Why financial sponsors will continue to sit on dry powder. Cash availability by itself doesn’t position financial sponsors (those focusing on non mid-market deals) strongly enough to put their capital to work. Lack of exit issues and higher equity contributions (“Tribune” transactions are passé) are among the key challenges to non-strategic buyouts.
CDO-backed deals (vs. those not backed by CDO structures) typically allowed LBOs to garner about 10% more contribution in transactions from banks, high yield bonds, and mezzanine debt. Such deals therefore had more wiggle room. Revolver drawdowns were frequently not required at outset, allowing sponsors more flexibility to re-raise. Loss of that appetite, coupled with requirement of higher equity cushions and already stretched existing investments, has effectively taken a lot of “free lunches” off the table. Financial sponsors are essentially being forced to increasingly restructure businesses without the luxury of wringing synergies through combining newly acquired businesses with over-burdened existing investments. Upside assumptions have been scaled back sharply. In anything other than very low-levered businesses, financial sponsors are much worse positioned against strategic buyers than they were in recent years – In 2009, strategic buyers accounted for almost 77% of middle-market deal activity vs. 69% in 2007. However, selective opportunities, particularly in the mid-market, will be actively pursued by financial sponsors. It is worth noting that a host of new players have recently entered the mid-market financing arena, with regional banks getting more active after CIT’s filing last year.
Here are a few businesses that may be in a position to get acquired without unduly stretching strategic buyers (see Exhibit 1). While there are quite a few ways to do this exercise, I am leaning towards businesses with strong cash positions in industries that have room to consolidate. Obviously, excess capacity can also turn out to be a significant distraction to consolidation if the industry happens to be over-fragmented – Why would you acquire capacity if you already have enough of it and new addition doesn’t benefit your pricing power ?. My current priority is to allocate an undisclosed % of capital to potential near-term targets. Some of these may not fit my usual idea of attractiveness but at this point I am comfortable with including potential targets that might otherwise not be on my radar, as long as their takeout proposition is compelling. Given the focus on “near-term” events, most of these positions will be liquidated if expected events take more than a year to occur, assuming nothing else changes. Since this strategy focuses on acquisition targets, the intention is to keep the focus limited to names with significant float and where trade isn’t crowded. I’ll summarize the following two situations – Forest Labs (NYSE: FRX; $29.48) and Versant Corp. (Nasdaq: VSNT; $15.12).
Exhibit 1 - Cash-rich potential targets
Sources: Company filings, Bloomberg
* QXM's shares o/s includes about 6 mil new shares (including restricted stock) issued post 3Q earnings, following exercise of some converts.
** includes short-term investments
FRX – trap of a kind. Usually, when I see too much pessimism, my eyes twinkle. That said, I am cognizant of the fact that in majority of cases valuations are reflective of something concerning. FRX is no different, except that it’s probably a bigger value trap than I normally see. At least there is something that makes it interesting. If cheap is all you ask for, blindfold yourself and start throwing darts on a board full of S&P 500 stocks. Odds are that you’ll hit something where current earnings power is significantly below what you saw a few years back. Some, such as FRX, are unlikely to regain that earnings power anytime soon.
I agree that FRX has a huge cash stash but the core business isn’t as cheap as it looks. The argument that shrinkage from patent expirations is “more than priced in” is bogus. For a business that will likely lose about 2/3rd of its existing sales between 2010E and 2015E, FRX is certainly not a valuation outlier (see Exhibit 2a and Exhibit 2b).
Exhibit 2a - Est. revenue loss from patent expirations
Exhibit 2b - Core PE vs. est. revenue loss
Source: Internal estimates, GPA, SEC filings, Bloomberg
Notes: Est. revenue loss was calculated as following - Price is expected to get cut in half, with unit share getting halved within 5 years of expirations; The statistically significant trend line in Exhibit 2b suggests one significant outlier – NVS; Core PE is adjusted for net cash position - Net cash is subtracted from market cap and after-tax interest income on this position is excluded from earnings.
Even if one builds in a 75% chance that each Phase III drug will launch at the expected time and ramps up to its expected goal even faster than expected (full achievement within 3 years vs. 5), their expected contribution in 2015E will still end up being no more than ½ of sales lost from Lexapro and Namenda going off-patent. Further, the whole idea revolving around cash being used to acquire new licenses, which in turn will offset revenue loss, isn’t very compelling either. Come to think of it, FRX’ current Phase III pipeline cost the company close to a billion dollars in just up-front payments (including $480 mil that the company paid for Cerexa, which came with Ceftaroline and two other early stage drugs, in 2006). Add in contingent payouts and you’ll come close to FRX’s current cash holdings. Also, the entire pipeline was acquired/licensed in Phase II or later, with launches expected 5-7 years after the deal. Even then, at its estimated prime, the current pipeline will likely not match Lexapro’s current contribution (Never mind Namenda). Effectively, FRX’ current cash is more of a “replacement” lever than a “growth” lever, if that. FRX in all likelihood will be a significantly smaller business by 2015E. For those that wish to look that far, it might be worthwhile looking at valuations on C2014E estimates, which suggest that FRX is the priciest drug name in town, not the cheapest. The fact that I estimate an incremental 30%+ loss in revenues in C2015E (from earlier patent expirations) doesn’t even need to be factored here. This is one of the biggest value traps I’ve seen in recent times.
