In earlier posts I mentioned the glut of recent private equity deals and M&A activity (see here and here and here). In those posts I characterized some of the private equity deals as "stupid money chasing stupid deals". More generally, I expressed concern about the spate of M&A deals, the multiples (premia) that acquirers have been paying, and the amount of debt that firms have been strapping on. I also pointed out that much of the activity had been fueled by cheap money from foreign central banks with excess reserves as a result of trade imbalances and the high price of oil leading to excess petrodollars that needed to be recycled. This excess capital led to historic lows in credit spreads and helped keep corporate default rates artificially low. I also claimed that when the cycle ends, it would probably end ugly. We may now be witnessing the beginning of the unwind!

In recent days, hedge funds and banks have been divulging losses associated with subprime loans, the most salient of these events being the collapse of two Bear Stearns funds. But you might retort, "these losses are associated with mortgages and real estate, what does that have to do with corporate credit?" Well, quite frankly, a lot. There are several ways in which contagion spreads from market to market. In this case, I believe that there are two main factors leading to a spillover to the corporate credit market.

First, after the Bear collapse, investors have likely been reassessing their tolerance for risk in general. Investors have been having that "Holy crap, risk exists!" moment of zen and re-pricing accordingly. Second, it might not just be the perception of increased risk that’s scaring away lenders, but also actual losses reducing the amount of available capital. For example, if I were an investor in the Bear fund, up until a few months ago, the world was hunky dory, my account was doing just fine, and I had plenty of cash on hand. Moreover, because my books were sound, I was able to borrow on my gains. After Bear, real capital was destroyed. If we believe that subprime losses are not limited to Bear (and they’re likely not), we should expect other hedge funds to fail (as some have in recent days), hedge funds to limit withdrawals (as some have), and increased margin calls from bankers (forcing investors to liquidate losing positions or to square up by injecting more cash). Voila, …less capital to go around, less capital available to lend.

As evidence of such a credit crunch, we have recently seen spreads in corporate debt markets increase to multiple-year highs. The ABX, CDX, and iTraxx indices are all pointing to increased risk aversion. As Nouriel Roubini so aply put it, "the CDO market has indeed literally seized up in July". Not only that, but bankers in high profile private equity deals such as Allison Transmission, Chrysler, and Alliance Boots have been unable to offload their bridge financing positions - forcing them to either convert temporary loans that they made to the private equity firms into long term loans, or to renegotiate credit terms.

Is this the beginning of a larger, more generalized credit problem? Although I hope not, I fear that it might be. At the very least, I hope that recent events instill some much-needed discipline into corporate and private equity acquirers. They have been borrowing too cheaply for too long. So, where do we go from here?

I don’t know if you caught the news in between the Dow flirting with 14,000 and Bear Stearns finally acknowledging the meltdown of two of its hedge funds, but IHOP announced yesterday that it would purchase Applebee’s in an all cash deal worth about $1.9 billion ($2.1 billion if you throw in the additional debt they will assume). These days, a deal of this size is really just a ho-hum deal, so I wouldn’t be surprised if it didn’t cross your radar screen. But I found this deal interesting.

There are many levels at which you can analyze this deal. You can look at it from a business strategy perspective to gauge whether the two companies fit. You could object to the deal on the grounds that IHOP is a down-market brand and they are acquiring a more up-market player (although it’s unclear how much more up-market Applebee’s is…). Integrating up-market and down-market brands can be extremely difficult - just ask the folks at Daimler and Chrysler.

You could look at this deal from a business portfolio perspective. In that sense, you might point to the complementarities in product offerings (hence the title). This pairs a traditional breakfast joint (and late-nite munchy joint) together with a lunch and dinner venue. Not sure what kind of specific synergies this might generate (I haven’t thought about it long enough), but it certainly rounds out the firm’s product portfolio.

Don’t get me wrong, there are some synergies here to be gained - common management of franchisees and franchising contracts, shared supply chain and supply chain management, scale economies in purchases and sales (marketing and advertising), etc. Are these synergies enough to overcome the premium paid of around 4.5%? It’s too early to tell.

However, for those of you who know me, you know that I’m less concerned with the ability to generate synergies that help offset the premium paid, and more concerned with the ability to keep integration costs under control.

The potential to achieve synergies in such deals usually exists. The real battle is in achieving them. That happens during integration.

Which brings me back to the what’s interesting about this acquisition. Specifically, the current CEO of IHOP (Julia Stewart) used to be the President of Applebee’s domestic operations. She spent 4 years in that role. Now I’m not sure how many employees Ms. Stewart brought with her when she left Applebee’s for IHOP (that would be interesting to know), but even if she didn’t bring any, she likely still has an incredibly detailed understanding of Applebee’s operations. Think about the ex ante benefits in due diligence, and the ex post benefits to the development and execution of an integration plan. What more could you ask for to help an integration process run smoothly?

