Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals

Analysts, investors and journalists who follow stocks have an obsessive focus on earnings per share, what it is now and what it will be in the future, as can be seen in the earnings announcement game every that takes up so much of Wall Street’s time and resources. Not surprisingly, acquiring firms, considering new deals, put their accountants to work on what they believe is a central question, “Will the earnings per share for the company (acquirer) go up or down after the acquisition?” A deal that will result in higher earnings per share, post-deal, is classified as accretive, whereas one that will cause a drop in earnings per share is viewed as dilutive. 

Is it better to have an accretive or a dilutive deal? If you asked that question of most investors, analysts or even CFOs, the answer, you would be told, is obvious. An accretive deal is better than a dilutive deal, with the logical follow through that if your earnings per share increase, your stock price will follow. But is that true? To see why it is not, let us break down the mechanics of what will happen to earnings per share, after an acquisition or merger. The net income of the two firms will be cumulated and divided by the number of shares outstanding in the combined firm, after the merger. Mathematically, here are the two factors that will determine whether a deal is accretive or dilutive:

1. What are the relative PE ratios of the acquiring/target firms? In a share swap, where the acquiring firm’s shares are swapped for the target firm shares, the combined company’s earnings per share will increase (be accretive) only if the PE ratio of the acquiring firm is greater than the PE ratio for the target firm. It will be dilutive, if the reverse is true. 
2. How will the deal be financed? If a deal is funded with cash on hand or by issuing new debt, the deal will be accretive, if the company being acquired is profitable and is generating a high enough expected income to cover the lost interest income (if cash is used) or the expected interest expenses (if debt is used). 

If you are interested, you can download a simple spreadsheet that works out whether a deal will be accretive or dilutive to the acquiring company.

Reviewing these two conditions make it clear why it is absurd to think that accretive deals are always good and that dilutive deals are bad. The Achilles heel in this reasoning is in the assumption that the PE ratio will stay fixed after the deal; if that were true, higher EPS will always translate into higher price, making accretive deals good for acquiring company stockholders. But it is not, and you can see the rationale by looking at all of the scenarios listed above:

1. If you are buying a company with a lower PE ratio than yours, there is usually a good reason why that company has the lower PE. It could be that the firm is riskier than average, has lower or no growth or is in a business with sub-standard returns. If any or all of these reasons hold, acquiring this company will bring those problems into the combined company and cause the PE ratio for the combined company to fall. If that drop exceeds the increase in EPS, the stock price of the combined company will also fall, notwithstanding the accretive nature of the deal. 
2. If you are funding a deal with cash, the deal will almost always be accretive because the income you are generating from cash (especially at today’s low interest rates) will generally be lower than the equity earnings you will get from the company that you are acquiring. But is that value enhancing? Not really. Replacing an investment that generates 1% riskless today with a risky investment that generates a 4% return will make investors in the company worse off, not better. 
3. If you are financing the deal with debt, the deal will be accretive if the equity earnings that you generate from the acquired company exceeds the interest expense. But here again, that is not a sufficient condition for value creation. You are contractually committed to make the interest expense, while the income you anticipate is “risky”. The basic tenets of the risk/reward trade off will require a much higher risky equity return than the interest rate on the debt you take on for the deal to be value creating. 

Using the same type of reasoning, you can see that it is possible for a dilutive deal to be value creating: the target firm may have higher growth/higher quality growth/lower risk than you do and acquiring it may push up the combined firm’s PE and/or there may be enough growth in the firm that even though the current earnings don’t cover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing.

There are CFOs who will hear this argument and say that it is “academic”. The market (and the equity research community) care about earnings per share, they will argue, and it is not sophisticated enough to make the adjustments to PE for risk and fundamentals. The proof, though, is not in what CFOs believe or what equity research analysts say matters, but in how the market reacts to accretive and dilutive deals. A McKinsey study of accretive and dilutive deals uncovered the following market reactions to these deals:

Note that at least in this short sample period, there is no evidence that markets reward accretive deals and punish dilutive deals. Thus, Leo Apotheker’s defense, offered two days after HP bought Autonomy, that “Autonomy will be, on Day 1, accretive to HP” would have rung hollow, even without the benefit of hindsight. I, for one, think that it is time that we consigned this dilutive/accretive analysis to where it belongs: the dustbin. It is not only truly useless in assessing the quality of deals, but worse, it allows companies to justify (at least to themselves) some really bad deals.


The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

Acquisition Advice: Big deal or good deal?

HP is one of a multitude of companies that has overpaid on acquisitions, and like those other companies, it cannot claim that it lacked outside advice and guidance. In fact, HP paid $30.1 million in advisory fees to Perella Weinberg and Barclay’s Capital for guidance on how much to pay for Autonomy and whether the deal made sense. So why did they not spot the accounting manipulation or recognize that synergy would be elusive? In general, why, if acquiring firms pay so much for "expert" advice, do so many deals go bad?

Conflicting roles: The answer can be seen in an imperfect analogy. Asking an investment banker whether a deal makes sense is analogous to asking a plastic surgeon whether there is anything wrong with your face. After all, if either party says “No”, they have no business to transact and no revenues to generate. Allowing the dealmaker (the investment banker) to also be the deal analyst (provide advice on whether the deal is a good deal) is a recipe for bad deals and we have no shortage of those. The solution is simple in the abstract but transitioning to it may be difficult. The deal making has to be separated from the deal analysis. Put differently, investment bankers should do what they do best, which is to manage the mechanics of the deal, and be paid for the service. There should be a third party, with absolutely no stake in the deal's success or failure, whose job it is to assess the deal to see if it makes sense, with compensation provided just for that service. Why has this common sense change not happened yet? First, as I noted in my last post, many acquiring companies want affirmation of decisions that they have already made (to acquire), rather than good advice. Second, the same entity (say, Goldman Sachs or Morgan Stanley) cannot slip back and forth between being a deal maker on one deal and a deal analyst on another, since there will be a shared and collusive interest then in shirking the deal analyst role. You would need credible entities whose primary business is valuation/appraisal and not deal making.