VSNT – Potential mid-market buyout candidate. Object oriented technology can certainly not be categorized as a growth business. Given legacy issues with relational databases, ramp-up is very slow and sales cycles can easily extend beyond a year - A company like VSNT typically adds 1-2 clients a quarter, with billings starting way below that at existing clients. However, VSNT is truly a cash engine, averaging 30%+ FCF margins. Further, given the niche VSNT operates in, acquisition opportunities are few and far in between, further bloating an already bloated cash balance.
The next identifiable opportunity area for object databases is in MMOGs – VSNT’s object database has been used in developing a few MMOGs. Still, object databases haven’t been as successful as expected while competing with relational database usage within MMOGs. One shouldn’t get too excited about this opportunity yet.
While this is clearly a sitting takeover duck, the problem is integrating this business and its difficult to make a strong case about anyone truly interested in building a large ODBMS platform. The two leading vendors are Versant and Objectivity (privately held). Progress Software (Nasdaq: PRGS; $28.23) competes in this space through its Objectstore platform, which hasn’t been its focus area. Also, ObjectStore is likely no more than a mid-single digit contributor to PRGS’ sales, and PRGS is, in my view, more likely to entertain bids by a buyer than to expand its ODBMS capabilities by acquiring an Object Management business. I could be wrong on PRGS’ strategy, but it doesn’t hurt my eventual thesis here.
Interest from relational database vendors isn’t straightforward either – Incorporation of object oriented features in RDBMS, and high switching costs provide ample safety from direct competition and therefore put a dampener on traditional DB vendors aggressively pursuing ODBMS investments.
VSNT isn’t a type of business I’ll typically buy. There is, at best, an outside chance that a strategic buyer might step in. However, it’s significantly more attractive to a financial sponsor than to a strategic buyer. I’ll bet you that it isn’t every day that you find a business, where despite paying a 40% premium, contributing 60% in equity to the deal, and doing little to squeeze out material synergies, one ends up with IRR in the mid-20s (see Exhibit 3). With no street coverage, such candidates may be out of the radar for now but it’ll likely get attention if it stays here too long.
Exhibit 3 - Est. buyout summary for VSNT
Source: Internal estimates, Company filings, Bloomberg
On the radar – QXM, TSRA. I have certainly passed on QXM (too little float, deteriorating pricing power and limited transparency). TSRA remains on the radar but that trade is too crowded, for now.
Qiao Xing (NYSE QXM; $2.49) faces variety of challenges in its end market but market is effectively pricing the company where cash is being offered just to acquire it (underlying business comes for free). The typical problem with such situations is float, with deal largely dependent on a handful of holders and many of these guys often under-estimate the severity of challenges and won’t sell unless they absolutely have to. The biggest issue at QXM, just as with many other Chinese handset makers, is cut-throat price competition and continued pressure from “fakes”. “Fakes” (also known as Shanzhai) possibly account for more than a fifth of all phones assembled in China, and may be one out of every three sold in the domestic market. Given immense fragmentation, continued cuts by larger vendors, and struggling end demand, handset component providers have also been unwilling participants in the ongoing price competition for handsets in China, which will likely continue in the foreseeable future. But that aside, QXM’s performance has been abysmal – In the two years ending 3Q09, shipments dropped by almost two-thirds. Over the same period, Chinese domestic handsets market grew by more than 20%. Thanks to a new launch of VEVA phones in 2H08 (sounds disturbingly similar to VIVA, which is an HTC brand), QXM was able to temporarily stabilize its ASP. Then came VAVE (Shanzhai’s answer to VEVA) and QXM’s strategy got derailed again. Since 2H08, management had been stressing its strategy to focus on the “high-end” VEVA phones. With VEVA shipments coming under pressure recently, QXM was forced back into launching lower-priced versions. That however, didn’t help in stemming a continued drop in shipments, which sequentially declined 40% in 3Q09.
Attractive handset businesses sell into markets that protect them from illegal competition, and have the culture and know-how of constantly re-inventing themselves. QXM has neither. QXM’s only true attractiveness is from the viewpoint of someone acquiring facilities and using them to export shipments, effectively yielding the CECT brand redundant. Trying to compete in the domestic Chinese market is an exercise in futility – Market is unwilling to pay a premium for differentiated technology (assuming that wireless infrastructure can support it). Further, return on innovation is paltry as handsets are quickly dismantled and fakes quickly eat away at price and unit share. Regulatory intermediation is therefore required to make it attractive to sell into the domestic market. Whether bold decisions that will hurt a $5 bil+ industry will actually be taken is another debate.
This isn’t the first time that an Asian handset business is effectively being given away. Blow-ups such as BenQ’s acquisition of Siemens’ handsets business or TCL’s acquisition of Alcatel’s are prime examples of such situations. Further, two of the chief reasons behind devices’ acquisitions are technology and brand. It’s hard to argue that QXM fits either way. One way to think of QXM’s situation is as following – If price drag continues at current rate for another year, investors’ implied premium on offer* (assuming an acquirer coughs up 40% premium to buy QXM) can be eaten away within 2 years of owning this business, assuming no incremental deterioration in pricing after the first year of ownership. While QXM is certainly cheap (any upside comes for free), a potential acquirer will have its work cut out for it. Admittedly, this one can go either way. It looks cheaper than what it may look like after a year of ownership by a potential buyer. I am not comfortable in such symmetric situations.
*Cash that the market will pay the acquirer to acquire.
Disclosure – Author has a long position in VSNT.
DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.
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