Monthly Archives: July 2012

Red flags for investments: “Transformational” acquisitions – Example Walgreen

Walgreen is one of the few large US stocks which looks good on my “Boss” Screen, with a consistently high ROE and low volatility. So I put it on my “priority” research to do list.

However,last week I dropped them from the list because of this.

Pessina had already hinted that his preferred exit would be via another merger rather than a fresh stock exchange listing: “If you do an IPO, you create financial value,” he said. “If you do a transformational deal, you create financial value and industrial value.”

Firstly, it is interesting that the seller makes this quote. Clearly, for him it was transformational as he transforms himself financially into a billionaire.

Secondly, if we look at some big “transformational deals in the past, we see that many of them fail.Some well known examples:

Daimler Chrysler
AOL Time Warner
RBS ABN Amro (Fortis, Santander, my all time favourite. everyone involved got screwed in the end))
Allianz Dresdner
Travelers Citicorp
Kraft cadbury
Vodafone Mannesmann

The list is endless. I actually don’t remember large “transformational” deals which actually worked well.

This aspect has not been unnoticed. A famous study by Bain showed that around 70% of large mergers fail:

Bain & Company M&A team leaders David Harding and Sam Rovit challenge the most common deal presumptions in Mastering the Merger: Four Critical Decisions That Make or Break the Deal (Harvard Business School Press, November, 2004) and found that while 70% of large deals fail to create meaningful shareholder value, 80% of the Fortune 100 companies have relied on mergers and acquisitions to fuel their growth over the past two decades.

The reasons are stunningly simple:

Bain examined over 50 case studies, analyzed 15 years of M&A data and surveyed 250 CEOs and senior executives about real-world successes and failures. They found that the top three reasons deals derailed were:

1. Ignored potential integration challenges (67%)

2. Over-estimated synergies (66%)

3. Had problems integrating management teams and/or retaining key managers (61%)

If we look at this article, Walgreen seem to rely heavily on point 2:

The deal will lead to cost and revenue benefits across both companies of $100 million to $150 million in the first year and $1 billion by the end of 2016, according to the statement.

Back to the Bain study. They identified a few critical success factors:

— Frequent acquirers outperform the pack – the more deals a company made, the more value it delivered to shareholders; the “frequent acquirers” outperformed the “never-evers” by a factor of two

— Frequent acquirers buy in good times and bad – frequent acquirers that bought constantly through both tough economic environments and boom times outperformed those that bought primarily in growth periods by a factor of 2.3; they also outperformed the “recession buyers” by a factor of 1.4

— Most successful dealmakers start small then ramp up – firms that focused on small deals on average outperformed those that made big bets by a factor of almost 6

In my opnion, Walgreen is unfortunately a very infrequent acquirer, to my knowledge it is the first acquisition outside the US and they only made one other acquisition in the US in the past few years. It rather looks like a desperate move to counter shrinking business in the US, which is never a good motivation to do a deal.

So despite the low valuation of Walgreen, this acquisition is definitely a “red flag” for any investor, as the chance for a positive outcome seems to be very low. However it looks like a great deal for KKR and Mr. Pessina. If you think about this, KKR and Pessina bought at boom prices in 2007 and seem to at least double their money after 5 years.

An additional remark on international expansion from retailers:Two of the best retailing companies of the world, Walmart and Tesco found out the hard way how difficult it is to transform local cometitive advantages into international markets. Walmart for instance failed in Germany, Tesco is still struggling in the US. As Bruce Greenwald said in “competition demystified”: All competitive advantages are local.


Based on historical numbers, Walgreen would look like an interesting “Boss” investment. However the large acquisition completely changes the picture. As outlined above, the success rates of such “transformational” acquisitions are 30% or lower. And historical numbers do not not ho
ave a lot of predictive power in such situations

So without any special insider knowledge, one should generally stay away from such stocks which in my case would also be the advise for Walgreen.

Sure it can work out, but the odds are strongly against a positive outcome.

How to correctly calculate Enterprise Value

After all that heavy macro stuff, back to the nitty-gritty world of fundamental analysis.

Let’s have a look at Enterprise Value, which as concept is gaining more and more attention, among others famous “Screening guru” O’Shaughnessy has identified Enterprise value as the most dominant single factor in his new book. Also a lot of the best Bloggers like Geoff Gannon and Greenbackd prefer EV/EBITDA

Interestingly many people seem to just use and accept the “standard” Enterprise value calculation.

