Boom time acquisitions come home to roost

Research carried out in 2004-5 by KPMG and Booz Allen indicated that some two-thirds of acquisitions destroy value, but that didn’t stop management teams from trying their hand at doing them.  In fact, even when prices were rising, bid up by competition from the flush-with-money private equity industry, M&A was at or near the top of many companies’ agendas.

It’s only now that we’re finding out whether the deals made then were worth doing, and increasingly the evidence is not good.  In the last 24 hours, three companies (News Corp, Hewlett Packard and Aviva) have written off a total of $12.5 billion of goodwill between them.  That means that they’re recognising that they massively overpaid for the acquisitions they made.  This follows the $6.2 billion goodwill impairment charge taken last month by Microsoft on the acquisition of Aquantive.  Expect more headlines along the lines of ‘News Corp in $2.9bn newspapers writedown’ as the economic outlook darkens.

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The growing importance of Debt IR

Speak to anybody about Investor Relations and they’ll assume that you’re talking about your relationships with existing and potential equity investors.  But companies of course finance themselves with both debt and equity and the markets have changed enormously in recent years.  Whereas the great majority of companies would have financed their debt needs 30 years via syndicated loans from the banks, now they will circumvent the banks and go directly to the markets for their money – it’s a deeper pool of capital and companies can borrow on better terms from the markets than the banks.  Today, some 70% of companies’ borrowing needs in the US (which has always been ahead of the UK and Europe in the growth of its capital markets) is now obtained from the markets rather than the banks, but the proportion is rising fast here in the UK.

This means that maintaining relationships with debt investors is becoming more and more important.  Debt, don’t forget, needs to be paid back (redeemed, in the parlance of the market), and the best place to obtain new debt is of course from those who are the current lenders (the current owners of the bonds).  Companies may also want to take advantage of the current low interest rate environment and refinance existing expensive bonds with cheaper funds. The problem, however, is in finding out who and where the bondholders are.  For historic tax reasons (a buyer of the bonds wanted to be anonymous and thereby avoid withholding tax being imposed on his interest coupon), the bond market is very largely a ‘bearer’ market, meaning that there is no register of the bond owners (the bearer of the bond is its owner).

Debt investors, of course, have a need for information flow just like their equity counterparts, although their needs are very different.  A debt investor is primarily interested in being kept informed about two things – whether the company is able to finance its interest payments and its ability to repay debt as it falls due.  The better a company can communicate with its bond investors about these two crucial aspects, the more comfortable those investors will in turn be to lend further funds.  Welcome to the world of Debt IR.

And it doesn’t end there.  Sometimes there’s a real conflict between shareholder and bondholder interests.  Imagine a company making an acquisition of a highly complementary business, financed wholly by debt.  The shareholders will applaud such a deal, focussing on the leveraged returns and the synergies from the fit.   But the bondholders will be looking at completely different ratios, worrying about the amount of debt in the company’s capital structure and its ability to service the interest payments.  The IR requirements of the two audiences are entirely different and the story is going to have to be tailored to each.

With the growth of the capital markets as a source of borrowing, Debt IR is going to become a increasingly important activity.  But because of the difficulty of it being a bearer market and the further problem then in identifying bond investors behind nominee and bank holding names, there aren’t many companies who can provide the necessary information about who the bondholders are.  For those who can, there’s a major opportunity ahead.

The French Disconnection

It’s been suggested by several commentators that one of the potential solutions to the eurozone crisis is for the ‘creditor’ countries of the north, led by Germany, to form a ‘nord-euro’ group, and the debtor countries of the Latin south to gather around a ‘sud-euro’ currency.  That way, the euro would be preserved and the millions of contracts written in euros would still be valid.  Better still, the fundamental problem of the lack of competitivity in the peripheral states would be solved because the nord-euro would harden and sud-euro weaken, probably dramatically, bringing immediate benefits to the balance of payment problems that are at the root of the crisis.

It’s a neat solution and one that I suspect will be increasingly debated as the financial world  looks urgently for an answer to the deepening crisis in the eurozone.  However, here’s the big question:  would France be in the nord-euro or sud-euro group?  They would of course  say the nord, but that might be pulling the wool over their own eyes. Today, it was announced in France that a large Peugeot factory would be shut and that this and other cuts elsewhere would result in the loss of 6,500 jobs.  The state has spent the not inconsiderable sum of Eur 4 billion supporting Peugeot in recent years, money which will now see no return, a situation which the French Social Affairs minister described today as ‘unacceptable’.  It’s classic French state-support gone wrong and the reason other countries stopped doing this sort of thing a long time ago.

The reality is that large parts of French industry are increasingly uncompetitive and they need to cut costs, but cost-cutting is socially unacceptable (state expenditure is 56% of GDP, easily the highest in Europe).  Indeed, the new Socialist government is moving in precisely the opposite direction, adding enormously to costs by lowering the pension age to 62 (as against 67 in Germany to whom, extraordinarily, the new French President is looking for support of his idea of eurobond-based mutualisation of sovereign debt).

The French situation is thus a particularly acute case of a disease that has for some time been infecting much of the western world – ‘we like our pensions and welfare and other entitlements but we don’t know how to pay for them’.  The Chinese, the Malaysians, the Brazilians and all the rest of the emerging world have no such costs, and they are the competitors with whom we are now competing.  However, a nice bit of currency devaluation would cure the problem for now and could even give the French government a chance to get the house in order and reduce the cost base.  But that would require an admission that the economic problems in France are specific to France – not, as the newly elected politicians argue, created by the casino traders in London and perfidious Anglo-Saxon capitalism.