The deal table: In many businesses, companies measure their success based upon market share and revenues. M&A bankers are no different and their success is often measured by where they fall in the deal table rankings. Here, for instance, is the latest deal table from Bloomberg, listing the top bankers for M&A globally, in 2011 and 2012.

Note that the rankings are based upon the dollar value of deals done, and that there are no extra columns for good deals and bad deals. Consequently, a banker who does a $11 billion bad deal will be ranked more highly than one who does a $4 billion good deal. There are three implications that follow.

1. When a big deal surfaces, bankers line up to be part of that deal, willing to bear almost any cost to get involved. 
2. The bigger the deal, the worse the advice you are likely to get; the conflict of interest that we mentioned earlier gets magnified as the deal gets larger. 
3. Individual bankers will be judged on their capacity to get deals done and not on the quality of their deal advice or valuation expertise. Thus, it is not surprising that the biggest stars in the M&A firmament are the dealmakers. In fact, it is interesting that Perella Weinberg is listed as one of HP”s advisors on the Autonomy deal. Joe Perella, co-founder of the firm has a long history in the acquisition business that goes back almost four decades to his position as co-head of M&A at First Boston in the 1970s. He left the firm, with the other co-hear of the First Boston M&A team, (Bid 'em up) Bruce Wasserstein, to create Wasserstein Perella, a lead player in the some of the biggest acquisitions of the 1980s. He returned to head M&A at Morgan Stanley for a few years before leaving again to found Perella Weinberg. Through all the years, it seems to me that the singular skill that he possesses is not his capacity to value target companies but that he can get any deal done. 

So what can we do to change this focus on deal making? We do have to begin by changing the way we compensate bankers in deals but we also have to follow up on deals. I would like to see some entity generate deal tables that track the largest deals from five years ago and report how much those deals have made (or lost) for stockholders in the acquiring firms. It would be interesting to see the list of the top 10 bankers in terms of value creating and value destructive deals.

Compensation: The third factor that contributes to the deterioration of deal advice is the way in which the deal advisors get compensated for their services. In most deals, the deal advisors get paid for getting the deal done and there is no accountability for deal performance. Neither Perella Weinberg nor Barclay’s Capital will have to return any of the advisory fees that they received for the HP/Autonomy deal, even though the advice that was offered was atrocious. I think that there is a solution, even within the existing system. Rather than tie the entire fee to getting the deal done, a significant portion should be contingent on post-merger performance. Thus, if the acquiring firm’s stock price or profitability fails to beat the peer group’s stock price performance or profitability in the years (two, three or five) that follow, the bankers will either not get a large portion of their fee or be forced to return a proportion of the fees that they have already been paid. Bankers will complain that this puts them at the mercy of  macroeconomic shifts and mismanagement of the post-merger integration, but those are variables that they should be considering when assessing whether a deal should get done.

In closing, though, acquiring firms are quick to blame bankers for bad advice. As I noted in my last post, I think that the ultimate blame has to lie with the top managers of the acquiring firms. No acquirer  is ever forced to do an acquisition at the wrong price and if they chose to do so, they should be held responsible.


The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

Acquisition Hubris: Over confident CEOs and Compliant Boards

In my last post, I noted that acquisitions are more likely to destroy value for acquiring firm stockholders than to add value, and that there is little evidence that companies learn from history. That is puzzling, given the manpower, data power and model power that is brought into the acquisition process. How can all these smart people working with sophisticated models and updated data be so wrong so often?

The answer I think lies in a simple fact: in most acquisitions, the decision to acquire is made first and the analysis follows, and all too often, the decision is not only made at the top of the organization, but at the very, very top by the CEO. That is not the way organizations are supposed to work. Big ideas, no matter who originates them, are supposed to be discussed honestly and openly, analyzed fully and then vetted by an independent, well informed board of directors to make sure that stockholder interests are being served. That may still happen in some organizations, but consider this alternate reality. In a moment of inspiration (insanity) or brilliance (lunacy), the CEO decides to do an acquisition of a target firm for strategic (empire-building) reasons. The managers around him or her, recognizing that the die has been cast, choose not to voice their opinions, get bulldozed when they do, or decide to join the CEO in pronouncing the acquisition a great idea. An investment banker is found to affirm that the deal is, in fact, a great deal and the rest as they say is history. Reminds you of this fairy tale, right? If you find this scenario to be absurd, start by taking a look at James Stewart's article on the HP/Autonomy deal and especially at the back story on how Leo Apotheker, HP's then CEO, pushed for the deal even as there were plenty of doubting voices (both within and without the firm), and how the board essentially went along with his wishes. Then, move on to take a look at these stories about Eisner's role in Disney's acquisition of Capital Cities in 1995 and Zuckerberg's role in Facebook's purchase of Instagram earlier this year to see how much head-strong CEOs can influence the acquisition process.

