Acquisitions and the destruction of value
Over the past month we’ve had a lot of new information from the AGM season. Companies typically update the market on current trading – a defacto Q2 earnings report if you will. The standout worst sub-sector in the small cap arena has been mining services. With one exception, Monadelphous, every other mining services company commenting at their AGM has materially downgraded their FY13 earnings expectations. When I say “materially” I mean typically a 20-40% earnings downgrade. Tough markets sort the wheat from the chaff. Followers of our commentary will recall that we have made mention of the over inflated expectations in the mining services sector before. At the end of the first calendar quarter this year, mining services were considered a “safe” way to play resources and had relative earnings certainty. Now, with the ‘about face’ on capital spending and a focus on efficiency within resource companies, this view has come to an abrupt end.
Some fairly typical analysis of mining services names assumed that a few years of strong earnings growth would suddenly become a trend and many projections of future earnings were made accordingly. These stocks are however a second derivative, or more leveraged play, on the resources sector. As fundamentals turn down in resources, the major mining companies return their focus to productivity, cost control and away from getting volumes out at any cost. Predictably, the lower quality drillers and mining equipment rental companies have been hit early and hard. Most management teams have unfortunately been following the ‘follow the trend’ research and have generally geared balance sheets into the downturn. The last time I checked, the only way to really differentiate your business performance in a commoditised industry was to think against the trend. On a recent tour through Perth we asked a number of management teams why they didn’t learn to structure their remuneration in such a way as to encourage counter cyclical thinking amongst their management teams. For instance, a bonus structure based on a rolling three year average returns on invested capital ought to start encouraging rational thinking. The question was greeted with an uncomfortable silence.
Whilst the stock market has a degree of volatility to it and earnings are not always predicable, it has in aggregate proved to be a good investment over time. Equity fund managers however have done an excellent job over the past 3-4 years terrifying their very investors out of equities and into bonds. Clever bond and money market funds have done the reverse – encouraging money into their open arms by offering the safety of fixed income. It’s tempting to believe your money is safe there, away from the volatility of the share market and earning a low but at least positive yield. “Yield”, “Safety”, “Dividend” have become almost interchangeable terms. Perversely, volatility in the stock market is at relatively low levels and dividend yields are reasonably attractive, suggesting that a reasonable equity portfolio at current market levels may well outperform fixed income. The reason we are harping on about this is that we see some serious and risky distortions taking place within capital allocation at the moment. Bond yields are only low because central bankers need them to be and this has resulted in the hunt for yield resonating loudly in the minds of some investors, such that many are chasing this at all costs. And at all costs it might just be. Recently, for instance, private equity owned MYOB (the accounting software firm) launched a “subordinated notes” offering. It sounds pretty harmless, but it means that you are pretty much “subordinated” to everyone else who has a claim over the company’s assets. Both the private equity owners and the underlying funding banks are using the proceeds from this issue to reduce their exposure to MYOB. There is nothing inherently wrong with MYOB, it’s a good firm with a good product, however the business is highly levered and its cashflow and interest coverage levels are at very low levels.
Sometimes the best thing a management team can do is sit on their hands, run their businesses efficiently, producing cashflow and returning it effectively to investors. There was another significant and surprising profit warning during November from the serial acquirer, Cardno. Cardno is a civil, structural and environmental engineering firm which has made 18 acquisitions over the past 5 years, that’s almost one per quarter and at a cost of $367 million dollars of shareholders’ funds. We are generally quite sceptical of companies who make many acquisitions but especially so when those acquisitions are bolted on for their earnings without proper integration. Intangible, but important, things like culture, camaraderie, incentives and alignment are hard to create and maintain in the best of companies let alone those that are bought up by a company that doesn’t even seek to integrate them into its way of doing business. Our suspicions were confirmed when Cardno released its first profit warning over November flagging lower margins in spite of an apparently healthy top line.
We are not always against acquisitions, but they need to make sense in the context of the business and be integrated into the acquiring business. There are many reasons to be cautious. These reasons include the information asymmetry that exists between the buyer and seller of the asset. This is the same situation arising during an IPO process and one of the reasons seasoned investors virtually eschew floatations. The incentive for the seller to over promise in order to maximise a sale price; in most cases the vendors have completely or largely cashed out to the acquirer and any failed promises are hard to redress. There is the possibility of cultural conflict, a bit like hiring an employee, some people and companies “interview” well. Lastly, there are some very clever, compelling and incentivised people trying to get deals done who work for intermediary banks. They are paid on a deal being done not on the quality of the deal (all care and no responsibility).
An extreme example of a large acquisition that has gone wrong occurred internationally during the month. I am talking of Hewlett-Packard’s (HP) massive write down in connection with Autonomy acquired just twelve months ago. HP paid US$10.3bn for Autonomy Software in November 2011. In late November 2012 they announced a write off of US$8.8bn, 85% of the purchase price and the ensuing open letter mud slinging match is the stuff corporate legends are made of. HP made a press release with the following on the 27th of November 2012:
“…The matter is in the hands of the authorities, including the UK Serious Fraud Office, the US Securities and Exchange Commission's Enforcement Division and the US Department of Justice, and we will defer to them as to how they wish to engage with Dr. Lynch (the former CEO of Autonomy). In addition, HP will take legal action against the parties involved at the appropriate time.
While Dr. Lynch is eager for a debate, we believe the legal process is the correct method in which to bring out the facts and take action on behalf of our shareholders. In that setting, we look forward to hearing Dr. Lynch and other former Autonomy employees answer questions under penalty of perjury…”
When a company makes this sort of announcement you know they’ve blown the dough. To put the write down in context US$8.8bn is one and a half years of after tax earnings – that’s a lot of blood, toil tears, and sweat from HP’s 350,000 employees to make up for a few of the mistakes at the top of the tree. Often doing nothing but running your business is best practice.
Amongst the background of the global macroeconomic din we aim to consistently apply our investment practice which is to seek out mispriced investment opportunities based on our assessment of sustainable earnings. In the small and micro cap arena it remains possible for strong businesses with good management to grow through tough times. As long as we see value in these opportunities we will add these opportunities to our portfolios. In addition, the corrections in mid cap Resources and other cyclical stocks may present good long term opportunities for patient investors.
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