Microsoft’s Nokia Adventure: Ballmer’s Parting “Gift”

Microsoft (MS) announced a $ 7.6B write-off of it disastrous September, 2013 acquisition of Nokia. MS shares were unchanged in a day in which the market faced a large sell-off. The write-off came as no real surprise as the deal was highly suspect from its inception. MS’s shares fell 6% when the deal was originally announced representing an over $15B market capitalization loss. The market was reacting not only to the deal itself, but also the strategic implications of the deal; namely MS’s deepening commitment to the highly competitive devices market and away from its core software business.

Two other strange facts surround the deal. First MS’s CEO, Steve Ballmer had recently announced his planned retirement. The market reacted with a 7%+ jump in MS’s stock on the announcement-not exactly a sterling endorsement of Ballmer’s performance. See Vanity Fair’s article for background on Ballmer’s management history. Next, it was uniting former MS employee Stephen Elop, Nokia’s CEO, with MS. Elop’s performance was equally uninspiring at Nokia as it was facing a rumored bankruptcy after losing billions. I guess you can call it a buddy deal involving the two Steves.

What is surprising is that such a deal championed by an out-going CEO with a checkered record could be approved given widespread apprehension within MS, including from its future CEO Satya Nadella. It essentially is a doubling down on Ballmer’s failed strategy to embed MS’s Windows software in smart phones where it had only a 3% share. MS was going up against Google’s Android and Apple’s IOS and expected to triple its share in 3 years. How it was going to do so with money losing Nokia against well entrenched competitors is the stuff of dreams-or is it nightmares?

I guess we should not be too surprised Nokia was approved given MS’s patchy acquisition record. Remember the $6.2B charge for aQuantive. Also there Ballmer’s $47B abortive Yahoo acquisition where he was saved by Yahoo Jerry Yang’s even bigger ego. MS was suffering from poor board oversight and bad governance. This seems to be endemic to many aging tech firms who use acquisitions in the elusive search for the fountain of youth to regain their mojo.

Ballmer’s Nokia adventure left his successor with both a strategic dilemma and a hemorrhaging acquisition. Their new CEO is addressing these “gifts”. Let’s hope he elects to let MS age gracefully by managing Windows structural decline with increased shareholder distributions instead of engaging in expensive adventures.

j

Tax Inversions and Economic Reality

We're written before about tax inversions and economic reality.  Businesses naturally gravitate to favorable environments.  Jobs follow.  A big part of a favorable environment relates to taxes.  Businesses, like all of us, prefer less taxes to more.  Unfortunately, our country has become uncompetitive in this regard and as a consequence businesses are leaving for more favorable terrain.  One way to accomplish this is a 'tax inversion' where a company in one country (say the US) merges with another company in a more favorable tax environment (say Ireland) and then also moves headquarters to that new location.  Politicians in the US were quick to implement laws making this process more difficult.  Unfortunately, when laws try to restraint natural economic forces the consequences are not pretty and the unintended consequences are downright ugly!  In our post, Mergers and Taxes, A Follow Up on 'Inversions', we concluded:

"A better long term strategy for the United States or any country is to recognize the economic reality faced by business and understand motivations for the inversions.  Imprisoning business with uncompetitive laws may work in the short run.  It will never work in the long run."

So pass a law to make inversions more difficult and the unintended consequence is that companies are still becoming targets due to the large tax burdens that can be avoided by being absorbed into other companies.  In an excellent article in Wednesday's Wall Street Journal, The Tax Inversion Wave Keeps Rolling Liz Hoffman, notes how Horizon, an inversion last fall and now headquartered in Ireland, is now acquiring other companies.  In particular, Horizon is going after Depomed, a California pharmaceutical company.  Hoffman notes that Depomed paid 38% in the US last year but that Horizon's acquisition could lower the rate (under Irish law) to 'low 20's' and that Irish Corporate tax rates are 12.5%.

So which is better 38% of nothing or 12.5% of something?  The answer is obvious to all but representatives who refuse to take steps to make our country more competitive, preferring instead to play Whack a Mole in denying economic reality, smacking every unintended consequence that arises with new laws.

An interesting chart from the article showing other deals is below:

Also see our post, Politics, Taxes and Economic Reality

All the best,

Ralph

 

Corporate Funding Process

The basic goals of corporate finance are (A) fund the firm’s strategic plan and (B) provide enough liquidity to satisfy the firm’s obligations as they come due. This involves a process incorporating strategy, operations, capital structure, and capital markets timing. This is the stuff of the practice v theory of finance-cash flow budgeting not models usually not covered in detail in textbooks.

The following diagram highlights the process:

The steps in the process are as follows:

1)     Investment Opportunities/Requirements: matching product market opportunities with the strategic plan gives rises to the investment budget. I find it useful to use Porter’s Five Forces model to gauge investment opportunities. Your strategy determines how fast you plan to grow and investment needs-CAPEX, working capital investment (WCI) and operating expenses like headcount and R&D.