If the acquisition process is prone to failure, as the evidence suggests that it is, there are many potential culprits that you can blame. The investment bankers who facilitate the deals for huge advisory fees are an easy target and the accountants/auditors who dress up the books are a close second, but the primary culprit has to be the top management (and particularly the CEO) of the acquiring firm. After all, once a CEO gets set on doing a deal, he can go about picking the facilitators (the investment bankers and accountants) to make the deal look good. As we bring behavioral finance into play, the evidence suggests that over confident CEOs  play a key role in greasing the skids for large (bad) acquisitions. To measure confidence, Malmendier and Tate, who have a series of interesting papers on how over confident CEOs manage, developed two measures:

1. Insider holdings in the companies that they manage: Rather than diversify and spread their risks by investing in other companies, over confident CEOs seem to double up and invest their wealth/income back into the companies that they manage.
2. Press reports: Looking across financial news stories for mentions of the CEO in question, they looked for the words "confident" or "optimistic" in descriptions of the CEO   opposed to words such as "cautious", "frugal" or "steady". If the former exceeded the latter, the CEO is classified as an over confident CEO, whereas if the latter dominated, the CEO was classified as a cautious CEO.

They then looked at a sample of 394 large US firms and found that over confident CEOs were 65% more likely to do acquisitions than cautious CEOs, though they were also less likely to draw on external financing; their over confidence led them to believe that the market was underpricing their stock and thus made them more reluctant to use stock in acquisitions. They were also more like to acquire just to diversify, and the market reaction to their acquisitions is more negative than to acquisitions by cautious CEOs.

Can no one stop a headstrong CEO? There is a counterweight built into the system, the board of directors, and it can act as a restraint on a CEO embarking on a value-destructive path. Unfortunately, one common feature shared by value-destroying acquirers is a compliant board, that shirks its responsibility to protect shareholder interests. It is not surprising that it HP, which has had issues with corporate governance and board oversight, was the ill-fated acquirer of Autonomy.

In summary, then, a headstrong, over confident CEO, combined with a compliant board creates a decision making process where there are no checks on hubris and large, value destroying actions often follow. If investors want to prevent their firms from embarking on deals like the HP/Autonomy deal, they need to pay attention to corporate governance, and not just at the surface level. After all, the board at HP met all the Sarbanes/Oxley requirements for a "good" board and may even have scored high on the corporate governance scores in 2010. The problem with corporate governance watchdogs, legislation and scores is that they are far too focused on what the board looks like and far too little on what it does. In my view, it matters little whether a board is small or large, whether it is filled with luminaries or unknowns, experts or novices and whether it meets the criteria for independence. It does matter whether the board acts as a check on the dreams and acts of imperial CEOs.


The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

Acquisition Archives: Winners and Losers

In my last post, I looked at HP's disastrous acquisition of Autonomy for $11 billion in 2011 and its subsequent write off of $8.8 billion. While it stands out as a particularly egregious example of a bad deal, it is unfortunately not the exception. In fact, the evidence suggests that a growth strategy built around acquisitions, especially of other publicly traded firms, is more likely to fail than succeed. To back this statement, you can look at three pieces of evidence:
(a) the behavior of the acquiring company's stock price, around the announcement of an acquisition
(b) the post-deal performance (stock price & profitability) of firms after acquisitions
(c) the overall track record of acquisition-based growth strategies, relative to other growth strategies

The acquisition date: Uninformed investors or Delusional managers?
When an acquisition of a publicly traded company is announced, the attention is generally on the target firm and its stock price, but the market's reaction to the event is better captured in what happens to the acquiring firm's stock price. In the figure below, take a look at the target and acquiring firm stock behavior in the twenty days before and after the acquisition announcement across hundreds of acquisition announcements:

The winner in public company acquisitions is easy to spot and it is the target company stockholders, who gain about 18% over the 41 days. On average, bidding company stockholders have little to show in terms of price gains; the stock price for acquiring firms drops about 2% during the announcement period and about 55% of all acquiring firms see their stock prices go down. Note that while the percentage price drop is small (relative to the price increase for the target firm), acquiring firms are typically much larger than target firms and the absolute value that is lost by acquiring firm stockholders from acquisitions can be staggering. A study of 12,023 acquisitions by large market cap firms from 1980 to 2001 estimated that their stockholders lost  $218 billion in market value because of these acquisitions. While this number was inflated by some especially bad deals done between 1998 and 2000, they illustrate the potential for massive value losses from acquisitions and the reality that one big, bad deal can undo decades of careful value creation in a company.

There is one final interesting statistic that can be gleaned from the announcement date market reaction. If you take the cumulative market value of the target and acquiring firms, just before the acquisition announcement and just after, that combined value increases, on average, across mergers. For better or worse, this is what the market seems to be telling us at the time of acquisitions announcements: it believes that there is value added from synergy or other sources in the typical merger, while at the same time also believing that acquiring firms over estimate the value of the synergy and pay too much.

The long term: Post-deal blues?
The defense that is offered by acquiring company managers, when confronted with the market's negative reaction to the acquisition announcement, is that the reaction is rooted in ignorance. Acquiring company managers claim to have access to information and forecasts that stockholders don't have and argue that they are in a better position to value "synergy" and "control". It is of course true that managers have more information on target firm than their stockholders do, but the proof is ultimately in the pudding. To make a judgment on whether this superior information pays off in superior performance, let's look at whether acquiring firms deliver on the promised synergy and other benefits.
Post-deal stock price performance: KPMG studied the 700 biggest mergers between 1996 and 1998 and compared the stock price performance for a year after the deal was closed to that of the peer group to conclude that 83% of the companies underperformed after acquisitions. Thus, the negative reaction to acquisition announcements does not seem to dissipate over longer periods.  In some good news, KPMG has updated its M&A study five more times since its 1999 study and reports that there has been some improvement between 1999 and 2011. While only 31% of deals made in the last study (looking at 2007-2009 deals) were value adding, that is an improvement over the 17% from the 1999 study:

While this study can be faulted for its short time horizon (it looked at only the year after the merger for improvement), the consensus across many academic studies is that acquiring companies' shares under perform their peer group over long periods (extending 3-5 years).

