Deal Ignores Risks of Debt Propelled Acquisitions
by the Curmudgeon with Victor Sperandeo
Analysis of the Avago-Broadcom Deal:
“We have seen a slowdown in top buying (economic) growth rates. So one of your options to at least generate growth on the bottom line is to do accretive deals..... This deal could mark the start of a new string of mega-mergers in the tech industry,” said Christopher Rolland of FBR &Co. Of course, he was referring to Avago Technologies proposed $37 billion buyout of semiconductor heavy weight Broadcom. "Money is still cheap. So those dynamics are sort of coming together to cause this consolidation," Rolland added.
Broadcom, based in Irvine, Calif., was founded in 1991 by Henry Samueli, PhD - an electrical engineering professor at the University of California, Los Angeles (UCLA) and Henry Nicholas III (Samueli's PhD student) who left the company in 2003. Mr. Samueli, the owner of the Anaheim Ducks hockey team, is Broadcom’s chairman and chief technology officer.
Broadcom's revenues last year were nearly twice the size of Avago’s. The acquisition would take Avago into new semiconductor markets, including cable modems, TV set-top boxes, Wi-Fi and data center switching systems. Broadcom is by far and away the leader in Ethernet switch chips for equipment in both premises and cloud based data centers as well as telco and campus networks.
“This is a landmark day in the history of the industry,” said Scott McGregor, Broadcom’s 58-year-old CEO, during a conference call on Thursday.
"Today's announcement marks the combination of the unparalleled engineering prowess of Broadcom with Avago's heritage of technology from HP, AT&T (Microelectronics), and LSI Logic in a landmark transaction for the semiconductor industry," Avago CEO Hock Tan said in a statement. "Together with Broadcom, we intend to bring the combined company to a level of profitability consistent with Avago's long-term target model."
Avago Technologies plans to finance its $37 billion purchase of Broadcom, with $15.5 billion of new syndicated term loans. Financing will come from Bank of America Merrill Lynch, Credit Suisse, Deutsche Bank, Barclays, and Citigroup, sources said. The issuer expects to refinance $6.5 billion of existing debt facilities and raise $9 billion of new money. A $500 million revolver would be undrawn at closing. The transaction would leverage Avago at roughly 2.7x, giving full credit for $750 million of synergies. Net of $1.3 billion of cash on hand, adjusted leverage would fall to 2.5x, according to an investor presentation.
The value of a combined Avago-Broadcom would be approximately $77 billion. The new company (which is to be called Broadcom Ltd) will have annual revenue of approximately $15 billion. It's the largest tech deal ever, as shown in the chart below:
A Company Built on Debt Fueled Takeovers:
Avago has used takeovers and mergers as an engine for economic growth and increased market capitalization. Some analysts have compared the company to Valeant Pharmaceuticals, a drug maker whose meteoric growth has been powered by serial acquisitions. Avago's relatively short company history is truly amazing and one for the record books.
· In 2005, private equity firms KKR and Silver Lake Partners acquired Agilent’s Semiconductor Products Group (SPG) for $2.66 billion. (Agilent was spun off by HP). In December of that year, Avago Technologies was established, creating the world’s largest privately held independent semiconductor company.
· From 2007 to its IPO on August 6. 2009, Avago acquired the fiber optic component and Bulk Acoustic Wave businesses from Infineon (formerly Siemens Microelectronics) and then Nemicon to complement its motion control product line. When AVGO went public in 2009, it seemed like a modest player in the semiconductor industry with a market value of just $3.5 billion. But few anticipated its future growth through debt funded deal making.
· Since Avago became a public company in 2009, its management team has pursued a half-dozen acquisitions. The biggest of which was its $6.6 billion takeover of the LSI Corporation (formerly LSI Logic), a networking and storage chip manufacturer, in late 2013. It was funded by a $4.6 billion leveraged loan which was ~70% of the price paid for LSI. The purchase price for LSI was more than six times Avago’s cash on hand at the time.
· Note that LSI had previously acquired Agere (formerly AT&T Microelectronics, then part of Lucent Technologies, IPO in March 2001) which at one time had a market cap of > $10 billion!
· Early this year, Avago struck a $606 million takeover deal for Emulex.
· Aiding Avago’s acquisitions are several rare factors, including a roughly 5% tax rate that comes from being based in Singapore and ready access to low-cost debt financing. Note that Singapore is the company's headquarters ONLY for tax reasons. Neither the original company nor any of its acquisitions were ever based there.
