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

Getting Real: Real Options and M&A

Facebook is at it again. Following up on their February Whatsapp announcement- they now plan on a $2B purchase of Oculus. This new transaction is even more difficult to justify using traditional valuation methods as Oculus is an early stage virtual reality firm with no customers or revenues. It is tempting to write it off as an unjustified irrational bubble. In fact, the initial market reaction was negative. Alternatively, the problem may be with the traditional Discounted Cash Flow (DCF) methodology used to value Oculus and other early stage firms. 

DCF was designed for mature assets with identifiable bond like cash flows from an installed asset base. Growth can be considered in the relatively short forecast period before it decays into a steady state terminal value. It is less well suited for evaluating the entry and exploitation of attractive new markets thru the acquisition of rapidly growing targets. In these instances, cash flows from installed assets, often negative, are of secondary importance. The real value is in the follow-on growth investments. Failure to consider this fact under values the target.

DCF views targets as independent projects based on passively managed identifiable cash flows. It ignores the sequential interdependence among projects, and management’s ability to revise the investment profile so as to increase value. It is like trying to value a convertible bond focusing only on the coupon while ignoring its option value. Real Option Valuation (ROV) provides a means of thinking about the alternative supplemental option value sources, and helps close the gap between strategy and finance.  The gap is illustrated as follows:

1) Financial analysis is frequently overridden for strategic reasons
2) Strategic considerations such as diversification at the firm level are ignored by finance
3) Overvaluation based on DCF methodology is deemed irrational. Markets and managers may, however, recognize hidden value
4) Uncertainty increases option value unlike in DCF where uncertainty reduces value
5) Option like investments have a time value even if their intrinsic value is zero (i.e. out of the money)
6) Bastardized DCF methods like the Venture Capital Method way of evaluating start-ups which relies on ad hoc high discount rates to evaluate uncertain cash flows
7) Questionable synergies-synergies can be viewed as a crude ROV

ROV is best limited to smaller private targets with limited comparables. Value for these firms depends more on future market developments and management’s reaction to them not existing operations. They have a small chance of large payoffs (i.e. right skewed distributions with winner take all characteristics). Frequently missed is management’s ability to actively manage the target after the acquisition to change its value from the following actions:

1) Delay further investments while it moves up the learning curve. Competition can, however, reduce the option value of waiting in the fast changing tech world.
2) Scale back investments should growth slow
3) Expand investments if growth accelerates
4) Abandonment or put options to truncate losses if the market fails to materialize

Care is needed when dealing with ROV as it can used, just like DCF, to justify overpaying. Some investors are wondering if Facebook’s acquisition spree, which could be viewed as a complement to internal R&D, is beginning to look like Hewlett Packard.Thus, it should be used to supplement not replace DCF only in narrow circumstances satisfying at least the following:

1) The option must be exclusive like a patent. If everyone has it then no one has it.
2) Make sure it is an option not just an opportunity. This means identifying the underlying asset and the payoff contingency
3) Limit to very early targets-more relevant for Facebook than General Motors
4) Management has the ability to exercise successfully the option
5) The option is not over priced
6) There is some rational expectation of future cash flow

If the only tool you have is a hammer, then everything looks like a nail. You now have another tool in your valuation toolbox. Chose and use wisely.

j

"A Man Hears What He Wants to Hear and Disregards the Rest"

The title comes from lyrics to one of my favorite songs by my favorite singer-songwriter, The Boxer by Paul Simon.  It also describes the subject of today's post: confirmation bias and how it might relate to acquisitions.  "Confirmation bias" is the tendency to overweight evidence that supports our views.  No sooner do you read the definition than you think of the countless ways this could apply to mergers and acquisitions.

First and foremost, consider the CEO determined to grow the company.  A possible target opportunity is identified and before beginning the analysis, the CEO has a favorable view. Being prudent, he or she state, "But let's see what the numbers say."  The danger is that he or she will overweight evidence that supports a positive  position.  It doesn't take much manipulation to change a negative net present value to a positive result.

While the CEO is generally not the person doing the analysis, we all know that when mangement asks "How much is 2 + 2?" the safest answer is "How much do you want it to be?"  That kind of bias leads to disastrous acquisitions.   Synergies, often used to justify deals,  are easy to imagine and tougher to realize.  

Confirmation bias can also be related to the frequency illusion, the odd feeling that some new thing you have just learned about is suddenly catching your attention more far more than seems probable.  Frequency illusion is thought to occur because we all have selective attention.  There are often far more sensory inputs occuring than we can process.  Consequently, our mind focuses on some pattern of interest and records that, ignoring much of the rest.  The pattern of interest, is likely to be the recently learned 'new thing' or information that conforms to our hopes and expectations.  Each new occurrence of the item increases our belief that our analysis and ideas are correct.

The solution, in the case of mergers or in any business decision is to ruthlessly challenge all assumptions, to stress test all analyses, to encourage and nurture dissenting views and to be constantly aware of they types of biases that can distort our thinking.

(For other posts on behavioral bias, see Behavioral Biases in Acquisitions - The Anchoring Effect and Roll's Hubris Hypothesis and Behavioral Bias.)

All the best,

Ralph

Bank M&A: He Who Hesitates Is Lost

Attached is a recent American Banker article. The idea is that M&A waves follow major legislative changes which change the rules of competition. The current changes, similar to those in the 1990s, have or will trigger consolidation waves, which is particularly well suited to M&A. Yet, bank M&A remains modest. One of the reasons for the weak volume is many bankers still believe M&A is a mug’s game. The problem with assuming all M&A is bad is it assumes managers are either stupid or under some collective behavioral cloud.