Post-deal operating performance: The evidence is mixed on measures of operating performance. While there are some studies that find improvements in operating margins after acquisitions, these gains seem to be exist for a subset of acquisitions (hostile seem to do better than friendly) or only for sub periods. McKinsey has looked at mergers over three decades, asking two simple questions of acquirers: (a) Does the acquisition generate a return on capital that exceeds the cost of capital for the deal? and (b) Does the acquisition lead the acquirer to become more profitable than the peer group? In its studies that have spanned three decades, McKinsey found that most acquirers fail at least one of the two tests and that many fail both. 

In summary, if the sales pitch for an acquisition is that it will help boost the acquirer's stock price and improve profitability, relative to the peer group, there is no evidence that either happens, at least on the typical acquisition.

Growing through acquisitions
For better or worse, some companies choose to grow primarily through acquisitions and it is true that some succeed. For instance, Cisco transformed itself from a small technology company to the largest market cap firm in the world (very briefly in 1999) by acquiring dozens of other companies.

Firms are often attracted to an acquisition-based growth strategy, because it seems to offer a speedier pathway to success, but acquisitions are not the only option for growth. A company can develop new products, take existing products in new markets or try to capture a higher market share of an existing market. The question then becomes not whether a company should grow, but the most efficient way to seek out that growth. Drawing again on a McKinsey study of different growth strategies in the consumer goods industry over several decades, we see a disturbing picture:

The payoff to investing in growth is greatest for new-product development, where a million invested in the strategy generates additional value of $1.75 million to $ 2 million, and generates the most bang for the buck (with share prices doubling with relatively small revenue growth of 5-6% from the new products). The payoff to growth investing gets steadily worse across the next four strategies and is worst with acquisitions, where a million investing in acquisitions generates between -.5 million to $.2 million in additional value.

There are shades of nuance that are missed in this aggregate picture. As I will note in a later post, there are subsets of acquisition strategies that do better; buying smaller rather than larger companies, private as opposed to public companies and strength-focused rather than me-too acquisitions. Notwithstanding these pockets of success, it remains true that it is difficult to create value with an acquisition-based growth strategy and it becomes even more so as the company gets larger. In fact, Cisco is a good example of the diminishing returns to acquisition-based growth, as the same strategy that worked to great effect in the 1990s worked against the company between 2001 and 2010.

And the disease is spreading
The scariest aspect of the acquisition disease (which destroys value) is that it is now spreading to emerging markets. Emerging market companies, which used to be targets for richer developed market companies, are now in a position to be acquirers and some of them are targeting developed market icons. Looking at the prices they pay, and the practices they adopt, it is also clear that emerging market companies are making the same mistakes that their developed market predecessors did. A study of the stock price behavior in the days before and after the announcement of 114 acquisitions of US companies by Indian companies  illustrates the problem:

Indian acquirers: Months before & after acquisitions

While the initial reaction to acquisition announcements is positive, market disillusionment with the acquisition sets in quickly and the cumulative returns deplete over time, turning negative as you get to 20 days after the announcement.

Why do companies persist?
Given this history of value destruction, you would think that companies would become more measured in pursuing acquisition-based strategies. That, unfortunately, does not seem to be the case. Not only do we continue to see big, bad deals, but we often see the same company repeatedly making bad deals and the same mistakes repeated over and over by other companies. Not only is there no learning built into the process, but this repeated losing behavior would suggest that there is some collective irrationality at play (a euphemism for insanity) or that the acquisition process is flawed, and in the posts that follow, I will take a closer look at both possibilities. I will begin by by putting the objectives and incentives of the key players in the acquisition process under a microscope, starting with the top managers in both the acquiring and target companies, following up with the "advisors" (investment banks, commercial banks and consultants) on these deals, and ending with the accountants whose job it is to provide information on the deals. I will then look at the mechanics of the process, first focusing on common errors that I see in acquisition valuations and then looking at how best to value "control" and "synergy". I will close with a post on how to improve the odds of success with an acquisition-based growth strategy, drawing on lessons from history.

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

HP's Deal from Hell: The mark-it-up and write-it-down two-step

I don't think that there can be any disagreement that Hewlett Packard (HP) had a terrible day on November 20. In a surprise announcement, the company announced that it was taking a write off of $8.8 billion of the $11.1 billion that it paid to acquire Autonomy, a UK based technology company, in October 2011, and that a large portion of this write off ($ 5 billion) could be attributed to accounting improprieties at Autonomy. Even by the standards of acquisition mistakes, which tend to be costly to acquiring company stockholders, this one stood out on three dimensions:

1. It was disproportionately large: While there have been larger write offs of acquisition mistakes , this one stands out because it amounts to approximately 80% of the original price paid. 
2. The preponderance of the write off was attributed to accounting manipulation: Most acquisition write offs are attributed either to over optimistic forecasts at the time (the investment banker made us do it..) of the merger or changes in operations/markets after the acquisition (it was not our fault). HP's claim is that the bulk of the write off ($5 billion of the 8.8 billion) was due to accounting improprieties (a polite word for fraud) at Autonomy.
3. The market was surprised: Most acquisition write offs, which take the form of impairments of goodwill, are non-news because they lag the market and have no cash flow effects. In other words, by the time accountants get around to admitting a mistake from an acquisition, markets have already admitted the mistake and moved on. In HP's case, the market was surprised and HP's stock price dropped about $ 3 billion (12%) on the announcement. Put differently, the market had priced in an acquisition mistake of $5.8 billion into the value already and was surprised by the difference.

