Cash that a company earns that cannot be invested for adequate returns belongs to shareholders. Keep it simple, and return it to them.".

J

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Value is Estimated, Price is Paid

Today's blog continues our more detailed analysis of each of the 14 Keys to Acquisition Success.  We are at Point 10.

10.  Value does not equal price.   As our friend Bob Bruner has noted, Price is what you pay, Value is what you estimate.

This one is simple.  And fundamental to success.  And often overlooked.When anticipating a deal, we estimate value.  It is an imprecise science involving discounted cash flow, price multiples, and comparables.  Each estimate requires judgement and our projection about the future.  True value is unknown and only realized with time.

This is, of course, at the core of business enterprise: risk and return.  Risk is inherent in business decisions - it is at the heart of opportunity.  But we need to be compensated adequately for the risks we take.  And the crucial, immediate key to that compensation is in the price we pay at the very beginning of a deal.

If the payment is in cash and doesn't involve earnouts or other contingent payouts, the price we pay is known, and even if payment is in stock or other securities, they can generally be converted to cash.  So a known price is paid in exchange for uncertain value.  There is no better or easier time to create or destroy value than when bidding for a potential target.   

The moral of the story is to be careful, very careful about estimating value.  It is easy to make mistakes.  To repeat: there is no better (easier) time to create (destroy) value than when setting the price.  Tread carefully. 

Joe's recent blog about the HP - Autonomy  deal noted is a good example: "The Autonomy deal - priced at 11X revenues, 24X EBITDA, 3X assets, and a 60%+ pre-bid stock price premium - was DOA at close."  Even without misrepresentations it would be hard to recover from such a rich payment.

Ralph

Repurchases: Part 2 The Positive Side

On our last post, Repurchases: Part 1 Shareholders Beware Joe pointed out some concerns about repurchases.  These are good cautions, but I'm an empiricist and I need to point out that the empirical evidence on repurchases is much more positive.  In the paragraphs below,  I'll first outline some theories about share repurchase and then discuss some empirical evidence.  

We generally assume one of six things is going on with a share repurchase.  First, a firm could feel that its stock is undervalued and the repurchase signals positive news to the market about this inside view.  In this case, we'd expect to see the stock price rise on the announcement of a repurchase.  Second, the firm could use repurchases as an efficient tax-advantaged way to return excess cash to shareholders.  It is efficient and tax advantaged since capital gains are taxed at a lower rate than dividends.  Third, the repurchase signals that management is not going to squander excess cash on things like unproductive acquisitions.  Both of these are positive effects and the stock price should rise upon announcement of a repurchase.  Fourth, an in contrast to the previous item the repurchase could signal a lack of growth opportunities for the firm.  In this case, we'd expect the stock price to decline at the announcement of a repurchase.  Fifth, since repurchases reduce the equity position in a firm, they change the capital structure producing less cushion for debt holders.  If true, debt holders would lose upon announcement of a repurchase; equity holders would gain.  Sixth, firms sometimes repurchase shares to fund executive options. One can imagine other motives, some of which Joe outlined in his post.  I'll return to that in a moment.  

The empirical evidence on repurchases is strongly consistent with a positive impact to shareholders and generally supportive of the first three hypotheses mentioned above: signaling, tax efficiency, and the return  (rather than squandering)  of excess cash.  The fourth and fifth hypotheses ( a lack of growth opportunities and wealth transfers from bondholders)  find less support.  On the sixth hypothesis, Kahle (2002) also provides compelling evidence on the use of repurchases to fund executive options.  This is not, by itself detrimental, but has clouded some empirical tests of the other hypotheses.  (For an elaboration on this see Share Repurchases see our article in the Journal of Corporate Finance, Share Repurchases Executive Options and Wealth Changes to Stockholders and Bondholders.) 

