Tag Archives: deals

Beware Profiteers Masquerading As Activists

Activist investors are supposed to play a critical role in the economy. They identify underperforming managers or conflicts of interest that prevent a company from achieving its potential. A few activist investors genuinely do great things for companies, their employees and investors. There are, however, many more investors that masquerade as activists for shareholders when they are really just looking to create short-term gains for themselves. The first kind of activist can create significant value for your portfolio. The second kind tends to weaken companies in the long-term. It’s no secret we’ve been on the opposite side of Bill Ackman’s Pershing Square Capital on many recent stock picks, such as Herbalife (NYSE: HLF ), Mondelez (NASDAQ: MDLZ ), and, most notably, Valeant Pharmaceuticals (NYSE: VRX ). We believe Ackman typifies the activist behaviors that destroy, rather than create, long-term shareholder value. “Serial Acquirers” Valeant remains one of Ackman’s most prominent (and most value-destructive ) positions. Valeant has a long history of acquiring other drug makers . This serial acquisition strategy looks superficially accretive due to the high-low fallacy , which allows the acquirer to artificially boost earnings per share (EPS), one of Wall Street’s most hallowed metrics. Certain activist investors love serial acquirers because they can create the illusion of growth by indiscriminately acquiring other companies. The illusion is growth in revenues, EBITDA, or non-GAAP metrics that overlook the price paid for the acquiree, which, more often than not, is so high that the real cash flows of the deal are highly negative and dilutive to shareholder value. Case in point, Valeant’s debt has increased from $372 million in 2009 to $30 billion over the last twelve months (TTM). At the same time, its shares outstanding have more than doubled while its economic earnings , the true cash flows available to shareholders, have declined from $93 million in 2009 to -$685 million TTM. Valeant has finally given up on its serial acquirer strategy, but the massive debt load seriously limits the company’s strategic flexibility going forward, and the lack of cash flow from all the deals has it in trouble with its creditors . Figure 1: Increase In Debt And Share Count For Valeant Click to enlarge Sources: New Constructs, LLC and company filings. Activists such as Ackman love to tout the “platform value” of serial acquirers. They claim these companies can unlock value from the companies they acquire through superior management. While it’s true that some companies have this capability [just look at how Disney (NYSE: DIS ) has unlocked the value in Pixar, Marvel, and Lucasfilm], these cases are few and far between. Playing Both Sides Of the Deal Another favorite Ackman strategy involves buying up shares in one company while working to help another company acquire that position. We saw this with both Allergan (NYSE: AGN ) and Zoetis (NYSE: ZTS ), two companies that Ackman bought shares in while working with Valeant on an acquisition. Beware what you hear about companies where an activist is on both side of the deal. They may be more focused on getting a quick win to boost their performance, while long-term shareholders deserve much more. Shareholders would be better off if activists just left the company alone. Since 2012, ZTS has grown after-tax profit ( NOPAT ) by 20% compounded annually and increased its return on invested capital ( ROIC ) from 11% to a top quintile 17%. Pushing the company to accept an offer from a firm such as Valeant, with a history of value destruction, is a disservice to current shareholders not an unlocking of value. On top of that, these acquisition dramas create unnecessary distractions from the important work of running the business. Allergan’s CEO David Pyott told CNBC that fending off Ackman and Valeant was a full-time job . The run-up in Allergan’s shares netted Ackman $2.2 billion, but one has to believe the company would have been better off with the CEO devoting his time to running the company. Financial Engineering The Valeant/Allergan saga is far from the first example of Ackman extracting short-term value from a company while hurting it in the long-term. For another case-study, look at his 2005 investment in Wendy’s (NASDAQ: WEN ). Ackman convinced the fast food chain to refranchise a number of stores, sell off Tim Hortons-its most profitable business-and use the proceeds to buy back over $1 billion in stock. The move delivered short-term gains to shareholders, and Ackman booked a nearly 100% return when he sold his shares soon after during a feud with management. Wendy’s never recovered from the loss of Tim Horton’s. Its credit rating was cut, making it more difficult to fund investment through debt, and buying back all those shares used up resources that could have helped renovate stores and keep the chain competitive with McDonald’s (NYSE: MCD ), where Ackman tried and failed to push through a similar plan. Today, Wendy’s stock price remains mired below its level from before Ackman’s involvement, and the company