How to calculate standard Enterprise Value

Investopedia has the “normal” definition of Enterprise Value:

Definition of ‘Enterprise Value – EV’
A measure of a company’s value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

Investopedia also offers an interpretation

Investopedia explains ‘Enterprise Value – EV’
Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company’s debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm’s value. The value of a firm’s debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.

So this is a good hint how to understand Enterprise Value: It originates from take-over valuation, most prominently from Private Equity investors or “old style” corporate raiders.

How to UNDERSTAND Enterprise Value

The private equity / Raider business in principle is relatively easy: You buy a company (or achieve full control) and then in a first step you extract all existing cash and/or assetswhich are not necessary to run the business from the company. In a second step, the corporate raider will then put as much debt onto the target company’s balance sheet and let it pay out as a dividend or capital reduction.

The more the Raider can get out quickly either as excess cash or as a “dividend recap” (short form for a debt financed dividend) the higher the return on investment.

The first important aspect: Excess cash OR excess assets

As I have written above, a raider of course likes best plain cash lying around. On the other hand, the raider will happily sell anything which is not really required to run a business and pocket this cash as well. However mechanical screeners will only capture cash on the balance sheet, not any “extra assets”.

A good example is my portfolio company SIAS. Their EV/EBITDA decreased strongly because the “exchanged” their extra asset in the form of a South American minority stake into cash. Another “extra Asset” company would be EVN with its Verbund stake.

Including the Verbund stake, EVN looks quite expensive at EV/EBITDA 8.3 (EV ~ 4 bn, EBITDA ~ 500 mn) against 5-6 EV/EBITDA at RWE and EON. However if we deduct the “extra asset” of 25% Verbund (~1.6 bn EUR) from the 4 bn EV, we suddenly end up with an EV/EBITDA of <5, a lot cheaper for this very conservatively run utility company.

In my experience, it is much more interesting to find companies with extra assets which don't show up as cash on the balance sheet. This was mentioned before as favorite technique of value legend Peter Cundill.

Next step: What to add to Enterprise Value

So its pretty clear that the less debt a company has the more a PE/raider will be willing to pay.

But it is also important to understand, how the capacity to put debt into a company is determined. Especially in the US, the debt will be put into the target in the form of corporate bonds. In order to sell them, you need to have a rating.

The lower the rating the more expensive the debt. In practice, raiders will try to achieve a BB rating as this is usually the “sweet spot” before bond spreads go up dramatically.

Rating agencies have relatively simple ratios to determine maximum debt loads within a certain rating category, however the most important point is this one:

Rating companies add additional items to determine debt capacity which are:

pension deficits or unfunded pension liabilities
– financial and operating leases (capitalised)
– any other known fixed payment obligations (cartel fines, guarantees etc.).

Economically, those items are very similar to financial debt which is usually included in the EV calculations, as they represent fixed payment obligations which sometimes (like pensions) even rank more senior than debt.

It is therefore no wonder that with a “standard” EV/EBITDA screener, often UK retail companies with huge (underwater) operating lease and pension commitments show up as “cheap” and then people are surprised that they go bankrupt soon (Game Group anyone ?).

Special case: prepayments

Prepayments are an interesting feature of some business models, among other for instance at Dart Group.

Normally, a company produces its goods first and then sells them again receivables until cash is then finally collected. In the case of prepayments, cash comes first in against a payable and the good gets produced at a later stage and then delivered with no further cash inflow to the customer. If the prepayments do not carry any formal restrictions, the company in theory can use the cash for whatever it wants. So for instance if a company can finance inventory out of payables, the prepayment cash could be used to finance even machinery or to reduce financial debt. So to make a long story short: cash from prepayments without formal restrictions should be considered “free cash” and deducted from enterprise value.

How to calculate Enterprise Value correctly:

So now we have all ingredients to correctly calculate Enterprise Value:

a. Equity Market cap
b. Financial debt (long + short term)
c. minorities, preferred
d. financial leases and operating leases
e. pension deficit or unfunded pension liabilities
f. any other fixed liability which has to be repaid independently of the business success

g. cash or cash equivalents
h. “extra assets”, assets not required to run the business

Of course, EBITDA has to be adjusted as well in order to make usefull comparisons.

