Friday, November 28, 2008

Someone Doing Her Job

Managing Partner Susan Glass of KPMG threw cold water on what was described as the "largest leveraged buyout" of BCE, Inc. of Canada. The deal was predicated on the company taking on $32 billion of new debt, along with sales of various assets now deemed "non-strategic." Spending four weeks or so running numbers under various scenarios, the conclusion of KPMG was that the entity post-buyout would be non-solvent.

We've written before about roots of the current crisis being found in the failure of boards, regulators, and auditors to execute their basic responsibilities. It's really heartening to see an auditor stand up and do their job. Presumably, having done the audit on the company for a while, they understand how their financials work, and something of their businesses. They can run spreadsheets out into infinity as well as as associates at investment banks. Based on this, along with some auditor skepticism and conservatism, BCE received a non-solvency opinion, which kaboshed the transaction per the deal documents.

Their are noises being made about essentially shopping the opinion, or rather engaging an accounting consulting firm to "check" KPMG's assumptions. Let's hope that common sense prevails. This is what the auditor was paid to do, and they have opined. Now let the board and management come up with their own plan to create shareholder value without the risk of insolvency.

Wednesday, November 26, 2008

The Basics of a Corporate Mission

One of the first times I heard Harvey Mackay speak about Mackay Envelope's corporate mission, I was taken aback. He said that it was the following "To be in business forever." A few uncomfortable chuckles broke out, and other CEO's in the audience shook their heads at each other. Shouldn't this be the fundamental mission of every corporate organization?

Look at the U.S. auto makers. In the Seventies and Eighties, they were reeling from bad products, poor management, burdensome labor contracts, and retirement costs. However, in the Nineties, with the economic recovery in full swing, things got much better. Cash flows were strong, as the SUV phenomenon swelled profits per vehicle, but the managements succumbed to the short-sightedness of Wall Street and its hedge fund activist investors. Shareholder value fell onto everyone's lips, and lots of stock was bought back and dividend payouts raised.

Reinvestment in the company's basis business, which is a key to a company being in business forever, was ignored. What about new plants, new processes, new ways of manufacturing, right shoring? What about looking beyond a wave that surely would not last forever and investing in the ability to build smaller, more innovative vehicles?

It's easy to guess what the Japanese did: Toyota and Honda ignored the self-interested and short-sighted cries of vocal institutional investors and they continued to innovate around their basic business, making vehicles.

Lots of traditional mission statements flow from the basic one uttered by Harvey Mackay. Looking beyond the current crises, one wonders which ones of today's industrial leaders plan on being around for a long time.

Friday, November 21, 2008

Corporate Jets

Grandstanding on Capitol Hill is national pastime. Surely the auto industry executives appearing, hats in hand, in Washington should know that by now. Instead, they walked into a buzz saw when asked about their transportation mode to the hearing. Now, the use of corporate jets will be inextricably linked in the popular mind with the arrogance--real or not--of the executives.

The economics of using corporate jets makes perfect sense in many cases, depending on the number of people flying, the destination city, its airport conditions, and the specifics of the destination site and the plans for the day. Almost two decades ago, a brokerage firm I worked for used a "plane share" system on a King Air. With six of us flying into Chicago for client calls-- the price for peak hour commercial flights, being able to land downtown versus O'Hare, avoiding rush hour traffic, spending more time with customers--the economics were a no brainer. Surely, a similar case could have been made on the Hill.

Instead, some of the press proxies for the auto executives had the chutzpah to talk about the risk of kidnapping flying from Detroit to Washington! Why not just explain the simple economics of the decision, including non-pecuniary benefits like being able to work full-time on presentations during the flight? End of discussion.

In Washington, DC, as in most places, perception trumps reality. This is a total non-issue in the current systemic crisis, yet it will be used as a defining moment for characterizing the industry. As ridiculous as it sounds, this question should have been anticipated in a well-prepared brief for the executive team.

Saturday, November 15, 2008

Fundamentals in a Down Market

David Katz of Wachtel, Lipton & Katz and his co-author, Laura McIntosh published a survey article about the results of the 2008 proxy season. Here is a link to the article via a Harvard Law blog:

Shareholder communications are vitally important, and they do yield tangible results in cases where there are direct inquiries about executive compensation plans, for example. The authors cite a union that withdrew more than half of its proposed pay-for-performance proposals after direct negotiations with the target companies. So, when a company is under the gun, well constructed outreach to shareholders yields results.

Looking beyond the state of the current market, investors still care the most about fundamentals, like the strategic direction of their portfolio companies, returns, and on management's creation of long-term shareholder value.

Tuesday, November 11, 2008

A Great Idea Lost in the Din

Glen Hubbard, the Dean of the Columbia University Graduate School of Business and Professor Chris Mayer, came up with a bold proposal for the residential mortgage mess back in early October. Here is a link to FAQ about their plan on the Columbia University GSB site:

I look at it this way. 1. Q: What is the home owner's worst nightmare? A: Being foreclosed out of one's home, creating heartache for the family, and losing your credit rating for the future.

2. Q: What is the last thing that banks want? A: To foreclose on a home and to be an owner of residential property. Why? Homes in foreclosure go into a parallel universe with fly-by-night service providers who promise a lot and do nothing. The home sits there and deteriorates through a winter, the grass goes unmowed, and this quickly affects the market value of adjacent homes that might themselves be coming on the market. This process does not work for the bank. It is a remedy that is worse than the disease. So, we come to the conclusion that avoiding foreclosure is not an issue of moral hazard or of bailing out people who made foolish decisions, but something that is really in no one's interest.