So, if nord and sud-euros are ever put on the table to cure the eurozone crisis, you can expect the French to apply for hard, nord-euro membership – but that will only massively exacerbate the existing problem of lack of competitivity, increasingly exposed as at Peugeot today.  So, Club Mediterrainee, s’il vous plait?  It’s the right way to go, but it’s not the path they’ll choose, which is why one of the few plausible solutions to the disastrous eurozone crisis will never see the light of day.

Goodwill does matter!

Of the arcane accounting subjects, the treatment of goodwill and how it should be accounted for has been through more iterations than most, but on one subject most market observers are agreed.  It can generally be ignored.  Vodafone, for example, acquired vast amounts of goodwill when it bought Mannesmann in 2000 and at the last count the impairments totalled around £30 billion.  An impairment charge in the billions and  wiping out reported profits virtually every year in the past decade was casually ignored by most observers.  An even worse case is AOL’s acquisition of Time Warner (‘the worst acquisition in history’) where the impairments to date total $102 billion out of a total transaction cost of $162 billion.  But in both cases, the acquisitions were made via share-for-share exchanges, not using hard cash.  So you could conclude that it was all highly valued paper taking out other highly valued paper, and the resulting accounting charges for goodwill impairment were just that, accounting.

But it’s hard to argue that goodwill impairments don’t matter when it’s hard cash that’s been used to make the acquisition.  Which makes the $6 billion write-down announced yesterday by Microsoft all the more egregious. Yes, it’s a non-cash charge that will impact this year’s earnings, but the usual accompaniment of analyst and investor disinterest won’t be there this time.  This one matters, and it’s an admission by the Microsoft management  team that they’ve wasted billions of shareholders’ cash on a failed acquisition.  It was, of course, the very same management team that acquired Skype (which in its brief history to date has never made a profit and on my understanding of its business model, such as it is, doesn’t look like doing so in my lifetime) for an even higher sum, $8.5 billion.  Might be worth keeping an eye on the goodwill value in that one too.

Applause, with a raised eyebrow

Anybody who has attended our courses knows that we applaud companies who talk not only about their earnings but also about the returns they are making on the capital they are using.  Increases (or decreases) in EPS tell you just that – they have increased or decreased, but no more.  Much more interesting for investors is how much capital has been used to generate that growth in EPS, as measured by return on capital invested.

So we always examine the commentary in financial press announcements, particularly in M&A situations, not just for the impact on EPS (such as whether the deal is accretive or dilutive), but also if there’s any comment about whether the deal will cover its cost of capital.  Our belief is that this shows that the company understands how investors think.

Yesterday’s announcement from WPP on its $540m acquisition of AKQA actually contained no details of its financial impact on WPP, but what caught my eye was Sir Martin Sorrell’s comments in the FT today when he was reported to have said that the deal would be accretive in the first year and “would meet WPP’s 6.1% cost of capital’. So applause to him for discussing not just the EPS impact but also commenting on the fact that it would cover its cost of capital.

But then, stop for a moment and consider that cost of capital.  6.1%?  How on earth does he get to that figure?  Measuring the cost of equity capital is an imprecise science, despite what the academics would have you believe with the betas and the risk-free rates, and there’s lots of scope for subjectivity, but you’d go a long way before you found an analyst who’d agree with Sir Martin’s estimate of WPP’s cost of capital.  But then, if he was to confess that it was somewhere nearer 9% (which I’d reckon it to be), the acquisition of AKQA would nowhere near cover its cost of capital and be destroying shareholder value.  And that would be confessing that he paid too much for it, which investors (being good at this sort of thing) know anyway.

Political intervention in euro crisis

About a week ago I was writing about how it was getting near that time for the politicians and central bankers to intervene.  It all that smell about it of ‘Do something or this whole thing is going to blow’.  I also wrote that I expected the positive market reaction to last a little less long than it has in the past (the LTRO news boosted the markets for all of about three months).

So the news on the bail-out for Spain was duly announced today amid shouts of ‘Victory for  the euro’ from Mr Rajoy and others, and the market’s reaction…..Well, it’s flat after a euphoric 1.5% rise first thing today, but a) watch the currencies and b) of course, watch the Spanish (and Italian, and French) 10 year bond yields.  The euro is 1% weaker today against both the pound and the dollar, and Spanish bond yields, far from falling in the wake of the €100 billion rescue, are up to 6.45% as I write.  Sorted?  Hardly, and that’s after throwing €100 billion at the problem.  Over to the politicians and central bankers for more sticking plaster, fast.

Keeping good company

What does a good company look like from an investor’s point of view?  Well, it would have a large market to go after and, most importantly, a competitive advantage in doing so.  And the longer it can maintain that competitive advantage (think Microsoft with Windows), the more profits it will make over time.  Investors pay up for companies with these qualities.

They will also pay up for management that understands how to create shareholder value and for high standards of corporate governance, in particular of disclosure and transparency.  Which brings me neatly on to Johnson Matthey, which reported its results at the end of last week.  JM recorded exceptionally good growth across all of its markets, but look also at the way it tells its story and sets it out on the first two pages with complete clarity.  Exactly as we teach it, actually – a box containing the key numbers, five bullets each on financial and operational highlights and a good quote from the CEO, part of which comments on the past year and part of which guides to the future.  Faultless.  And it scores well on one other key issue.  Don’t just talk about Earnings per Share (up 29% at JM) – that doesn’t tell you anything about the amount of capital that’s being invested to grow. Talk also about Return on Capital Invested (or Employed), as JM also does so well (ROCI up from 19% to 22%).  The only problem for JM might be the expectations treadmill, but the shares are up 17% over the past year compared to a fall in the FTSE of 5%.  Investors are more than happy to pay up for a good story well told.