consistently earns an ROIC near the bottom of its peer group. By focusing on financial maneuvers such as refranchising, spin-offs, and buybacks, Ackman successfully extracted short-term value from the company while hurting long-term shareholders. Bad Corporate Governance From Focus on Non-GAAP Earnings The use of non-GAAP metrics is something we have warned about many times. The biggest issue with non-GAAP metrics is that management has wide discretion to add income or remove expenses, which means they can easily manipulate the non-GAAP metrics. Unfortunately, activist investors gravitate towards firms that highlight their non-GAAP metrics because it becomes easier to hide shareholder destruction in the short-term. Unsurprisingly, Valeant was one of the biggest proponents of non-GAAP metrics. The company’s executives bonuses were tied to a non-GAAP metric they called “Cash EPS” that excluded costs related to acquisitions, as well as stock-based compensation. Valeant is far from the only example of lax corporate governance on non-GAAP issues. Take for example, Jarden Corporation (NYSE: JAH ), a firm Ackman voiced strong support for in May 2015. We put Jarden in the Danger Zone in October 2015 due in part to its use of non-GAAP metrics for executive compensation. As long as the firm pays executives based on “adjusted EPS,” which conveniently removes certain restructuring and acquisitions costs, JAH will continue to destroy shareholder value. Jarden also fits the description of serial acquirer and takeover target when it agreed to a deal with Newell Rubbermaid in December 2015. “Unlocking Value” Misses Opportunities Valeant might be in the news more of late, but one of Ackman’s most high profile positions might be Herbalife , about which he released details in a 342 slide presentation in late 2012. We highlighted the strengths of Herbalife’s business in August 2013 and despite continued criticism, the company continues to counter each of Ackman’s claims, as well as investigations by the SEC. Instead of going to $0/share, as Ackman predicted, HLF increased over 144% in 2013 and remains up over 80% since Ackman first announced his position. We noted the strength of Herbalife’s business in our report and the thesis hasn’t changed. Over the past decade, Herbalife has grown NOPAT by 15% compounded annually and increased its ROIC from 21% to a top quintile 32% over the same timeframe. Best of all, Herbalife remains undervalued. At its current price of $55/share, HLF has a price to economic book value (PEBV) ratio of 1.4. This ratio means that the market expects Herbalife to only grow NOPAT by 30% over the remainder of its corporate life. If Herbalife can grow NOPAT by just 7% compounded annually over the next decade , the stock is worth $80/share today – a 37% upside. Activists Should Play A Positive Role… But They Don’t There is no shortage of targets out for activists that truly want to unlock long-term value. Many companies have misguided executive compensation plans that push management towards acquisitions and other activities that destroy shareholder value. Just look at how misaligned executive compensation plans helped push profitable Men’s Wearhouse (NYSE: TLRD ) into the disastrous acquisition of Jos. A. Bank . Activists have more opportunity than ever to push back against misaligned executive compensation plans. The Dodd-Frank Act in 2010 requires all companies to allow “Say On Pay” votes where shareholders can make their voices heard on executive compensation. We’d love to see activists with the resources to take on big companies make a push to better align executive compensation with long-term shareholder value. We have compelling proof in the form of AutoZone (NYSE: AZO ) that linking executive compensation to ROIC can help companies deliver market-beating returns . Unfortunately, activists seem to be going the opposite direction. Between 2009-2014 , fewer activist campaigns targeted issues surrounding executive compensation and corporate governance. Instead, activists radically increased their demands for buybacks, spin-offs, acquisitions, and other feats of financial engineering. Activists also seem to be taking a short-term on their investments. 84% of all activist investments last less than two years, according to FactSet. The good news? These types of activists have underperformed this year . Ackman has led the pack downward. Even before Valeant dropped 50% in March, his losses in 2015 and 2016 had already erased any gains he made in 2014. Maybe this underperformance will push activists away from the financial engineering and towards more substantive changes that truly benefit shareholders. Until then, don’t listen to activist investors claiming they can unlock value unless they articulate a focus on ROIC and long-term cash flows. Look past the typical noise and focus on fundamentals. Find companies that consistently generate profit, earn a quality return on invested capital, and have a stock price where expectations for future cash flows are low. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Lessons From The Fall Of SunEdison