2)     Financing Need: based on cash flow available for debt service (CFADS) = Net Income ( after interest and taxes) +DA-(CAPEX+WCI) +/- (AS-AA + CND) with DA being depreciation and amortization; AS-AA representing asset sales or acquisitions; CND being changes in net debt. Mature firms with excess CFADS focus on shareholder distributions (sometimes prefunded debt financed share repurchases i.e. recapitalizations) while growth firms with negative CFADS need to raise cash.

3)     Funding Sources: selection of instruments depends upon market conditions and financing preferences.

a)     Capital market conditions: influenced by macro factors such as rates and economic growth. Just like ordering lobster -prices and availability are subject to market conditions. We saw an extreme example of this during the market crisis years of 2009-2012 when markets shut.  Some key factors include market depth, cost, terms, access, and disclosure. You can only take what the market gives.

b)     Financial strategy: the objective is to match sometimes conflicting financial preferences with market conditions in a cost effective manner to assure certainty of funding. Key factors include

Control-closely held firm will be reluctant to fund with equity if it upsets control positions

Dilution-equity financing impacts dilution and can be an impediment

Flexibility-growing firms need flexibility hence avoid debt with covenants and prepayment restrictions

Ratings-rating targets influence the debt versus equity choice and debt capacity

Cost-both absolute and relative cost among instruments

Public or Private-firms seeking confidentiality balance depth of public markets with disclosure requirements

Dividend Policy-high dividend policy constrains debt capacity

Investor Base-banks, private equity, hedge funds, etc.

Liquidity Needs-financial slack is valuable especially for growth firms as s#$% happens

Speed-how soon you need the funds determines which sources you seek

Currency Preferences-USD or others

Nature of Funding Need-one-off or on-going; if on-going focus on relationship type investors

Hedging Policy-for financial exposures like rates and currencies

Accounting Policy (on/off balance sheet)

Taxes

Maturity Structure

4)     Instruments: the funding instruments choice usually becomes apparent once you go thru the above process. The key is to customize the instruments to capitalize on investor segments to achieve the best terms. Most firms utilize a Pecking Order approach to minimize information asymmetry costs reflecting the following order:

Debt

Hybrids-convertibles and warrants

Equity-preferred and common

5)     Repeat Step 2 once the cash flow implications of the choices are determined. Reflect plan in cash flow budgets and use scenario analysis to ensure it works with a sufficient margin for error.

The funding decision is like playing with a Rubik's Cube trying to match up sometimes conflicting goals under time constraints in an uncertain dynamic capital market environment. Compromises are needed to ensure adequate funding under all states of nature-not just the current state. As a general rule- raise funds when you can and not when you must as many capital challenged firms learned the hard way during the great recession.

J

Merger Waves: Pharma, Telecom and the Scramble for Position

We've talked about merger waves many times in these posts.  In general, some catalyst produces shocks in an industry and creates opportunities (and sometimes necessities) for consolidation.  The shock can be a change in technology, consumer tastes, regulation or any other shock that alters the costs or benefits of acquisition.  

In the current environment, Telecom and Pharma represent merger waves with multiple parties scrambling for position.  Let's consider Pharma: The Pharma wave has been under way for quite some time.  As far back as 2009 we saw the mergers of Merck/Schering-Plough, Pfizer/Wyeth and Roche/Genetech.  We continue today with deals by players such as Sun Pharmaceuticals and Bayer.
Among the catalysts for Pharma are the exploration of patents as companies search for new sources of growth, and the realization that some of the large R&D expenditures of the past haven't paid off.

For Telecom the catalysts include deregulation and dramatic changes in technology including increased use (and uses) of hand held devices, tablets, and smart phones.

As rivals combine, the competitive landscape in any industry changes and firms scramble to maintain viability.  In today's market many deals in Pharma and elsewhere remind some of the heyday of 2007 with high multiples as too many bidders search for too few deals.  

Indeed, there is empirical support for different valuations at different stages of a merger cycle.  Harford (2005), for example, notes that bids later in a wave cycle are associated with lower returns.  This makes practical sense as well - when a catalyst makes various firms attractive, the low hanging fruit is the first to be acquired.  As attractive targets become scarce, bid prices rise and acquiring returns decline.

Some experts appear unconcerned about the current high multiples, but as Joe has said many times, when they start telling you "this time is different" grab your wallet!  While good deals remain, acquirers must be careful to assess risk and return objectively and only make those deals that are value additive and consistent with a firm's strategy.  It is important to beware of behavioral biases especially when deals are occurring quickly all around you.  Nevertheless,  while markets are efficient, deal makers are human.  Tread carefully,

All the best,

Ralph

Sale Leasebacks: Fact and Fiction

SALE LEASEBACKs (SLB) allow the separation of ownership from control in the use of real estate reflecting the comparative advantages of owners and operators. It has a long history in the hotel industry where the hotel groups manage the hotels which are owned by investors such as REIT. SLBs are undergoing renewed popularity in the challenged retail and restaurant industries by firms with substantial real estate assets including Macy’s, Sears and Darden. This is due, in part, to the recovery in real estate values since the bottom of the Great Recession in 2009. For example, Sears is using SLBs to fund continued operating losses to hopefully stabilize the firm. Darden transferred restaurants like Olive Garden to a REIT, and plans to use the proceeds to reduce its debt (probably not the wisest use of funds). Activists are pushing Macy’s to lever up by selling assets to a mall operator and leasing them back to fund a share repurchase.