AVGO went public August 6, 2009 at $15 a share. The stock closed Friday at $148.07. That's an increase of 987.13% and triple its value of December 2013. Evidently, Avago's aggressive acquisition strategy has paid off big time for its shareholders.
Other Debt Fueled Deals:
Avago's acquisition of Broadcom is not the only one taking advantage of unparalleled access to cheap debt. FedEx has made a series of acquisitions in recent months, most recently (April 2015) a $4.8 billion deal to acquire TNT In January 2015, FedEx paid $1.4 billion for Genco Distribution Systems Inc., a third-party logistics provider that specializes in the product-returns business. In December 2014, it said it acquired Bongo International, a provider of services for international e-commerce orders and shipments.
This March, NXP Semiconductors NV agreed to acquire Freescale Semiconductor Ltd., an Austin, TX based chip company (formerly Motorola Semiconductor), for about US$11.8 billion in cash and stock. Freescale was taken private before the financial crisis and, while it now has publicly traded shares, it’s 64% owned by private-equity companies including Carlyle Group, TPG Group Holdings and Blackstone Group. NXP, the former semiconductor arm of Koninklijke Philips NV (earlier known as Signetics), was also taken private and returned to the market in a 2013 IPO.
The NY Times reports that Intel is close to clinching a takeover of FPGA chip maker Altera for more than $15 billion, a person briefed on the matter said on May 29th . It's yet another sign of massive consolidation in the semiconductor industry.
Intel is expected to pay about $54 a share for Altera, whose specialized chip designs would help Intel expand beyond chips for personal computers, this person said. An agreement could be announced as early next week, though this person cautioned that talks are continuing and might still collapse.
S&P Rating Services - Large U.S. Takeovers are Bad for Credit Quality:
In a startling September 2013 report titled: The Credit Cloud: Large U.S. Takeovers Are A Bad Omen For Credit Quality, the analyst/authors wrote:
"Roughly half of the U.S. companies rated by Standard & Poor's Ratings Services that have completed major strategic acquisitions since 2000 now have lower (credit) ratings, and a third have ratings that are at least two notches lower than when the deal was originally announced. Numerous studies have been done in recent years suggesting that corporate acquisitions frequently hurt shareholder value. Standard & Poor's research suggests that major acquisitions also often contribute to a slide in credit quality."
Apropos to the current free money Fed policies (bold font added where deemed relevant): “Companies will often take advantage of strong credit markets (ultra-low interest rates) to increase their financial leverage to fund an acquisition, thus weakening their balance sheets and credit metrics.”
According to S&P, another important contributor to the long-term credit quality erosion of a significant number of acquirers, is that “the rationale driving acquisition strategies is the desire to counteract slowing or declining profitability as their business matures. However, large scale acquisitions often do not produce sufficient benefits to offset the loss of momentum in the acquirer's existing business. Large companies that have strong core growth momentum usually have limited need for major acquisitions--and often avoid them--because of their potential business and financial pitfalls.” We wonder if Avago has read the above report. Or maybe they're the exception to the rule that credit quality and financial strength deteriorates after large acquisitions.
Victor on Economic Growth via Stock Buybacks and Mergers:
Historically, the growth of a company was to build a product and grow it, so as to create greater long term value. Coca Cola was built that way. So were IBM, GE, and many other large companies.
In the late 1960's, conglomerates became the vogue. Gulf & Western City Investing, Ling Temco-Vought (LTV), Litton Industries, ITT, and Teledyne are just some of those companies of that decade. As you may have noticed, none are around today.
The main problem for the conglomerate companies was the inability to manage all the different areas of the business and to repay the debt they created buying them through earnings. This was the way to show a growth in earnings without building anything, merely buying companies with creative financing to capture their earnings stream. This led to the "Junk Bond" method of making money using “creative financing.”
The junk bond craze began in the late 1970's led by Michael Milken, who worked at Drexel Burnham Lambert. The concept took off in the mid 1980's and accelerated from the mid-1990''s till 2000. From 1995-1999, the S&P 500 had the greatest five year appreciation in history at +28.5% compounded. Financiers then got into mortgage backed debt to help everyone own a house, whether they could afford to or not!
Fast forward to today and we are back to debt to finance acquisitions and share buybacks, due to the irresponsible and unpredictable Central Bank policies of QE and ZIRP. With the economic outlook so uncertain, few companies invest in their own business as they don't see a good enough return on investment (ROI) to justify the risk. Therefore, companies are buying back their own stock, often with borrowed money (e.g. Qualcomm and Apple). Some are buying other companies (as the Curmudgeon notes above) to increase earnings and also to increase their company's stock price.
