Deal Flow Update – Big Cash Premiums Limit Odds Of Success

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinsk@sector-sovereign.com

August 13th, 2012

Deal Flow Update – Big Cash Premiums Limit Odds Of Success

  • The deal flow we anticipated in our note on May 29th has not disappointed with four deals in our group since June. With cash flows high and growth anemic, the pressure is on would be acquirers to get deals done, perhaps whatever the cost.
  • Our fear was that cash deals would dominate, which are very risky at anything but cyclical low multiples of depressed earnings, and this is the case so far. Debt is cheap and returns on cash are low, so companies are being persuaded to pay up at a time where sellers are unwilling to move without a riskless premium.
  • The PPG and Georgia Gulf basic chemicals combination is unique in structure and one very bright spot in what is otherwise quite a concerning picture. A deal with lots of integration benefit, lots of synergy and no real premium penalty to overcome. The starting point here was likely two companies looking for a similar outcome as opposed to a buyer trying to bid a business away from a reluctant seller.
  • We think that the CBI/SHAW deal and the GWR/RA deal contain significant risk for CBI and GWR shareholders, not just from deal execution, but also from the prices paid and the industry structure/economic environment. The cash may be cheap to come by, but it is an unhedged premium in a very uncertain world.
  • We expect to see more high priced risky deals than well structured collaborative deals as we go forward. We would encourage investors to stay very focused on companies that are open to an acquisition approach rather than those wanting to grow at any cost.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

In late May we wrote a piece on the
historical success of M&A activity
in our sectors from the perspective of shareholder returns. We wrote this following the announcement by Eaton that it was acquiring Cooper Industries. Since then we have seen four more deals of significance:

  • PPG combining its basic chemicals business with GGC
  • GWR’s acquisition of RA
  • CBI’s acquisition of SHAW
  • RBN’s acquisition by NOV

We will discuss the first three in some detail, but we believe that we are in an environment where deal flow is likely to remain very high.

There is limited underlying growth in the global economy, making it very difficult for companies to produce top line growth. While many companies have shown good recent results, mainly through cost cutting, this cannot go on forever. At the same time, three other stars are in alignment – first, lots of cash flow and free cash; second, cheap and readily available debt; and third, a broad recognition that overall volume growth is not coming back to save the day in a general sense any time soon. Many companies in the Industrials and Basic Industries sectors are faced with the choice of returning cash to shareholders, either through dividend increases or through buybacks, or buying something in an attempt to boost both the top line and the bottom line. The average CEO/Board would rather grow a company than shrink one.

Our analysis shows success where you have the following; asset intense businesses, where synergies are obvious and where cultures are similar. Obviously price and deal structure play a dominant role. It also helps if you have a senior management team that has acquired businesses before and has already discovered the pitfalls and the critical issues to get right. Rarely does an acquisition change the structure of an industry such that competition is more rational and pricing more stable.

The deals we have seen since June cover the spectrum, from very sensible to very risky in our opinion. Part of the reason why the range exists is because it is rare that both buyer and seller want the same thing (as is mostly the case with PPG and GGC). It is most common for the buyer to give up a lot in order to get the seller to the table, as appears to be the case with CBI and SHAW, GWR and RA, and NOV and RBN, where we have high priced deals that are mostly or all cash – great (and relatively risk free) for the seller. In the rail space we perhaps have some synergy opportunities and an improving market structure. In Capital Goods/Oil Services we see some synergies and we see growth. In E&C we have a cut-throat competitive market in a weaker global economy.

For the Industrials and Basic Materials Sectors, cash has not been this plentiful and “worthless” in 40 years. For those with a good credit rating debt has not been this cheap in 40 years. Growth is as anemic as it has been in past cyclical lows, with no immediate hope of recovery. The deals are going to keep coming.

GGC/PPG – Basic Chemicals Combination – Sensible

We like this deal a lot because it is likely to result in meaningful synergies that are not being priced away in some sort of deal premium.

  • There is very good geographic proximity
  • Obvious integration benefits
  • A deal structure where any synergies, either cost or revenue, will accrue equally to both participants shareholders (assuming PPG shareholders keep the GGC stock)
  • Easy exit for those PPG owners that do not want the commodity exposure (which may put some pressure on GGC stock pre and post close)
  • Accretion to both sides
  • It is asset intensive
  • The customer base is relatively diverse
  • Suppliers are plentiful
  • PPG has significant successful transaction experience, GGC less so, but PPG will remain in the picture for a while

The odds of this deal creating shareholder value are very high. Both stocks are up since the announcement of the deal, GGC more meaningfully than PPG. Valuations are stretched for both GGC and PPG, although we could probably get comfortable with a revised mid-cycle earnings number for GGC post deal that would make valuation look more neutral. This is harder to do for PPG, but it could be argued that the company without basic chemicals deserves a higher multiple, and if we were to give PPG the same historic multiple as DuPont, it would screen as only moderately expensive.