There are many reasons, some real - others bogus, for using SLBs. Bottom line, SLBs are just another form of financing. Their value to the seller/lessee depends of the sale price, lease terms and ultimately on the use of the proceeds. Some bogus reasons include:

1)     Improve Balance Sheets by Reducing Assets:  need to distinguish accounting from real effects. In any event, accountants have gotten tougher about removing such assets from the balance sheet. Even if they do remove them they are disclosed in footnotes allowing analysts to adding them back.

2)     Improve Debt Ratios: again unlikely as the rent obligations disclosed in footnotes are easy to add back. Most analysts focus on EBITDAR (earnings before interest taxes depreciation amortization and rent) over funded debt plus lease debt.

3)     Monetize Equity: This may, however, trigger possible capital gains taxes. You can structure the transaction to avoid true sale treatment to avoid taxes. This usually complicates achieving off balance sheet treatment for accounting purposes. Finally any book gain realized will be given back in the new higher lease terms.

4)     Increased Debt Capacity: giving up residual ownership and flexibility.

5)     Improved Focus: this may have some merit if the buyer/lessor has a comparative advantage in managing/owning the real estate AND is willing to share some of that with the seller. There may be a benefit in expressly charging an explicit rent to better reflect true operating performance.

As long as the sale price and lease terms are fair, which you would expect in a large relatively efficient real estate financing market involving sophisticated parties, there is unlikely to be any value created. You need to compare SLB against alternative functionally equivalent secured real estate financing (e.g. mortgage) to determine if market conditions may favor a SLB over a mortgage.

The second step is to review the use of the proceeds raised by a SLB. These include:

1)     Capital Structure Change: use to reduce debt in a potentially over leveraged situation like Darden. This was not well received by shareholders (possibly reflecting a decrease in Darden’s tax shield and reduced debt discipline). Alternatively, increase leverage in an under leveraged situation by repurchasing shares as activists are suggesting for Macy’s.

2)     Fund Operating Losses as in Sears

3)     Finance an Acquisition/LBO using an Opco-Propco structure as reflected below:

Be careful of free lunch arguments when evaluating SLB pitches from investment bankers (e.g. Mesirow ). Focus on how the transaction impacts firm cash flows and risk to determine the value impact and not the accounting. Finally, no matter how good the SLB, the key is the use of the proceeds.

J

A Quick Overview of Acquisition Finance

 As readers of our blog know, Joe and I teach an Acquisition Finance Course in Amsterdam every year.  The current offering is scheduled for December 9-11, 2015.  Information can be obtained here.

Acquisition finance involves structuring a deal to best obtain the objectives of the various parties involved.  There are numerous considerations in this process and we spend quite a bit of time in the course analyzing and illustrating best practices.  In today’s post, I’ll just outline a few of the basics.

Finding the optimal financial structure for a deal leads one inevitably to the topic of capital structure – the best mix of debt, equity and hybrid securities for a particular situation.  At the heart of this is the desire to minimize the cost of capital, while also being cognizant of risk, flexibility and requirements (and personal desires) of buyers, sellers, regulators and suppliers of funds.

Two major techniques for finding the best financing solution for a deal are the cash flow and asset based approaches.  Let’s take the latter first.  When we complete a deal, it is the assets that we are financing.  As we all know, Assets must equal Liabilities plus Equity.  Thus, the left hand side of the balance sheet (assets) must equal the right hand side (Liabilities plus Equity).  A given set of assets suggests particular opportunities with regard to risk, liquidity and the use of collateral. 

It is important to note that when we structure a deal, the securities we use (debt, equity and hybrids) are merely claims against the assets and against the cash flows generated by those assets.  That is, the securities are merely contracts promising particular provisions for the future.  And – while there are standard contracts for debt and equity, a contract is merely an agreement – it can be crafted, altered and structured in any way the parties can agree upon.  Thus, ultimately some deals are completed with more creative (non-standard) structures such as earn outs and other contingent payments.

The cash flow approach to acquisition finance is easy to understand.  Returns to the suppliers of capital will ultimately be generated from the cash flows of the business.  These include ordinary cash flows from running the business as well as one-time cash flows from spinoffs and asset sales.  A given cash flow projection suggests the level of risk inherent in the deal.  Generally, the returns (payments) promised will be compared with the funds projected to cover these payments.  Ratios like Times Interest Earned and Fixed Charges Coverage and tools like simulations are used to help assess deal risk. 

The paragraphs above provide just a sketch of the myriad considerations in structuring a deal.   One thing that is missing – and that we always emphasize in our class - is the analysis of markets.  That is, the paragraphs above outline some of the important items related to the parties involved and the deal itself.  But capital is raised in dynamic capital markets and different markets suggest different opportunities.  We’ll continue with an elaboration of these and other factors in subsequent posts.

All the best,

Ralph