I admit I used to believe that as well. Ralph's Paper on the possible miss measurement of M&A gains forced me to re examine my position. Once the anticipation effects before the bid announcement are included, M&A starts to look better. Illustrating again that business men are sometimes smarter than academics believe, Ralph excluded.

The other aspect is over caution regarding a possible over priced deal has competitive consequences. Banking is undergoing a metamorphous. Banks refusing to participate will suffer. There will be no second place prizes.

j

Behavioral Biases in Acquisitions - The Anchoring Effect

This post is one in a series where we continue to explore how behavioral biases can affect merger decisions.  Joe started this discussion over a year and a half ago in a post entitled, Behavioral Bias, the Hidden Risk in Mergers and Acquisitions.  For years, economists have assumed that men and women were rational in their decision making and that markets were efficient.  To quickly come to the defense of economists (because on my better days I resemble one), these assumptions are not necessarily in place because we thought they were true.  Rather, they present a meaningful standard for testing alternate hypotheses.  After all, I can explain virtually anything but just telling you the decision maker was irrational.  So too can I explain any movements in the stock market by simply throwing up my hands and declaring markets are inefficient.  There is not much value in those two statements.  

There is value in carefully documenting empirical regularities in decision making.  The advancements in the field of behavioral finance have occurred simultaneously with two phenomena: 1)  the growth of experimental economics where subjects are presented alternate choices  in a controlled setting and researchers are able to carefully measure and calibrate the tests and 2) an increased appreciation in the field of finance for the psychological sciences.  

The literature on behavioral biases has been voluminous in recent years and we can only hope to start the dialogue and acknowledge some of the issues in these short posts.   Today, I just want to talk a bit about one of these biases: anchoring.  

The anchoring effect occurs when we give too much weight to some value presented early in the decision making process.  Research shows that final values are influenced by this initial number, even if it is irrelevant.  An interesting article in by Edward Teach in (see CFO magazine, Avoiding Decision Traps) gives many excellent examples.  In one, researcher Dan Aerily asked his MBA students to write down the last two digits of their social security number. Subsequent to this, they bid on bottles of wine and boxes of chocolate.  Students whose SS numbers were higher placed bids that were 60 to 120 percent higher.  Obviously, one's SS number has no relation to the actual value of the item, yet it had a major influence in the bidding.  

In many cases the anchoring number is presented to us as with the list value of a car, or the stated value of an item at a department store.  When we purchased the item at a lower price we feel that we obtained a bargain.  In fact, the initial number may have been grossly overstated or irrelevant.  Similarly, when a bidding or target firm suggests an initial value an anchor is created, one that often influences the outcome.

The price at which we purchased a stock can create an anchor even though (except for tax purposes) that value is irrelevant today.  I don't feel good about the Apple stock I purchased at $700 and I might be irrationally reluctant to sell below that price even if the true value is less.  

Other times, investors will anchor at the recent 52 week high value of a stock or its book value even though these numbers can bear little resemblance to true value.  

The lesson is to be aware and wary of the anchoring phenomena and where possible estimate values on your own without initial regard to other estimates.  

We will continue with other observations.  

All the best,

Ralph

Warren Buffett: Dividends and Acquisitions

Warren Buffett’s Berkshire Hathaway BRK is facing a dividend challenge from a small investor. The investor is seeking a resolution to be voted upon at BRK’s annual May meeting. The resolution calls for a regular dividend. BRK argues against the resolution on technical grounds stating the board already decides each year on shareholder distributions. To date BRK has not paid a dividend, although it has engaged in share repurchases when it considers its shares undervalued (defined as share price< 120% of intrinsic value).  Initially, it appears the investor may be right. Essentially, he argues as follows:

1.  BRK’s share price has lagged the S&P 500 index for 5 years
2.  Buffett admits having difficulty investing BRK’s huge cash flow and cash balances
3.  BRK is “elephant hunting”-looking for big deals
4.  The elephant hunting may result in forced errors
5.  Investors could better use the funds if they were return to them via dividends as repurchases would be ill advised at BRK’s current share price

Sounds like an approach used by activists like Carl Icahn against similar large firms with excess cash (e.g. Apple).

Buffett correctly points out dividends do not directly affect shareholder value. Dividends merely distribute value-they do not create value. What matters is who can invest the funds better-the firm or the shareholder. If the firm can do so thru organic or acquisition investments then it should retain the funds and make the appropriate capital allocations. Otherwise, the funds should be returned to shareholders. The decision rule is to retain and invest provided the expected returns exceed the cost of capital. The Dividend Discount Model shows Share Price=Dividend/ (Cost of Equity-Growth) where Growth= (1-Dividend Payout Ratio) x Return on New Investment. If investors need cash, then a better alternative, which may be more tax efficient, is for them to create homemade dividends by selling some of their shares.

Buffett’s record demonstrates good long term capital allocation decisions-albeit the last 5 years have been more problematic. Buffett, unlike the firms Icahn targets, eats his own cooking. Thus, the risks of value destructive capital misallocations from Agency Costs are reduced. BRK is more like long only hedge fund than a traditional maturing firm continuing to invest in declining projects. BRK can chose from a number of undervalued opportunities. I remember the last time Buffett was attacked as losing his touch in the 1990s with the tech boom. He was subsequently proven right.

I would trust Buffett for now to continue make good investment decisions. The dividend decision can be reconsidered should that trust turn out to be misplaced. For now, advantage Buffett.

J