GWR/RA Acquisition Questionable at best

We are much less comfortable about this deal:

  • GWR has paid a premium, in cash, for a company which was already trading at a very high multiple of earnings, and a high multiple of EBITDA
  • A cash deal at the peak of a cycle?
  • Synergies should be meaningful, but not excessive as the companies operate complimentary rather than overlapping track routes for the most part
  • Customers are plentiful, but the economy is slowing
  • With cheap natural gas, GWR’s coal business could disappoint
  • The regional rail companies have not seen the price driven return on capital improvements that Class 1 rail has seen and it is not clear that the business structure will allow it to happen, regardless of consolidation
  • Asset intensive business so you are paying mostly for assets – which is good
  • GWR does have a great deal of acquisition experience, though nothing of this scale
  • Valuations are very scary. Simply looking at CapitalIQ data (the company tearsheet) GWR is trading at 22.5x diluted earnings today and it is buying RA, which lost money last year and is trading at a multiple of 40x 2010 earnings. The S&P500 is trading today at 14-15x current earnings

The odds of this deal creating value for GWR shareholders are quite limited in our opinion. The stock is up meaningfully since the announcement of the deal, although this was mainly driven by a good Q2 earnings report since the deal announcement. Historically rail deals have created value, but this is dominated by the Class 1 space where the mergers created real industry structural change – see our initial
research on Transports
and the analysis below.

CBI/SHAW Acquisition – The least likely to work – Roulette

We do not cover CBI, even as part of an index, and we do not have a model on the company. However, the points below and our more generic work on M&A would steer us well clear.

  • An expensive cash deal – if you pay cash and the market multiple or sector multiple re-rates to a lower level you will destroy shareholder value – every time (DOW- ROH, Lyondell- Arco Chemical, Apollo Group-HUN; all good examples). The same applies to the GWR deal.
  • Synergies limited partly because SHAW is a majority US business while CBI is mostly focused outside the US.
  • Not as much of an asset intense business as the other two, which is a concern.
  • The project based business is very competitive and very lumpy – the deal may give customers an excuse to choose a competitor in the near-term, while CBI goes through the integration process.
  • Competitors will use the distraction of the deal as a selling point to customers around why they should not use CBI right now. There is a real risk that near-term business disappoints.
  • Much of the E&C business is people rather than asset intensive – and key people could easily be bid away from SHAW as a result of the deal, particularly if competitors see growth opportunities in the US requiring more senior staff.
  • E&C earnings are very volatile – projects get delayed and they get cancelled and they get renegotiated, particularly in periods of economic weakness. SHAW has had years when its revenues have barely covered its cost of goods sold, as has CBI, though not recently. If there is cyclical weakness over the next two years the dilutive impact on CBI could be huge. Because it is a cash deal CBI is completely exposed.
  • The history of M&A deals in the E&C space is terrible – see later section.
  • CBI bought Lummus Technology from ABB in 2007 but apart from that has limited acquisition experience.

CBI stock fell quickly after the announcement of the deal, which we would have expected. However, it has recovered since.

We Care About This Because Deals Will Continue

It is important to understand the elements of risk being taken on by acquirers as we believe that we are just seeing the tip of the iceberg here. As indicated above, it’s all about chasing growth and having the necessary cash and borrowing capacity. Part of what is driving the high priced cash deals for CBI and GWR is the very low return on surplus cash and the very low real cost of borrowing. This will be an incentive for others.

Much of what is included below is updated from our report of May 29th but it has been reworked to include transports and to reflect current valuations.

The Industry In Aggregate Has Both Capacity and Incentive to Buy

At the end of 2011, the companies that make up our index (excluding GE) had a combined total of $110 billion of cash and short term investments on their balance sheet (so a little more than Apple!). This is a slight decline on 2010 (2%), but it is almost double the cash of the same group at the end of 2006. Cash as a percent of Revenues and Net PP&E is summarized in exhibit 2. Cash flows for the first half of 2012 suggest that the upward trend is continuing for those that have not already elected to spend on deals or special dividends or buybacks.

Exhibit 2

Source: Capital IQ and SSR Analysis

The cash is to a large degree surplus to operational needs as PP&E spending is stable, though up from a cyclical low in 2009/2010. Commodity chemicals is a sector where we would expect to see an increase in PP&E spending as companies invest to exploit the lower cost natural gas opportunity in the US, but cash flows are higher as a result of the cheaper natural gas so there is considerable offset. Furthermore, the big cash expenses for these projects are likely to be in 2014 and beyond, not near-term. Capex as a percent of installed PP&E by sector is summarized in Exhibit 3 and while we have bounced back from the fear driven lows of 2009 and 2010, we would still expect to see some further increases in all sectors. However, as can be seen in the prior exhibit there is plenty of cash available to do this and have plenty left over.