The blame game
I am sure that this case will be examined and reexamined over time in books like this one, but at this moment, every one involved in the merger is blaming someone else for the fiasco. So, here is a roundup of the suspects:

• Meg Whitman, the current CEO of HP, blamed the prior top management at the company, and said that "(t)he two people that should have been held responsible are gone ".
• Leo Apotheker, the prior CEO who orchestrated the acquisition, claimed to be shocked at the "accounting improprieties" at Autonomy. 
• Michael Lynch, the founder of Autonomy, said that two major auditors had performed "due diligence" on the financial statements and had found no improprieties at the company. 
• Deloitte LLP, the auditor for Autonomy, denied all knowledge of accounting misrepresentations and claimed to be cooperating with authorities. 
• The advisers on the deal (Perella Weinberg & Barclay's Capital for HP, Quatalyst, UBS, Goldman Sachs, Chase & BofA for Autonomy) have all been mysteriously silent, though none have offered a refund of their advisory fees. 

So, who is telling the truth here and who is to blame? Perhaps, the only way to answer this question is to go back to the original deal, which occurred just over a year ago.

Building up to an acquisition price: The original deal
Before we look at the numbers, it is worth reviewing the history of the two companies involved. Autonomy was a company founded at the start of the technology boom in 1996, which soared and crashed with that boom and then reinvented itself as a business/enterprise technology company that grew through acquisitions between 2001 and 2010. Hewlett Packard, with a long and glorious history as a pioneer in computers/technology, had fallen on lean times as it's PC business became less competitive/profitable and due to top management missteps.

On August 18, 2011, HP's then CEO, Leo Apotheker (who had worked at SAP) announced his intent to get out of the PC business and expand the enterprise technology business by buying Autonomy. While the deal making began on his watch, the actual deal was officially completed on October 3, 2011, with Meg Whitman as CEO. If she was a reluctant participant in the deal, it was not obvious in the statement she released at the time where she said that "(t)he exploding growth of unstructured and structured data and unlocking its value is the single largest opportunity for consumers, businesses and governments. Autonomy significantly increases our capabilities to manage and extract meaning from that data to drive insight, foresight and better decision making."

One of the perils of assessing "big" merger deals is that the fog of deal making, composed of hyperbole, buzzwords and general uncertainty, obscures the facts. So, let me stick with the  facts that were available at the time the deal was done (a time period that stretched from August 18, 2011, to October 3, 2011):

1. Acquisition Price: While there have been varying numbers reported about what HP paid for Autonomy, partly reflecting when the story was written (between August & November) and partly because of exchange rate movements (HP paid £25.50/share), the actual cost of the deal was $11.1 billion. 
2. Market Price prior: Autonomy's market cap a few days prior to the deal being announced was approximately $5.9 billion.
3. Pre-deal accounting book value: The book value of Autonomy's equity, prior to the deal, was estimated to be $2.1 billion. (Source: Autonomy's balance sheet from its annual report for 2010)
4. Post-deal accounting book value: After acquisitions, accountants are given a limited mission of reappraising the value of existing assets and this appraisal led to an adjusted book value of $ 4.6 billion for Autonomy. (Source: HP's 2011 annual report, page 99)

The advantage of working with these numbers is that differences between them are revealing. In the figure below, I attempted to deconstruct  the $11.1 billion paid by HP into its constituent parts:

You can see the build up to the price paid by HP as a series of premiums:

1. The accounting "write up" premium for book value: One of the residual effects of the changes that have been made to acquisition accounting is that accountants are allowed to reassess the value of a target company's existing assets to reflect their "fair" value. For technology companies such as Autonomy, this becomes an exercise in putting values to technology patents and other intangible assets and that exercise added $2,533 million to the original book value of equity.
2. The pre-deal "market" premium over book value ($1.3 billion over post-deal book value): Even if accountants write up the value of assets in place to fair value, markets may still attach a premium for growth potential and future investments. As with any market number, this number can be wrong, too high for some companies and too low for others. Prior to the HP deal, the market was attaching a value of $6.2 billion to Autonomy, $3,833 million higher than the original book value of equity and $1.3 billion more than the post-deal accounting book value of equity. 
3. The acquisition premium ($5.2 billion): To justify this premium, HP would have to had to believe that one or more of the following held:  (i) the market was undervaluing Autonomy, i.e., that the true value of Autonomy was much higher than the $ 5.9 billion, (ii) there are synergies between HP and Autonomy that have value, i.e., that there are value-enhancing actions that the combined firm (HP+Autonomy) can take that could not have been taken by the firms independently and/or (iii) that Autonomy was badly run and that changing the way it was run could make it more valuable, i.e., there is a control premium. Even without the benefit of hindsight, neither undervaluation nor the control premium seemed to fit as motives in this acquisition. First, Autonomy was being priced by the market richly in August 2011; the market cap of $ 5.9 billion was roughly 6 times revenues and 15 times earnings and neither number looked like a bargain. Second, for a company that had been as badly run as HP to be talking about inefficiencies at other companies (and control premiums) strikes me as absurd.