“The boom is drawn out and accelerates gradually; the bust is sudden and often catastrophic.” – George Soros, Alchemy of Finance There was a very interesting article in The Wall Street Journal a few days ago on the story of “the swift rise and calamitous fall” of SunEdison (NYSE: SUNE ). Like a number of other promotional, Wall Street-fueled rise and falls, SunEdison became a victim of its own financial engineering, among other things. SUNE saw rapid growth, thanks in large part to easy money provided by banks and shareholders. Low interest rates and deal-hungry Wall Street investment banks helped encourage rapid expansion plans at companies like SunEdison and provided the debt financing. Yield-hungry retail investors suffering from those same low interest rates on traditional (i.e., prudent) fixed-income securities helped provide the equity financing. Just like MLPs and a number of similar structures popping up in related industries, SunEdison provided itself with an unlimited source of growth funding by creating a separate business (actually, a couple of separate businesses) that are commonly referred to as yield companies, or “yieldcos”. These yield companies are, in effect, nothing but revolving credit facilities for their “parent” business, and the credit line is always expanding (and the yield company is the one on the hook). The scheme works as follows: a company (the “parent”) decides to grow rapidly. To finance its growth, it creates a separate company (the “yieldco”) that exists for the sole purpose of buying assets from the parent (usually at a hefty premium to the parent’s cost). To source the cash needed to buy the parent’s assets, the yieldco raises capital by selling stock to the public, by promising a stable dividend yield. The yieldco uses the cash raised from the public to buy more assets from the parent, and the parent, in turn, uses these cash proceeds to buy more assets to sell (“drop down”) to the yieldco, and the cycle continues. Thanks to a yield-deprived public, these yieldco entities often have an unlimited source of funds that they can tap whenever they want (SUNE’s yieldco, TERP, had an IPO in 2014 that was more than 20 times oversubscribed). As long as the yieldco is paying a stable dividend, it can raise fresh capital. As long as it raises capital, it can buy assets from the parent, who gets improved asset turnover and faster revenue growth. In SunEdison’s case, the yieldco is Terraform Power (NASDAQ: TERP ). (There is TerraForm Global (NASDAQ: GLBL ) as well). I made a very oversimplified chart to try and demonstrate the crux of this relationship: It Tends to Work, Until it Doesn’t Buffett said this recently regarding the conglomerate boom of the 1960s, whose business models also relied on a high stock price and heavy doses of stock issuances and debt: If the assets that the yieldco is buying are good quality assets that do, in fact, produce distributable cash flow (i.e., cash that actually can be paid out to shareholders without skimping on capital expenditures that are required to maintain the assets), then the chain letter can continue indefinitely. The problem I’ve noticed with many MLPs is that the company’s definition of distributable cash flow (DCF) is much different than what the actual underlying economics of the business would suggest (i.e., a company can easily choose to not repair or properly maintain a natural gas pipeline. This gives it the ability to save cash now [and add to the DCF, which supports the dividend], while not worrying about the inadequately maintained pipe that probably won’t break for another few quarters anyhow). Another thing I’ve noticed with businesses that try to grow rapidly through acquisitions is that the financial engineering can work well when the asset base is small. When Valeant (NYSE: VRX ) was a $1 billion company, it had plenty of acquisition targets that might have created value for the company. When VRX became a $30 billion company, it is not only harder to move the needle, but every potential acquiree knows the acquirer’s game plan by then. It’s hard to get a bargain at that point, but it’s also hard to abandon the lucrative and prestigious business of growth. ( Note : Lucrative depending on which stakeholder we’re talking about.) In SunEdison’s case, the Wall Street Journal piece sums it up: “As SunEdison’s acquisition fever grew, standards slipped, former and current employees, advisers, and counterparties said. Deals were sometimes done with little planning or at prices observers deemed overly rich… Some acquisitions proceeded over objections from the senior executives who would manage them, said current and former employees.” So, the game continues even when growth begins destroying value. Once growth begins to destroy value, the game has ended – although it can take time before the reality of the situation catches up to the market price. Basically, it’s a financial engineering scheme that gives management the ability (and the incentives, especially when revenue growth or EBITDA influences their bonus) to push the envelope in terms of what would be considered acceptable accounting practices. In some recent yieldco structures, I’ve observed that when operating cash flow from the assets isn’t