Merger Activity in the First Six Months of 2013

In February it looked like the year was off to an upswing in merger activity, sparked by Berkshire and 3g's $28 Billion acquisition of Heinz and Dell's $24 Billion LBO.  Six months out finds the Heinz deal closed and the Dell LBO awaiting a shareholder vote.  Meanwhile overall merger activity is down for the year.  As the headline of Tuesday's New York Times States, Merger Activity Was Down But Not Out, in the first half of 2013.

It is interesting that many factors are in place that are associated with greater deal activity. Interest rates are low facilitating demand.  Stock prices are high and historically the number of deals has been strongly correlated with the general level of stock prices.  In addition, companies are sitting on record amounts of cash.  All of these factors should signal a strong robust market.  Why haven't they?

One explanation is that firms have been restructuring themselves rather than acquire other firms.  There has been some increase in share repurchases - companies essentially buying themselves.  Plus, this year's merger numbers may be a bit distorted, as there was increased activity in the 4th quarter of 2012 as companies rushed to avoid the fiscal cliff.  I think a bigger factor is general uncertainty about the state of our economy.  It is difficult to plan in the face of great uncertainty and there is much to be uncertain about.  Not in any order of priority, let's consider a few reasons for reduced activity.  

First is the increased regulatory environment.  We haven't witnessed such an environment in recent history.  What is worse is that so many of the regulations coming down the pike are unknown.  Over two thirds of the Dodd Frank Act remains to be written.  Bank M&A still lags largely due to regulatory approval uncertainity.The deals being done are very small.  We can adapt and adjust to most any set of rules but when the rules change in the middle of the game it is hard to plot your strategy.  The same could be said for the new health care laws, etc.  

Second, is the economy itself.  The Fed and Quantitative Easing have increased uncertainty.  The recent 80 basis point increase in the 10 year t-bill (140bp+ on BB credits) will curtail the level and types of deals (e.g. covenant lite and PIK) funding. This is a big thing and will require big adjustments. During the interim it is sure to depress deal activity.  Government intervention in markets means ‘artificial’  and that is not a word associated with market equilibrium. See point one.  

Third is the political uncertainty in the world.  European deals have really suffered.   Of the three points mentioned, this is the one that feels most like something we've seen before.  But even here we see technology shaping political unrest and revolution in ways that couldn't have been imagined a few years ago.  At the same time, we are increasingly aware of the technology used by our governments and by businesses themselves to track our movements.  This could turn out to be necessary, even beneficial, but it is unsettling.

My colleague, Joe Rizzi, also mentions a possible behavioral angle.  Managers who experienced the recent crisis have become ‘depression babies’ and may have a reduced appetite for M&A risk.

Those are just four items leading to a feeling of unease and increased risk.  There are signs of optimism for dealmakers, but it may take positive thinking to see them.  Risk means opportunity and deals are being completed, particularly in certain sectors of the economy.  Well-conceived and well-executed mergers create value and as we've noted before, regulatory, economic and political shocks are often catalysts for increased merger activity.  Let's see what the second half of 2013 brings.

Happy 4th of July, America!

Ralph

Convertible Bonds: Free Lunch or Expensive Banquet?

Convertible bonds are a hybrid instrument. Their combined return is based on a coupon plus an option to convert the bond into the firm’s equity at a set price. They are similar to straight debt with non detachable warrants. Convertible bond issuance peaked in 2007 at around $100B.Issuance bottomed out at $20B last year. Concerns over rising rates, both treasury and credit spread increases, following recent Federal Reserve QE statements have sparked renewed interest in convertibles. The selling point for issuers is they can cushion the impact of rising rates. Issuers should, however, beware of investment bankers using less than transparent option features to disguise the true costs of convertibles.

The first alleged convertible benefit is the offer of cheap debt compared to a straight debt instrument for the same firm. The difference is frequently 2% or more. It is only cheap if you ignore the option value of the conversion right into common shares. Unless investors are stupid, and they are not, they are willing to accept a lower coupon only because they believe the conversion feature is valuable. 

The second alleged benefit is the ability to sell expensive equity. The conversion price is usually set at a premium of 20-25% to the current share price. Thus, it is claimed you are effectively issuing shares at a premium to the current price. Obviously, this cannot be true otherwise there would be no IPOs - everyone would use convertibles as a backdoor IPO. What is missing in the analysis is that when the conversion occurs, the firm will be issuing shares at a discount to the then current market price. Conversion occurs when the issuer’s prospects are bright and when it could best use debt interest rate tax shields. Conversely, the convertible remains debt when the issuer’s prospect dim -  just when it could use the flexibility benefits of equity.

As you can probably tell, I am not a fan of convertibles given the potential for investment bankers overselling them. I would prefer, for most issuers, a straight debt or equity issue.  Nonetheless, there are certain firms for whom convertibles make sense. They are primarily smaller, lower credit quality and faster growing firms. Such firms have a difficult time accessing financial markets given their uncertain prospects. Convertibles give investors upside opportunities (the equity conversion kicker) with downside protection (the debt component). Hence, they are frequently used in start-ups and venture financings. Larger, mature and more creditworthy firms, however, should not issue convertibles-absent some unmet investor demand that offers a bargain deal.

The announcement impact of a convertible issuance on a public firms stock price is usually negative (usually 2 %+). This is similar to what happens with an equity issuance announcement. Convertibles can be valued using an option pricing approach. In practice, a breakeven years (BE) approach is often used for pricing purposes. It compares the conversion premium (Prem) to the coupon (C) less the issuer’s dividend yield (DY) as follows: BE=Prem /(C-DY).The usual range BE range is between 2-4 years. Shorter BEs are attractive to investors whereas, issuers favor longer BEs. The size of the Prem investors are willing to accept depends on the extent to which the convertible offers higher current income (C) than an investment in the underlying common (DY) would.