Certainly the goal of a CEO is to help increase the value of the company's stock for its shareholders. The question is how they do it. Is it a "pyrrhic victory" they seek, or a long term gaining market share and increased revenues and earnings through stable, consistent economic growth?
GE under Jack Welch was a different company than GE under Jeff Immelt, even though the name of the company is the same. GE started in 1889 and has gone through many changes and transformations since then. It took on a lot more debt under Immelt that caused its financial division to crater during the 2008-2009 financial crises.
The debt being created by the U.S. Federal Government is mind boggling. The majority is held by China at $1.2244 and Japan at $1.2237 trillion, as of the end of February 2015 (Japan now holds more U.S. debt than China, as of April 15, 2015).
“The debt will never be repaid, but inflated away," according to Dr. Pippa Malmgren who was interviewed by "Real Vision TV" (subscription only).
Ms. Malmgren was special assistant to President George W Bush and is currently President of Principalis. She specializes in quantifying risks on geopolitics to markets. Her father Harold, served in the Kennedy, Johnson, Nixon, and Ford administrations. She holds a PhD from the London School of Economics. Dr. Malmgren has many credentials and high end contacts. Her book "Signals" has received many accolades from noted people. When Malmgren talks, she is not “whistling Dixie.” Therefore, her remark that “the U.S. will not repay its debt" is a monster statement from a former DC insider.
Dr. Malmgren says China knows the US will inflate the debt away, and is shortening the maturity of its U.S. debt holdings to 2 year maturities while also buying Gold.
Apropos to this comment, an explanation of these obvious tactics from the movie "Under Siege: Dark Territory," goes like this: In Guanghou China a chemical weapons plant is posing as a fertilizer plant. The U.S. knows this. The Chinese know we know, but make believe we don't know, and the Chinese make believe we don't know-but know that we know. Everybody knows!" The morale: as always, debt will kill the goose!
If the U.S. debt gets inflated away the corporate sector will feel the effects as well and cause markets to be deeply affected. Rates will rise, bonds, and stocks will decline, and cash flow will be cut. That's the worst of all worlds for the buyback M&A strategy of today!
The National Bureau of Economic Research (NBER) has done a number of excellent studies on debt. For example, "Private Debt Kills the Economy Too Much Government Debt Hurts the Economy … But Too Much Private Debt Kills It," September 09, 2012. That paper analyzed 138 years of economic history in 14 advanced economies. It proves that high levels of private debt cause severe recessions. As summarized by Business Insider:
“Through a series of tests run on a sample of 14 advanced economies between 1870 and 2008, Mr. Taylor establishes a link between the growth of private sector credit and the likelihood of financial crisis. The link between crisis and credit [i.e. private debt] is stronger than between crises and growth in the broad money supply, the current account deficit, or an increase in public debt. Over the 138-year timeframe Mr. Taylor finds crisis preceded by the development of excess credit, as in Ireland and Spain today, are more common than crisis underpinned by excessive government borrowing, like in Greece. Fiscal strains in themselves do not tend to result in financial crisis."
"The study shows that excessive private debt is a much more accurate and consistent predictor of financial crisis than the amount of public debt. However, high levels of public debt exacerbate the problems caused by massive private debt, since governments which are already “in the red” have little ammunition left with which to help out the economy.”
“The NBER study validates what Steve Keen has been saying for years: excess private sector debt is the main driver of deep recessions and depressions. And yet Ben Bernanke and all other mainstream economists literally believe that the amount of private debt doesn’t matter and isn’t even important to quantify.”
American Private Debt [was] 310% of Gross Domestic Product in 2008. That was the highest since 1929, the last Great Depression when Private Debt was 240% of GDP.
Victor’s Closing Comments:
This has happened over and over again through history yet governments ignore it to stay in power. It’s politics as usual. Who will be blamed this time for the next economic bust?
[Note that the 2008-2009 "mortgage meltdown" was blamed on the banks, whereas it was our government’s decision to let Lehman Bros fail just months after they saved Bear Stearns (via JP Morgan buyout). The latter caused AIG to believe Lehman would also be saved by the feds. However, our government officials didn't do it and later blamed unchecked “capitalism,” not themselves for the financial fallout.]
Corporate debt is a musical chairs game. You run up the debt, cash out, and pass the debt onto the next CEO with a good luck wish. Ogden Nash summed this up beautifully:
"Some debts are fun when you are acquiring them, but none are fun when you set about retiring them."
Good luck and till next time...
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2014 by the Curmudgeon and Marc Sexton. All rights reserved.
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