enough to pay for the dividend, cash from debt or equity issuances can make up the difference – something akin to a Ponzi. Incoming cash from one shareholder is paid out to another shareholder as a dividend. Even when fraud isn’t involved, this system can still collapse very quickly if the assets just aren’t providing enough cash flow to support the dividend. Incentives The incentives of this structure are out of whack. The parent company wants growth, and since it can “sell” assets to a captive buyer (the yieldco) at just about any price, it doesn’t have to worry too much about overpaying for these assets. It knows the captive buyer will be ready with cash in hand to buy these assets at a premium. In SunEdison’s case, management’s incentive was certainly to get the stock price higher because, like many companies, a large amount of compensation was stock-based. But their bonuses also depended on two main categories: profitability and megawatts completed. Both categories incentivize growth at any cost – value per share is irrelevant in this compensation structure. You might say that profitability sounds nice, until you read how management decided to measure it : “the sum of SunEdison EBITDA and foregone margin (a measure which tracks margin foregone due to the strategic decision to hold projects on the balance sheet vs. selling them).” Hmmm… that is one creative definition of profitability. Not surprisingly, all the executives easily met the “profitability” threshold, and bonuses were paid – this is despite a company that had a GAAP loss of $1.2 billion and a $770 million cash flow loss from operations. Growth at Any Cost At the root of these structures is often a very ambitious (sometimes overzealous) management team. The Wall Street Journal mentioned that Ahmad Chatila, SUNE’s CEO, said that SunEdison ” would one day manage 100 gigawatts worth of electricity, enough to power 20 million homes .” Just last summer, Chatila predicted the company would be worth $350 billion in 6 years , and one day would be worth as much as Apple (NASDAQ: AAPL ). These aggressive goals are often accompanied by a very aggressive, growth-oriented business model, which can sometimes lead to very aggressive accounting practices. I haven’t researched SunEdison or claim to know much about the business or the renewable energy industry. I’ve followed the story in the paper, mostly because of my interest in David Einhorn, an investor I admire and have great respect for. Einhorn had a big chunk of capital invested in SUNE. David Einhorn is a great investor. He will (and maybe already has) made up for the loss he sustained with SUNE. This is not meant to be critical of an investor, but to learn from a situation that has obviously gone awry. Parallels Between SUNE and VRX The SUNE story is very different from VRX, but there are some similarities. For one, well-respected investors with great track records have invested in both. But from a very general viewpoint, one thing that ties the two stories together is their focus on growth at any cost. To finance this growth, both VRX and SUNE used huge amounts of debt to pay for assets. Essentially, neither company existed a decade ago, but today, the two companies together have $40 billion of debt. Wall Street was happy to provide this debt, as the banks collected sizable fees on all of the deals that the debt helped finance for both firms. Investing is a Negative Art A friend of mine – I’ll call him my own “west coast philosopher” (even though he doesn’t live on the west coast) – once said that investing is a negative art. I interpret this as follows: choosing what not to invest in is as important as the stocks that you actually buy. Limiting mistakes is crucial, as I’ve talked about many times . While mistakes are inevitable, it’s always productive to study your own mistakes as well as the mistakes of others to try and glean lessons that might help you become a little closer to mastering this negative art. One general lesson from the SUNE (and VRX) saga is that business models built on the foundation of aggressive growth can be very susceptible to problems. It always looks obvious in hindsight, but a strategy that hinges on using huge amounts of debt and new stock to pay for acquisitions is probably better left alone. Sometimes, profits will be missed, but avoiding a SUNE or a VRX is usually worth it. General takeaways: Be wary of overly aggressive growth plans, especially when a high stock price (and access to the capital markets) is a necessary condition for growth. Be skeptical of management teams that make outlandish promises of growth, and be mindful of their incentives. Be careful with debt. Try to avoid companies whose only positive cash flow consistently comes from the “financing” section of the cash flow statement (and makes up for the negative cash flow from both operating and investing activities). Simple investments (and simple businesses) are often better than complex ones with lots of financial engineering involved. Here is the full article on SUNE , which is a great story to read. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Is There A Merger Arbitrage Opportunity In Cleco?