The reaction to the deal was negative, a the time that it was done. The analysts and experts were generally down on the deal, but more importantly, the markets voted against the deal by pushing down HP's stock price. Between August 18, 2011 (the date the deal was announced) and October 3, 2011 (when the deal was consummated), HP's market cap plummeted by $15 billion from $58.5 to $43.5 billion. It would be unfair to attribute this meltdown to the Autonomy deal alone, since HP was announcing spectacular failures on so many different fronts, but it would be fair to say that markets did not share HP's hopeful assessments of synergy in this deal.

The cost of accounting impropriety & breaking down blame
Let's fast forward to today. In the conference call on November 18, the CFO of HP attributed the write off of $8.8 billion to two primary sources: $5 billion to accounting improprieties at Autonomy and $3.8 billion to a drop in HP's stock price. The latter rationale does not really hold up since it mistakes cause and effect; the stock price went down because of HP's misstep (though it has made so many that I am not sure which one) and is not the cause of the write off. Thus, it makes sense to attribute the entire write off to the deal. Applying HP's write off of $8.8 billion to the acquisition price of $11.1 billion, brings Autonomy's estimated value (according to HP) back down to $2.3 billion (almost equal to the pre-deal book value of $2.1 billion). In effect, HP is arguing that almost all of the premiums in the original deal (the accounting write up, the pre-deal market premium, the acquisition premium) were not justified.

So, what form did these accounting improprieties take? Based on news reports, HP's contention is that Autonomy was "overstating" and "mis-categorizing" revenues (they were allegedly booking low margin hardware sales as higher margin service/software sales). Assume for the moment that HP is right, and that Autonomy's revenues in 2010 were overstated by 15% and that its true operating margin was the industry average of 31% (and not the 36% that Autonomy was reporting in 2010). Since the accounting misstatements predated the HP acquisition, the pre-deal market value of $5.9 billion should already have been inflated because of the misstatements. Using the pre-deal market value of $5.9 billion as a base, I extracted an expected revenue growth rate of 14.25%. I then substituted in the lower revenues (15% drop) and lower margin (31%) into the valuation and estimated a value for the equity of $4.2 billion. Put differently,  if you buy into HP's story fully, the value effect of the accounting misstatement was $1.7 billion (the difference between the pre-deal market value and the adjusted value)  on the pre-deal value.

HP's argument would be that the synergy premium of $5.2 billion that they paid was also overstated because of the accounting improprieties. Since we do not have access to the detailed synergy estimates (assuming that they were made), we assumed that the accounting overstatement would comprise the same percent of the synergy value it was of the pre-deal market value ($1.7 billion is 28.81% of $5.9 billion) and that half of this value is Autonomy's share (since synergy accrues to the combined firm):
Estimated accounting impropriety portion of synergy value =0.5( 28.81% of $5,200) = $749 million
I know that this may not be fair and that I am going with incomplete information, but here is my breakdown of blame for the $ 8.8 billion write down:

As I see it, everyone involved in this process owns part of this disaster. Leo Apotheker, the CEO who pushed this deal through, gets the lion's share with $4,451 million, though the investment bankers who advised him were his enablers in the process. To the extent that HP is right in its contention that Autonomy cooked the books (inflating revenues and margins), Autonomy's founder/ managers and its auditor (Deloitte) are responsible for $2,449 million in value destruction. That leaves us still with an additional $1,900 million in write offs, which I can attribute to either a deterioration of Autonomy's business in the eleven months since HP took it over (a form of reverse synergy) or game playing on the part of HP, where taking bigger losses now will allow them to claim improvements and look better in the future. In either case, I would hold HP's current management responsible for that portion ($1,900 million) damage. As HP stockholders, though, don't expect any of these parties to offer to cover their fair share.

This deal offers important lessons about headstrong CEOs, the ineffectual accounting for acquisitions and the flaws in the acquisition process that allow bad deals like this one to get through, but this post has become too long to expand on these issues. So, more in my next few posts....


The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

Acquisition Alchemy: Creating value from deals

Much ado about liquidity? Lockup expirations and stock prices

Last week shaped up as a big one for Facebook. On Wednesday (November 14), the company faced the steepest of its lockup expiration cliffs so far, with 777 million shares released for sale by insiders. Its two earlier lockup expirations, of 271 million shares on August 16 and 234 million shares on October 29, did cause stock price pullbacks of about 5% and 3% respectively. Consequently, there was concern that Facebook’s stock price would take a beating on November 14, but the stock price climbed 12.6% on that day.

There are a host on intriguing questions that derive from lockups, their expiration and the market reaction to them, and I think it is worth taking a look at them.

The mechanics of and rationale for a 'lockup"
            Facebook is not unique. Most initial public offerings (IPOs) have lockup agreements that prevent insiders (which include owners/founders and VC investors) from selling their shares for a period after the offering. These lockups are not mandated by regulatory authorities but are contractual agreements between issuers and underwriters, with the terms disclosed in the IPO prospectus. While the most common lockup period for IPOs in the US is 180 days, there are quite a few firms that stagger their lockup dates (as Facebook did).  So, why do we see lockup periods in initial public offering? There are at least three reasons for the practice.