So the empirical evidence is overwhelmingly positive and I find myself more optimistic about repurchases than Joe.  This does not mean that shareholders shouldn't be concerned with the cautions that Joe notes.   The empirical results we discuss in this post are statistically significant tendencies.  Individual firms could still be using repurchases for less than desirable reasons.  Indeed, some of the items Joe notes (use of repurchases to mechanically raise earnings per share, for example), have no empirical justification.  Concerns about firms overpaying shareholders who tender make sense.    Other items like repurchases to alter option values suggest fruitful additional ideas for additional analysis.    These things may exist in a subset of the data.  The wise investor or board member can take comfort from the positive evidence about repurchases, but should sprinkle this with healthy skepticism for possible abuse.  

Ralph

Share Repurchases: Part 1 Shareholders Beware

Happy 2013 to All!

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A strength of our blog is the combined and sometimes differing viewpoints on topics.  Today, Joe warns of the dangers of repurchases.  On Monday, I'll talk about some positive elements of repurchases.

Ralph

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Slow organic growth and a tepid M&A environment have caused an embarrassment of riches at many firms with increasing capital and cash levels. Managers are concerned about falling ROEs , stagnant earnings per share (EPS) and their incentive compensations plans which are tied to those measures. Shareholders are also expressing concern over raising capital levels. Their concern is it may be reinvested in over- priced acquisitions among other things. Thus, they are putting pressure on management to return excess capital. This in turn raises the question of how best to return capital. The focus of this post is on excess cash funded repurchases-not debt financed repurchases -which involve capital structure considerations.

Share repurchases, aside from technical tax differences depending on the tax status of the firm’s investor clientele, have similarities with dividends as a cash distribution mechanism. For example, a dividend combined with a reverse stock split yields the same result as share repurchase of the same amount. Dividends and repurchases differ, however, in certain important respects. For example, EPS will be higher with a repurchase compared with a dividend absent a reverse split because of a reduced number of shares. This is true even though the ROE is same under both distribution alternatives. Thus, repurchases can be used to disguise poor earnings growth through manufactured EPS growth by reducing the denominator of the calculation instead of improving the numerator.

Another difference concerns the allocation of value between the selling and remaining shareholders. All shareholders receive dividends. Only the selling shareholders receive cash in a share repurchase. Remaining shareholders are penalized when shares are repurchased at a price above their intrinsic value. In that case value is transferred from the remaining shareholders to the selling shareholders. Managing this risk is difficult as it can only be assessed after the fact. Historically firms are poor at timing share repurchases at the appropriate price-i.e. they overpay.

A simple discount to a target is insufficient to justify a repurchase.  The discount may be warranted due to poor earnings prospects. Management over-optimism frequently results in over-paying departing shareholders at the expense of those who remain.  Particular attention is needed to guard against repurchases that are overpriced to influence stock prices by increasing EPS. Managers seeking to game incentive compensation systems tied to these measures will propose repurchases. EPS improvements following a repurchase are, however, offset by falling price-to-earnings ratio without necessarily increasing long term value. Repurchases affect the distribution of value, not the creation of value as operating results remaining unchanged.

Boards reviewing a repurchase proposal should follow a three-step process. First, they need to understand and approve the motive for the repurchase. Motives other than the efficient return of excess cash should be challenged. Next directors must understand the firm’s conservatively calculated intrinsic value. They should approve stock repurchases only below that value. Thus, managers should justify repurchase prices based on credible intrinsic value estimates.

Boards should be skeptical of managerial undervaluation claims. This may reflect a poor investor communications that should correct over time. Alternatively, investors may not believe management value estimates. When in doubt a special dividend may be better than a potentially overpriced repurchase. Finally, the distribution should be part of an overall capital plan that is tested under adverse macroeconomic scenarios.

The repurchase decision involves complex valuation and governance considerations. Investors are not and should not be indifferent to these factors. This requires clear thinking by the board to protect the interests of non-selling shareholders against potentially conflicting management motivations. Capital management assumes Uheightened importance in a low growth environment. This includes selecting the best means to return capital to shareholders when it cannot be profitably reinvested in organic or acquisition opportunities. Repurchases are not necessarily bad, but when misused they can reduce shareholder value. So, shareholders beware.

Joe