Summary Cleco agreed to be acquired by a group of North American infrastructure investors led by Macquarie Infrastructure and Real Assets (MIRA). We believe the likelihood of the deal closing is high. The deal is expected to close in the first quarter of 2016. Shares look appealing with a weighted return profile of 22.87%. This article discusses the potential merger arbitrage opportunity in Cleco (NYSE: CNL ). On October 20, 2014, a group of North American infrastructure investors, led by Macquarie Infrastructure and Real Assets (MIRA) and British Columbia Investment Management Corporation (bcIMC) (Group), entered into a definitive agreement to acquire Cleco for $55.37 per share in cash. The deal is valued at $4.7 billion, which includes ~$1.3 billion of CNL’s debt. Cleco is a public utility company and owner of regulated electric utility Cleco Power LLC. It has served residents and businesses in Louisiana for almost 80 years. It owns 11 generating units with total capacity of 3,340 megawatts. This partnership will allow the company to operate as an independent and local business, which will help it stay focused on keeping its strong culture. Cleco is a well-run utility with a dearth of knowledge, experience, and expertise. It’s a very attractive infrastructure business, which just so happens to operate in a regulated, but stable industry. These attributes should help the company grow long term. Here’s what Bruce Williamson, Cleco’s chairman, president and CEO, had to day about the deal: “With this agreement, Cleco’s existing investors will receive an exceptional value for their shares to top off a superior total shareholder return of the past few years, and our customers and employees can expect us to retain our strong commitment to service and reliability. The board and management worked together in structuring this transaction to deliver a premium valuation to our public shareholders and ensure a continued local presence in the communities Cleco serves. This agreement is the right transaction for our shareholders, employees, retirees, and customers of all types. The new owners understand the value Cleco brings to the region and are committed to Cleco’s strategy as a safe, reliable electricity provider positioned to meet Louisiana’s long-term power needs.” So is there opportunity as a merger arbitrage candidate? Let’s dive in and find out. Despite the drop in commodity prices, this group led by Macquarie has very deep pockets. The new owners plan on refinancing Cleco’s debt at closing. The group of investors includes Macquarie, British Columbia Investment Management Corporation, and John Hancock Financial. We do not see a high probability of failure given the group’s strong capital position. The deal is said to close in Q1 of 2016 (three months); both sides appear to be excited about the deal and the synergies involved. Final stages of the state regulatory approval process have pushed the initial timeline back to Q1 2016. Initially, the deal was supposed to be finalized in Q4 2015, but utility deals always seem to take longer than expected. The Louisiana Public Service Commission (LPSC) stated that it was “recommending strong commitments” from the investor group. The investor group filed testimony with more than 70 commitments addressing concerns raised by the LPSC. The commitments appear to be more than adequate, and management expects the deal to go through in Q1 2016. Cleco is currently priced at ~14x FCF, which gives an implied yield of 7.26%. In addition, the company sports an EV/EBIT of 14.85. Although shares are not significantly undervalued at current levels, we would be surprised by a takeover either. However, the current commodity depression may hamper and potential bidders. There are many uncertainties around potential mergers, such as anti-trust approvals, multiple government reviews, changes in market conditions, shareholder approval, and due diligence. If the deal was not completed, we would expect prices to drop to the pre-deal price of $48.50, or a loss of $3.55. We give the deal a 95% chance of being complete based on the parties and terms of the buyout offer. If we look at the recent quote, the stock is trading at $52.05 per share, $3.32 below the announced cash offer of $55.37 per share by the investor Group. We calculate our expected return with the probability of a successful deal ($3.32 x .95 = $3.15). And we subtract that from our expected loss with the probability of that loss occurring (3.55 x .05 = $0.18). This is the expected weighted return, which gives us a potential return of 5.72%, or $2.98 per share. To calculate our annualized expected return, we divide that by the expected time of holding in years (three months = .25). This gives us an annualized expected return of 22.87%. Bottom Line The Cleco acquisition is an interesting deal. And we do not see a high probability of failure given the investor Group’s strong capital position. The regulatory interference concerns us some; however, it appears that the recent commitments from the investor Group may be more than adequate for a state regulatory approval. This appears to be an interesting opportunity at current levels with a potential 22.87% annualized return profile. The return appears to justify the risk in this case. Notable Shareholders: Abrams Capital Andromeda Capital Bryn Mawr Capital LMR Partners Adage Capital GAMCO Diamond Hill Capital Please share your thoughts in the comments section below, as I learn just as much from you as you do from me. It can be a time-consuming endeavor, but I answer all of your comments and questions myself. Your patience and understanding are greatly appreciated. Disclaimer: Merger-arb can be tempting for investors to use leverage to increase their annualized return on high probability events…Resist the urge! Many Wall Street firms conduct merger-arb as their main business and they will normally have 50 or more merger-arbitrage investments at any one time. They understand that if a couple of deals go bad, the winners will more than take care of the loses. Merger-arb can be a very crowded strategy at times. Similar to value investing, it can be cyclical and go in and out of favor over time. The key to merger-arb is to focus on the few deals that are highly probable (ideally ALL cash deals) with minimal regulatory hurdles and an acquirer with a great capital base. And if you’re new to merger-arb, watch a few deals play-out over various industries to get an understanding of the deals. If you do invest in merger-arb situations conduct proper due diligence and make sure to spread your risk appropriately. If you are so inclined to learn more about these types of special situation, I highly recommend Graham’s writing on arbitrage in his Security Analysis book.