As I’ve said in the past, you can get a sense (not a perfect predictor by any means of course, but not a bad one either) of the future success or failure of a deal based on the reaction of the equity markets to the announcement. If the equity market reaction to this deal is any indication, this should be a swimming success. Applebee’s shares rose 2.2% (after having received an offer with an attached premium of 4.5%) while IHOP’s shares rose 8.9%. Although a 2.2% bump on a 4.5% premium offered is not very impressive, likely reflecting that the market isn’t convinced that the deal will go through, the 8.9% bump is pretty impressive for IHOP. It’s even more impressive when you think that at the very least IHOP is transferring cash that belongs to its shareholders to the shareholders of Applebee’s.

My take is that part of that bump in IHOP’s share price is a result of the spot on assessment of the value that Ms. Stewart brings to the integration of these two firms. I bet that the bump would be much less had IHOP announced the acquisition of any other restaurateur. Might the share price appreciation also have something to do with the 4.5% premium that IHOP paid, which is less than the industry average? Maybe, but given the recent, and expected, slowdown in the restaurant industry as consumer spending declines, I’ll go with the former.

I read with interest yesterday ConocoPhillips’ announcement that they will increase their share buyback program to around $15 billion through 2008. It was originally expected that their share buyback would be around $4 billion in 2007. The new number represents nearly a 100% increase in their original buyback plan. The announcement sent their shares soaring by 3.5% on the day. Conoco’s announcement did not surprise me (there has been little in this market that has surprised me of late). Rather, it’s made me wonder what we can infer from the fact that Conoco decided to buy back more shares.

A firm has several options with its free cash flow. It can reinvest the money back in the business or give it back to its rightful owners (the shareholders) in the form of dividends (and/or ostensibly, share buybacks).

Oil companies have a substantial amount of free cash flow right now.
After all, oil is hovering around $70 per barrel. How can you not make
money in this environment? What then can we infer from Conoco’s
increase in its share buyback program with its increased cash? There are several possible inferences:

1. Management does not think that there are any more profitable opportunities to invest in in its current business.

2. Management is acting in its own short-term interests instead of the long-term interests  of the firm and its shareholders.

I find the first explanation not very convincing. I am left then to conclude that, unfortunately, explanation #2 makes more sense.

Why do I not believe that reason #1 holds water? Well, just as recently as February, Conoco announced that it would be reducing its capital expenditure by 25% from 2006 to 2007. You mean to tell me that with oil prices near an all time high, there is no more value-increasing investment in exploration, new refining capacity, or the expansion desulfurization and/or cat cracking capabilities? If we believe the recent OECD report, we are near peak oil and we are likely to face an oil shortage within the next five years - leading to further increases in oil prices. This is not to say that oil will run dry anytime soon. Rather, it seems that there are a confluence of events leading to a general upward trend in prices. First, demand is growing briskly in emerging markets like China and India. Emerging markets will represent 46% of worldwide demand within five years (versus 42% currently). Second, demand growth projections for the next five years were revised upwards (from 2% to 2.2%) in developed countries. Finally, although there will be an ample supply of dirtier crude oil for some time after peak oil and the opportunity to convert coal to fuel and/or oil sands to fuel, these processes are currently expensive and would likewise result higher oil prices. For this reason, there seems to be ample opportunity for investment in this market.

I am therefore left to conclude that there is a bit of an incentive problem at work here. When firms buy back their shares, the effect is immediate. There is an automatic bump in share price. Therefore, the shares and options that managers hold instantly increase in value. By contrast, when management announces a large capital investment, its outcomes are less certain to market participants, and the immediate effect on share price isn’t always realized, …even though we expect managers to make such investments when projects are NPV positive. Moreover, as I described in a previous post, market participants are not very good at valuing the long-term
consequences (with more than a 5 years horizon) of current managerial decisions.

There is one other potential explanation that I neglected to mention in the list above. Some  macro economists have recently pointed out that share buybacks have reached an all-time high in 2006 and 2007 as a result of general market pessimism. That is, with remarkable earnings over the past several years, managers are becoming nervous that their earnings will not be able to keep pace, especially as the business cycle turns and the economy stumbles. As a result, companies buy back their shares to increase there earnings-per-share growth. With fewer shares outstanding, EPS looks more impressive even though total earnings have not changed. It’s essentially an illusion meant to buffer the company’s stock price when managers expect tough going in difficult markets. I’m not a macro guy, but some of this could be at work as well. However, I’d like to believe that investors are smarter than that. But even if you buy into that rationale, on closer inspection, it’s not too far removed from reason #2.