The New York Times Dealbook published an article last week on a corporate deal that worked for the right reasons (see A Merger that Works). According to the NY Times:

Academic studies generally support the idea that shareholders of companies that make acquisitions get the short end of the stick.

MY COMMENT: Yes, that’s a fair assessment of the academic literature. Most deals fail; and often, shareholders of the acquiring firm end up bearing the brunt of the costs (see Great Shareholder Ripoff and Why M&A Deals Go Bad).

But that’s not always the case. Stanley Black & Decker, the tool giant created this year, is shaping up to be a notable exception if Wednesday’s quarterly report is any guide. Investors might want to make a punch list of the deal’s key components.

From the start, the merger, announced last November, looked good on paper. Stanley Works agreed to buy Black & Decker for stock valued at a 22 percent premium…[but] the amount Stanley was paying above Black & Decker’s market capitalization was dwarfed by the value of cost cuts promised by the deal.

MY COMMENT: OK, but I am hard pressed to think of a deal in which decision-makers don’t justify the acquisition by appealing to “the premium is justified by the cost cuts” rationale. The numbers, however fabricated calculated, should always come out that way. Otherwise, the deal makes no sense. Where most deals fail is in the integration phase – in the process of trying to capture the supposed cost savings/revenue enhancements. And in fairness to the author of the NY Times piece, he/she recognizes that…

These, of course, were no sure thing; achieving them depended entirely on management making them happen. But in the first full quarter as a combined group, these are now being captured.

The company reported better-than expected second-quarter results and raised its outlook… Moreover, the company said it was “firmly on track” to meet its estimates for cost cuts and was examining opportunities for revenue synergies.

Since the deal was announced, Stanley shares have risen by more than 20 percent…By comparison, the Standard & Poor’s 500-stock index has added just 4 percent.

The lesson should be fairly simple: mergers can work if the blueprints are solid. In the Stanley Black & Decker case, the elements included overlapping businesses with broad scope for expense reduction, a modest premium amply justified by the synergies, clear governance and control, and a shared distribution of future gains. Put those tools in the box, and there’s no reason shareholders can’t benefit from such deals.

MY COMMENT: Maybe. But I think that most managers enter such deals believing (perhaps erroneously) that their blueprints are solid. Further, we always hear about synergies and the benefits of buying overlapping businesses, and yet most deals still fail.

And therein lies what makes evaluating individual deals so difficult.

First, we don’t get to observe the counter-factual. Although the share price of the combined entity (in this case Stanley Black & Decker) may have risen (by 20% according to the author), we don’t get to observe what would have happened to Stanley Works’ stock and Black & Decker’s stock individually had the deal not gone through. Perhaps it would have increased by more than their combined shares, perhaps by less.

In addition, there is another potential explanation for Stanley’s positive outcomes that I think the author may have overlooked: market power. Bringing together two powerful competitors within a largely commodity business is one way to quickly extract value. Whereas the firms previously competed vigorously with each other in various segments of the market, the ability to remove a competitor via acquisition enhances the pricing power of the combined entity. So although there may have been cost cutting synergies for Stanley to exploit, the true benefit may have come from the industry consolidation itself. The lesson: Industry structure matters, …and that is not easy to replicate no matter how complementary the businesses.

So when it comes to M&A deals, I am always weary of a one-size-fits-all punch list. And you should be too.

For those of you who read my blog, you know that I’ve had an interest in Tata’s acquisition of Jaguar and Rover. When it was announced, I failed to see the value proposition in the combination of Tata and JLR, and I remain somewhat skeptical of JLR’s ability to provide value to Tata (for background see Jaguar/Rover Revisited, Jaguar/Rover Update, and Buyer’s Remorse).

Irrespective of my opinion, it was with great interest that I read this week’s Economist, which contained an article on Tata’s progress with those previously beleaguered brands (see Tata Motors’ Boss Moves Up a Gear).

After a torrid couple of years in which demand for JLR’s pricey models evaporated…2010 has seen at least a partial recovery in sales and profits…

After the success of the mid-size XF and with heavily revised Range Rovers and the radical new XJ saloon just launched, JLR’s product line-up has never looked in better shape.