1. Skin in the game:  There are many risks that investors face when investing in newly public companies, but one is that the investors and founders of the company will cash out and leave behind a vacuum. Lockup periods ensure that the venture capitalists and owners of a business have skin in the game at least for a limited period after a stock goes public.
2. Signal of company quality: As a related point, having a lockup period makes the offering price more credible for outside investors, since insiders have to wait to sell their shares (rather than dump them at the offering price). A study of British IPOs found that longer lockup periods are associated with better performing IPOs (both in terms of profitability and stock price performance). In fact, it is worth remembering that Facebook, in its pre-offering hubris cut the lockup period to three months for some holders just before the offering date.
3. Stage management of offering: Having a lockup period for insiders also ensures that only a small fraction of the outstanding shares  hit the market on the offering date. This, in turn, enables investment bankers to "discount the price" at the offering and allows them to use the initial offering more as a marketing event leading up to the main event (which is the sale of shares when the lockup period expires). As this study notes, there is evidence that investment bankers and insiders both have an interest in underpricing the offering shares to create price momentum, which can then be ridden (hopefully) to the end of the lockup period. 

Lockup expirations: The insiders' choice to sell (or not)
When a lockup expires, insiders get the right to sell their shares, though they can choose not to sell. While there may be other motives at play, there are three reasons why insiders may sell at the end of the lockup period:

1. Need for cash: Some insiders, while wealthy in terms of the market value of their holdings, a can still be cash poor if the bulk of their wealth is tied up in the shares of the company. If they need the cash (to either fund conspicuous consumption or to pay taxes), they may have to liquidate at least some of their holdings.
2. Diversification : In a related point, the founders and even some of the venture capitalists in a company that has just gone public may find that they have too much of their wealth tied up on that company. Having weighed the desire for control of having a concentrated position against the peace of mind that comes from diversification, some of them may choose to cash out on at least a portion of their holdings and invest that cash elsewhere.
3. Information: Perhaps the trickiest part of the equation is that insiders do have access to information that the rest of the market does not about how a company's operations are performing. If they feel that the market price is too high (relative to their judgment of value), they will be inclined to sell their holdings.

The rest of us get to observe the actions (whether insiders sell at the end of the lockup period and how much they sell) but not the motives. Not surprisingly, we still try to find signals in the actions and react to how much insider selling there is, relative to our expectations.

Lockup expirations: The evidence and analysis
Lockup periods are therefore par for the course in initial public offerings and insiders have multiple motives for selling when lockup periods end. So, what typically happens when lockup periods end? To understand the market reaction when lockup periods expire, let's look at the effects, both positive and negative, of these events:

1. Liquidity effect: In the short term, the end of the lockup period releases shares for sale into the market, creating a demand/supply story that goes as follows: the end of the lockup releases news shares into supply, and holding the demand for these shares constant, this should reduce price. In the longer term, the release of the “locked up” shares to the market increases the shares that are available for trading (the float) and may should improve liquidity. 
2. Information effect: When insiders exercise their right to sell their shares, they are also conveying their views on what they think about the market price. As we noted in the last section, you are more likely to see heavy insider selling, if insiders view the stock to be over valued and less if it is under valued. In particular, markets form expectations about how much insider selling you should observe and if there is less (more) insider selling than anticipated, it is viewed as good (bad) news. 
3. Backstop effect: While investment banks may be under no legal obligation to provide support services beyond the immediate IPO, there is evidence that issuing banks continue to provide at least partial support for an offering until the lockup date. That support can range from buying shares, if the stock price goes into free fall, to favorable recommendations from the issuing banks’ equity research analysts. The removal of the investment banking support system may have negative consequences for stocks. 

Looking at the trade off, the net effect should vary then across companies. You would expect the most negative price impact from lockups ending at small lightly-traded firms (where the near term trading imbalance can overwhelm the long term liquidity benefits), where there are few institutional investors or analysts tracking the firm (making insider trading that much more informative) and where issuing banks have been active in providing support (ensuring that the removal of the backstop will have more consequences.  The effect should be more muted with larger firms that are already actively traded by institutions and tracked by analysts. Since these firms are already heavily traded, the liquidity impact is likely to be smaller, the institutional and analyst following should reduce the information impact of insider trading and the size of these firms will make it impractical for investment bankers to provide more than surface level backstop support.

The studies that have looked at this phenomenon seem to reach consensus on two broad conclusions::
1. The price impact is negative: When lockups expire, stock prices drop. The drop is statistically significant (between 2 and 5%) and there is no rebound from this price drop.  In case you are tempted to try to take advantage of this price drop by selling short prior to lockup expirations, it is too small (relative to transactions costs) and too unpredictable (about a third of lockups end with increases in stock prices) to build a profitable investment strategy around.
2. The trading volume surges: Trading volume increases  on the expiration of lockup periods, with volume increasing substantially both at the time of the expiration and the periods after.  One study finds that the price impact on the lockup expiration is related to the change in liquidity in the post-lockup period, with more positive (negative) stock price reactions correlating with increases (decreases) in liquidity.


Looking at Facebook
Based on the last section, I would argue that analysts who have used the lockup expirations as a rationale for Facebook's stock price performance since its IPO  have been reaching for straws. Facebook is a large market cap firm (market cap > $50 billion), with substantial trading volume and a heavy analyst following. It is not the type of company where you would have expected to see dramatic up or down moves on lockup expirations.