Basically we have to add back leasing expenses and pension expenses to EBITDA in order to compare the ratio against other companies.


Standard screening EV/EBITDA does omit various relevant elements of an “economical” Enterprise value. Adjusting it for relevant items will prevent an investor to end up with relativ obvious value traps.

I am willing to bet that a back test on the adjusted EV/EBITDA ratios would generate even better results than the “standard” EV/EBITDA calculations.

Performance review June 2012 & comments

June finished with a big bang in the markets on the last trading day. So instead of a 1% outperformance for June on Thursday, the Portfolio underperformed -2.6% for the month. However as discussed before I don’t take monthly numbers to serious.

So quickly the updated Portfolio performance table:

  Bench Portfolio Perf BM Perf. Portf. Portf-BM
2010 6,394 100      
2011 5,510 95.95 -13.8% -4.1% 9.8%
Jan 12 5,972 99.27 8.4% 3.5% -4.9%
Feb 12 6,275 105.90 5.1% 6.7% 1.6%
Mrz 12 6,330 107.22 0.9% 1.2% 0.4%
Apr 12 6,168 108.02 0.8% -2.6% -3.3%
Mai 12 5,750 108.90 -6.8% 0.8% 7.5%
Jun 12 5,969 110.17 3.8% 1.2% -2.6%
YTD 12 5,969 110.17 8.3% 14.8% 6.5%
Since inception 5,969 110.17 -6.7% 10.2% 16.8%

The portfolio gained 1.2% in June, mainly driven by HT1, SIAS, EMAK and AS Creation. YTD, the portfolio is now up +14.8% with a relatively low volatility.

The portfolio composition has changed somehow against last month, especially with regard to the 3 new entries, Dart Group, Cranswick and April. For April SA, I took advantage of the low prices in the second half of last week and bought a 3% position, Installux has now reached 2% (and paid a 8 EUR dividend last week…).

Name Weight Perf. Incl. Div
Hornbach Baumarkt 5.0% 4.98%
Fortum OYJ 4.0% -20.73%
AS Creation Tapeten 4.0% 0.50%
EVN 2.8% -11.04%
WMF VZ 3.8% 33.87%
Tonnellerie Frere Paris 4.8% 7.03%
Vetropack 4.4% -3.42%
Total Produce 4.3% 6.70%
OMV AG 2.1% -14.04%
Piquadro 1.4% 1.24%
SIAS 5.9% 15.58%
Installux 2.0% 0.04%
Poujoulat 0.1% -1.57%
Dart Group 2.5% 1.18%
Cranswick 2.6% 1.53%
April SA 3.1% -0.67%
Drägerwerk Genüsse D 8.7% 44.55%
IVG Wandler 2.0% -0.64%
DEPFA LT2 2015 2.9% 22.53%
AIRE 5.0% 109.69%
HT1 Funding 4.7% 9.48%
EMAK SPA 5.1% 15.59%
DJE Real Estate 2.3% -3.65%
Praktiker 2016 2.4% -2.85%
Short: Kabel Deutschland -2.2% -25.63%
Short Ishares FTSE MIB -2.4% 3.56%
Terminverkauf CHF EUR 0.2% 4.42%
Tagesgeldkonto 2% 13.6%  
Summe 100.0%  
Value 49.3%  
Opportunity 33.1%  
Short -4.4%  
Cash 13.6%

Outlook & Actions:

As discussed before, I will accept the AIRE KgAA offer at 18,25, so cash will increase again. In parallel, I will still try to collect some more Installux and Poujoulat shares but apart from this I am currently done with buying.

In the next few days it will be interesting to see how the situation at Praktiker developes. If the “locust” succeeds with its “super Senior” loan I might sell the bonds.

As written before, on a macro level I see lower tail risk in the Euro zone going forward, although a real recovery might be still far away. I am still mostly concerned with the situation in China and the other “BRICs”. Everyone takes it for granted that China powers ahead and transitions smoothly from an epic construction boom into a happy consumer economy, but if you look closely to the other BRIC’s like India, one can see the BRIC story is crumbling at an increasing speed.

As a consequence I will try to stay clear of too much BRIC and commodity exposure. At some point in time it might be interesting to short some “can’t lose” stocks with large BRIC exposures.

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