 For example, assume the issuer’s current stock price is $8, and the bond offers the right to convert into 100 shares. This represents a conversion price of $10 ($1000 par/100 shares conversion right). Thus, the conversion premium is 25% (($10-$8)/$8).If the issuer’s dividend yield is 2% and the bond coupon is 7%, then the BE is 5 years [25% Prem/ (7% coupon-2% dividend)]. This is slightly more favorable to the issuer, but may still be acceptable to investors depending on market conditions.

 Changing Federal Reserve QE policy will impact financing decisions. It is important to carefully think thru the options to avoid being sold investment banker snake oil. For most firms it is best to keep it simple. If you need equity - raise it now and ignore the dilution. You can consider repurchasing shares later. If need debt and have the cash flow to cover the debt service requirement, then issue the debt even at a higher than planned coupon with a subsequent equity refunding as an option.

J

p.s. As a “reformed” investment banker I have a limited pass to poke at them now and again. I may have exceeded that pass in this post.

The Google Waze Acquisition

The proposed Google, Waze acquisition illustrates many of the themes we've developed in previous posts.  First would be motives for acquisition.  In this case, we have acquiring technology, increasing market share and staying relevant - all consistent with increasing shareholder value (see Catalysts for Merger and  Motives for Merger).  But then we also have Merging defensively - (to prevent a competitor from doing the deal and getting an advantage) and the motive of 'eliminating the competition - by acquiring them'.   Now this may also increase shareholder value, but is, of course, frowned upon by the FTC, which is precisely why the FTC is now investigating the issue.  What criteria will the FTC use in deciding whether the deal is in restraint of trade?  See our post concerning the Herfindahl index.  

As the Wall Street Journal reports, 

"The FTC is expected to focus on whether Waze would have become a head-to-head competitor with Google, whose Google Maps software is the dominant digital mapping and navigation service around the world, or whether there is any evidence, such as emails, that show that Google wanted to acquire the company only to keep it out of the hands of rivals."

The complete WSJ article can be downloaded here.  

All the best,

Ralph

The Power of Subtraction: When 2-1=3

Difficult economic and industry conditions have depressed operating results for many firms. This has stimulated changes in corporate strategy and structure. Fusion based mergers and acquisitions are a means to implement such changes. They are based on the premise of 1+1=3, largely through synergy based improvements. The other side of the merger coin is the less well know fission-based de-mergers approach where 2-1=3. The focus of this post is on voluntary as opposed to imposed de-mergers due to financial distress or bankruptcy issues.

De-merger activity, like its merger related cousin, runs in waves. Currently, the wave is in an upswing. For example:

1)     Smithfield: the friendly acquisition to a Chinese firm is challenged by an activist shareholder claiming a de-merger of the vertically integrated pork producer would create one-third to two-thirds value increase over the acquisition alternative.

2)     Sony: activist investor Daniel Loeb is seeking a 15-20% equity carve-out (partial public offering) of Sony’s entertainment division to unlock value and fund the turnaround of its lagging electronics unit.

3)     Media Industry: McGraw-Hill split of its publishing and ratings units and the Fox spinoff of its print from electronic media just to name a few.

De-mergers, unlike mergers have a surprisingly positive value impact. Despite this, it is not something that comes naturally to most managers. It is seen more as a mark of failure-shrinking versus growing- than as a natural process in portfolio management reflecting changes in market conditions and the firm’s life cycle. Consequently, most firms engage in de-mergers only after being prodded by activist or frustrated shareholders signaling their displeasure with disappointing performance. Also, de-mergers appear to be more about financial engineering than value creation. This is partly true as de-mergers are about releasing trapped value inherent in multi-divisional diversified firms than creating something new.

Typically, such firms suffer from a conglomerate discount, which reflects the difference between the values of the separate individual business units on a standalone basis in a conglomerate from the market value of the parent. This difference is in effect a negative synergy or management as an off- balance- sheet- liability. The negative synergy can result from increased overhead expenses, capital misallocation, cross subsidies, and suboptimal incentives. These suggest that the current parent is not the best owner of the division.

The major de-merger methods include among others:

1)     Divestment: usually taxable sale to a third party. An example is McGraw-Hill’s sale of Business Week to Bloomberg. Getting an acceptable price depends on finding a natural buyer (best owner). As Warren Buffett notes, divestment is not Gin Rummy where discard your worst cards. As you are unlikely to get much for losers. Rather, it is about selling good businesses to someone who pays more to you than the assets are worth to you as a continuing operation.

2)     Spinoff: frequently a tax free distribution of subsidiary shares to the parent shareholders - similar to a stock dividend. They continue to own the same operations, but in a separate form. It can be faster and more assured than a divestment - especially, when no natural buyer can be identified. Can be both leveraged and un-levered. In a leveraged spin-off, the subsidiary borrows to fund a special dividend to the parent before the spin.

3)     Split-off: related to a spinoff, whereby parent shares are exchanged for direct ownership in a subsidiary.

4)     Equity Carve-out: portion (typically 15-20%) of a subsidiary’s shares are sold to the public as a partial public offering. Carve-outs, like spin-offs, can be either leveraged or un-levered.

5)     Tracking Stock: separate classes of parent stock whose dividends depend on the performance of an individual subsidiary.

The relative merits of each method vary are beyond the scope the scope of this post. Nonetheless, it illustrates some of the many ways to unlock trapped value in underperforming diversified firms. The key is to recognize that subsidiaries come with different “sell-by” dates. Management needs to watch and act on these dates as part of it on-going portfolio management process.

J