That is not to say that lockup expirations are non-events, since even at Facebook, there have been sizable price reactions to the first three lockup expirations - negative (-5%) for the first one, slightly less negative on the second one (-3%) and positive (13%) for the third.  Rather than search for elaborate rationale for the different market reactions, I would point to price momentum around each of the expirations. The first lockup period expired in the immediate aftermath of a bad earnings report in August, with the stock price already sliding, and the market reaction was negative. The second lockup period expired after the stock had spiked on the third quarter earnings report but was retracing its steps in the days after. The lockup period that expired last week (on November 14) was after the second earnings report, which was viewed as good news, and when the stock had upward momentum. Looking at this small sample, it seems to me that at least in Facebook, insiders have behaved like other momentum investors, selling when everyone is selling and holding if the prevailing sentiment is positive.  If there is a broader lesson to be learned from these experiences, it is that we attribute too much wisdom and knowledge to insiders, at least at young growth companies.  Rather than being ahead of the market in their assessments of value, insiders at these companies are often just as uncertain as the rest of the market and just as likely to follow the crowd. As a stockholder in Facebook now (my limit order did come through), I am less inclined to pay attention to what Zuckerberg thinks or does about the company and more to the fundamentals that will drive its value over time.

Storms and Stocks: Dealing with Disruptive Shocks

Sandy, the super-storm that terrorized New York and its environs is now history, but it left a trail of destruction. As communities around the city and New Jersey dealt with power failures, gas shortage and transportation chaos, I was thinking about the lessons that I learned from the experience and their application to financial markets, which have been buffeted with their own storms for the last five years.

1. Once is an accident, twice is bad luck, but three times is a pattern: For much of the time that I have lived in the United States, power failures were not only unusual but when they did occur, lasted at most for a few hours. However, in 2011, we lost power for several days twice, once after Hurricane Irene and once after a freak ice storm, and this year, we lost power again for a week. While it is entirely possible to attribute these occurrences to chance, it is also possible that weather systems have changed and that the last two years may be more the rule than the exception going forward. The last five years in financial markets have been characterized by “unusual” macro events (banking crisis, Greece, Spain etc.) but they are unusual only because we are viewing them through the lens of recent history (the prior six decades in developed markets). As with the weather, it is possible (and I think it is likely) that these macro crises are not an aberration but are part and parcel of markets for the foreseeable future, and that investment strategies and risk management systems have to be adapted accordingly.  
2. History provides little guidance: When there is a disruptive shock (and the storm definitely qualified), it is human nature to use past history to fill in the gaps, even if it does not quite fit. Thus, my neighbors argued that since train service was up and running a couple of days after the storm last year or the terrorist attacks in 9/11, it was likely to be back up after this one too. In financial markets, investors have used the crutch of historical data (equity risk premiums from the past, PE ratios over time) to evaluate when and where to invest these last five years. In both cases, extrapolating the past would have yielded poor predictions. 
3. Misinformation fills the news vacuum: In the immediate aftermath of the storm, there was an information vacuum where the power and transportation companies had no useful guidance to customers and rumors filled in the gap. With each macro crisis over the last few years, we have seen the same phenomenon in markets, where rumors of deals made and unmade have moved markets substantially. 
4. It is good to have back up systems: About 15 months ago, none of the houses in my neighborhood had back-up generators, as the cost of installing one seemed to be well in excess of any potential benefits. After this storm, I would not be surprised to hear generators starting up at a third of the houses the next time we lose power. The problem, though, is that these generators are themselves dependent upon fuel (natural gas or gasoline) to work and may end up being idle in their absence. Risk managers (at companies and financial service firms) have devised their own back up systems to protect themselves against the “last” crisis but these systems may themselves break down, in the face of the next crisis. 
5. But it is better to design resilient systems: One reason that this portion of the East Coast was hit so hard by the storm was that it was never designed to withstand it. In particular, large power-dependent houses with finished basements, power stations that are close to the ocean or rivers and overhead power lines are all rich targets for storms like Sandy. If these storms are the new norm, we have to think about building houses that are livable without power (those older houses have lower ceilings, unfinished basements and fireplaces for a reason) and a more defensible power system. In investing we have to think about a similar redesign of how we invest, with dynamic asset allocation (reflecting the constant shifts in the macro environment) and a stock selection process that is less dependent upon rules of thumb (many of which were constructed for a past that no longer applies). 

More generally, in the face of the increasing frequency of disruptive shocks, I would pick:

(a)Simpler over more complex systems: Over the last few decades, lulled by the growth of technology and access to data, we have built more and more complex systems (in both day-to-day living and investing) that are dependent upon both. Since disruptive shocks cut off both technology and data, simpler systems will survive and bounce back faster in the face of these shocks. I am glad that my investing strategy is based on intrinsic valuation and that I can value a company with an annual report and a calculator (or even an abacus) and that I am not dependent on access to real time data or computerized trading for investments. I am even happier that I could go two weeks without tracking either the market or looking at the investments in my portfolio, without fear of a meltdown. 

(b) Decentralized over centralized systems: The “hub and spoke” system, where you centralize resources does have its advantages, primarily related to efficiency, at least in normal times. The problem with these systems is that failures at the system’s center can shut the entire system down, as passengers on United and Delta discovered, when their hubs (Newark for United and LaGuardia for Delta) shut down during the storm. Decentralizing these systems may create more coordination headaches during normal time periods but allow for faster recovery after disruption.

I am glad that the storm has passed, that I have power and that I am able to type this post on my train ride home from work. At the same time, I realize that as an investor, there are more storms coming, both from within (the fiscal cliff) and from outside (Asia’s slowdown and the EU’s future) and that I need to become more agile to weather these storms. Time to get to work….