Exhibit 3

Source: Capital IQ and SSR Analysis

The Data Show That All Things Are Possible

Exhibit 4 shows the spectrum of 12 month returns relative to sector for 187 M&A transactions in the Industrials and Basics sectors that we cover. The chart shows a very large number of deals in the +25% to -25% range, but plenty of outliers in both directions.

Exhibit 4

Source: Capital IQ and SSR Analysis

We have only included acquisitions that were either greater than $1.0B in value or were greater than 8% of the acquiring company in terms of market value. The complete list of transactions is shown in Appendix 1. For each deal we have looked at performance of the acquirer in the 12 months post announcement and the 12 months post completion. We have then cut the analysis in a number of different ways:

  • Absolute performance aggregated by sector
  • Performance relative to the S&P500 aggregated by sector
  • Performance relative to the specific sector (aggregate by sector)
  • Relative performance based on time period
  • Relative performance based on size of deal relative to acquirer.

A summary of the results is shown in Exhibit 5, but the most interesting conclusions are discussed following the exhibit.

Exhibit 5

Source: SSR Analysis

Recent Deals Have Driven Negative Investment Returns – Exhibit 6

Prior to 2000 we saw a poor period of performance from acquirers, although this poor outcome was biased to the second half of the decade. The period from 2000 to 2010 saw aggregate acquirer stock performance well above the 25 year average. Since 2010 the average has fallen dramatically, and shareholders have lost absolute and relative money by owning acquirers post deal completion. While the recent data point does not represent a long time period, we have a sample of 36 deals in this period. Part of the explanation of good returns in the 2000 to 2009 period is explained by the outperformance of the Industrials and Basics groups in general over that period.

Exhibit 6

Source: Capital IQ and SSR Analysis

Outliers Distort the Analysis In Some Cases

If you look at the performance metrics relative to the S&P500 and take out the handful of deals that have extreme results – i.e. 12 month relative performance over 75% or worse than -75% you get a different picture in a couple of cases – Exhibit 7. The Chemical sector, which on the full analysis suggests that acquirers have outperformed post deal close, gives you the opposite answer when you take out the extreme cases, suggesting that the data is distorted by one or two positive outliers. Capital Goods and Metals and Mining also look worse with the outliers removed. E&C is changed completely – one deal that went extremely well, and was well timed, completely distorts the average and without it the track record is poor.

Exhibit 7

Acquirer 12 Month Performance relative to the S&P 500

Source: Capital IQ and SSR Analysis

The outliers excluded from Exhibit 7 are not necessarily good or bad deals; they may have been well timed, to coincide with a cyclical recovery, or badly timed, to coincide with a cyclical collapse. There is no theme to the outliers from which we can derive conclusions about what is a good or bad deal – they simply distort the analysis.

Engineering and Construction and Conglomerates have the Worst Results

We began this report by referencing the Eaton/Cooper deal, and it is noteworthy that Capital Goods is the sector where you should have been indifferent about owning the acquirer rather than the group. There is considerable variation but the average return relative to the sector is zero.

Engineering and Construction has seen one good deal and the rest have been very bad news for shareholders. Generally the acquirer underperforms post announcement and post closure.

The transport space has a history that is close to the overall average- some outperformance post deal close.

Size Does Not Matter

As show in Exhibit 8, size appears to be irrelevant – there is minimal correlation between the size of the acquisition relative to the acquirer and 12 month performance. While there are instances where deal post-mortem might have concluded that the “deal was just too big”, the data is not supportive.

Exhibit 8

Source: SSR Analysis

Given the variability of returns for acquirers and the almost guaranteed premium for targets – there is no question that you want to own the target not the sniper.

In the analysis above we are comparing results that have relatively small average returns relative to the market and the specific sectors, whether the average is negative or positive. In addition, in every sector and in aggregate the range of historical outcomes is extremely wide and it is not obvious what makes a good deal and what makes a bad deal at the margin.

By contrast, almost every target is taken out at a premium either to book value or to market value and that premium is earned quite quickly and with a high degree of certainty. Premiums paid for acquisition targets are multiples of average returns generated by acquiring companies, with the possible exception of Metals. Taking a sample of more than 25 public deals, we have an average acquisition premium greater than 30%. The premium in the CBI/SHAW deal was 70% and in the GWR/RA deal only 10%. RBN is getting a 28% premium from NOV in the merger announced on August 9th.

There is little argument that you want to own the buyer.

In Exhibit 9 – we show an updated list of companies in our coverage universe with valuations below normal and a market cap below $5bn. We would put these in the acquisition target camp. While we include the simple screen below, it is worth noting that none of the three acquisition targets discussed above was at a discount to mid-cycle value at the time the deals were announced. So far acquirers are paying top dollar for already highly valued companies.

Exhibit 9

Source: SSR Analysis

In Exhibit 10 – we show a list of companies with a market cap above $5bn and net debt to capital below 30%. These companies sit in our potential acquirers camp.

Exhibit 10

Source: SSR Analysis

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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