The Hubbard-Mayer proposal is the only one I've seen that addresses this reality. Much of the current Wild West buffet of bailout-du-jour strategies serve only to address the balance sheets of the financial institutions. There is much more at stake than this, as the banking system contagion feeds back, through the mechanism of declining GNP and employment,onto home prices. Since this has already begun, the proposal probably needs a bit of tweaking, but this is minor.

Their proposal excludes investors and speculators, and basically resets all interested homeowners to a 5.25% fixed rate mortgage based on a reasonable loan-to-value ratio, provided the homeowner can support the new mortgage. A new SPE would administer the program and write-downs from the current mortgage and value situation would be shared between the originator of the old mortgage and the new Federal SPE. The homeowner would give up 20% of the future home appreciation to the government when the home were sold.

There is a lot to like about the proposal, because it doesn't whittle away at the problem, it cuts the Gordian Knot.

Edwards Life Sciences

Here is a solid, low-growth, small cap medical device company with good cash flows that was always underwhelming at analyst conferences, where I got to listen to their presentation, after having presented for Possis Medical. I posted earlier today about acquisitions, and just got an email from the Canaccord Adams medical device analyst about Edwards ("EW")

"EW signed an agreement with Dexcom to develop continuous glucose monitors for the hospital market, which represents a multi-billion dollar annual revenue opportunity, in our estimation. That said, product and market development are long-term projects at this point." (Nothing wrong with that!)

Access to this opportunity costs a small upfront R&D payment, plus ongoing product development support for three years, the net effect of which, according to Canaccord Adams, is to raise the ratio of R&D to sales by ten bp or so in that period. Big deal!

For Edwards, which has historically had free cash flow not returned to shareholders, this seems very much in the spirit of our thoughts in the previous post about acquisitions. Good luck to Edwards and congratulations for not standing pat, but for taking what seems like a minimal, measured risk for a potentially large reward.


Everyone loves and needs transparency, right? So, with $2 trillion in taxpayers money being doled out for emergency aid to financial companies, there is almost no information about the assets being accepted as collateral for our money. This is so despite assurances to the contrary and invocations of the mantra "transparency," by Secretary Paulson and Chairman Bernanke.

Dan Fuss of Loomis Sayles, a very savvy and experienced fixed income investor who manages about $17 billion in bonds, points out that the lack of disclosure is particularly critical in a market that is "very nervous and very thin."

Congratulations to Bloomberg News for suing under the Freedom of Information Act for details on the Fed's lending. Let's see how this plays out.

Isn't It Strange?

During the pre-crisis market euphoria, M&A activity was robust. Multiples offered by buyers were rich, and premia to market prices of public companies sometimes took the breath away. Think about the many deals that were put on hold or which are no longer on the radar screen of the acquiring company's board. Does this make sense?

If an acquisition fills a legitimate strategic need, bankers are hired, spreadsheets are cast, fairness opinions abound, the acquisition is now teed up. Markets freeze and the deals wither. However, if all the reasons for looking at the acquisition were truly of strategic value, then all that should have changed--in many cases--is just price. Markets handle this issue all the time.

I remember some McKinsey research that said in market downturns, 60% of companies that made acquisitions in frothy markets choose to do nothing in a downturn. Isn't that strange?

Seller's expectations will be brought back down to earth. This is particularly true for private companies that are now facing a change in the capital gains regime from a new, activist administration in Washington. Weakened currencies of the buyers hamstring their ability to be indulgent with their owners money. If the strategic reasons are still there, come up with a new deal structure, or start with some form of partnership that leads to a deal later.

There are a number of microcap public companies that are profitable, with cash on their balance sheets that can earn higher valuations if their growth prospects are visibly enhanced. Acquisition targets for these companies are most likely private companies. It would seem that CEO's and their boards, instead of worrying about next quarter's earnings--which are probably going to worse than plan--should be looking at acquisitions.

Some key criteria for the acquisitions? A business with good long-term economics. A business that adds luster to the portfolio. Honest, trustworthy and committed management. A reasonable price.

Boards and management almost never talk about overpaying in a frothy market, and yet it is almost always the case that the acquirer does so. In these kinds of markets, there is some risk that prices continue to decline for targets, driven largely by macro issues that diminish the economic value of the target. Again, these are things that can be negotiated into a structure provided that both sides see the strategic benefits of the acquisition.

Thursday, November 6, 2008

Restoring Confidence..or Not

Financial markets, and particularly credit markets, rest on a foundation of confidence, the first principle. When banks lend to each other, when strong industrial companies float commercial paper, there is a confident belief that the lenders will be paid back on a timely basis. This belief is fostered by due diligence and analysis of the credit, for sure. However, it really rests on experience, a history of transactions, and on a belief that a market player will play by the rules.

So, in traditionally deep and liquid markets, like the interbank markets and commercial paper, the risk premia applied to the cost-of-funds rate are usually thin. Now, despite all the Treasury and Fed's opening of the checkbook, the markets still remain frozen, albeit with a thin layer of melted water on top.

The confidence to make credit markets work has not been restored. Massive amounts of liquidity have been injected, but the liquidity has become trapped, to borrow a usage from John Maynard Keynes.

Jim Grant's observation is on point: "The bear market is truly a value restoration project. Wall Street will be going on sale--if the government will let it." We need to get on with the "creative destruction" process. First the cleansing, then the renewal. Forty government folks sitting in a building deciding who is going to survive and who will not is no way to get us out of this fundamental crisis. The Federal Government needs to stand down and let the markets work. There are certainly some legal, administrative and regulatory adjustments that need to be made to facilitate this process. But, no more, "Ready, fire, aim."