MY COMMENT: I will give that to them. Tata Motors is performing better now than in 2009. They are profitable again, with net income of around $550 million. However, a look under the hood suggests that profitability was not bolstered much by results at JLR (Jaguar Land Rover). A good chunk of Tata Motors’ profitability came from a gain booked on the partial sale of Tata’s stake in Telco Construction Equipment. JLR’s net profit was reported at around $20 million. That’s very small (less than 5% of total profit for a brand that represents greater than 50% of Tata’s entire automobile enterprise), …but it’s admittedly greater than zero.

Another thing that I will say about Jaguar and Land Rover: Their new models are stylish. They are good looking cars. And boy have they been marketing the heck out of them in the US. Everywhere I turn I feel like I see/hear another JLR advertisement – on TV, radio, billboards, and even through the internet (e.g., pandora radio). This is more than I ever remember Ford promoting those brands.

So Tata Motors is definitely making the investment. The question remains: Will the pricey advertising campaigns pay off, or are the brands already too far gone??

Nevertheless, I will admit there are definitely some things for the optimists to get excited about.

Back to the article:

One of the biggest puzzles Mr Forster [the Chief of Tata Motors] has to solve is how to replace the legendary Land Rover Defender…The new vehicle will have to be cheaper to make (and sell) than the current “Landie” to make it competitive with Japanese rivals in developing-country markets…[and] come up with a product capable of finding at least 80,000 buyers a year—four times as many as the current Defender. There is a good chance that, to keep costs down, the new model will be made in India.

MY COMMENT: Um wait. From what I remember of the original deal, Tata agreed not to shift production out of the UK, and made pledges not to cut staff or close plants. It’s unclear to me therefore how many of those 80,000 cars they’ll be able to assemble in India.

The new-model blitz is in impressive contrast with the sluggish pace of development under JLR’s cash-strapped previous owner, Ford.

MY COMMENT: Yes, I agree the new models (especially the Jaguar XF/XJ and the Land Rover Evoque) are impressive. However, lest we forget, these models were designed and developed under the previous owner, Ford. What matters most is what comes next, …in the generation of models that follow. We’re still several years away from seeing the fruits of any design efforts under Tata Motors.

And one of the big takeaways from the article:

Apart from economic uncertainty in its traditional markets, there is, however, one big cloud on the company’s horizon: ever-tightening fuel-efficiency and emissions rules.

MY COMMENT: Really?? That’s it? Fuel-efficiency and emissions rules? That’s the best you can come up with?

C’mon, JLR’s downside risks are far greater than that. For example:

1. How will JLR compete with the Japanese (Acura, Infiniti, Lexus) on price or the Germans (BMW, Audi, Mercedes) on perceived quality? My view is that JLR’s models are too expensive to effectively compete with the Japanese manufacturers. They just don’t have the volume. And they are not as highly regarded as the German brands. They just don’t have the prestige, and as a result must settle for lower margins. In this sense then, JLR is stuck in the middle.
2. The auto industry continues to be saddled by mass overcapacity. Coupled with what I suggested in point #1, it’s not entirely clear to me how Jaguar and Land Rover can survive the inevitable industry shakeout.
3. What happens if/when the global economy slows again (especially in Europe and the US) and sales of durable goods decline? JLR is already teetering on the verge. Even a modest economic slowdown could spell the end to the brands.
4. JLR still carries a hefty debt burden that Tata Motors is working through. Even with a restructuring of that debt, a turnaround of JLR is a tall order, and $3 billion in debt is not chump change. It’s reasonable to ask whether Tata will ever earn enough (even if JLR remains profitable) to provide a reasonable return on investment.
5. As in my previous posts, I still wonder about Tata’s ability to derive synergies from JLR, to rationalize JLR’s operations, and right two long-uncompetitive brands.

But who knows. Tata Motors might just prove me wrong. After all, JLR is marginally profitable (for now). And Tata Motors certainly picked a qualified leader in Carl-Peter Forster to lead the group.

Only time will tell…

…at least not according to the US Treasury (see the Treasury’s Interim Report on Exchange Rate Policy).

According to the Treasury’s report:

China’s continued foreign reserve accumulation, the limited appreciation of China’s real effective exchange rate relative to rapid productivity growth in the traded goods sector, and the persistence of current account surpluses even during a period when China’s trading partners were in deep recession together suggest that the renminbi remains undervalued.

It was easy to overlook the recently released Treasury report in the wake of the G20 summit, where much of the debate centered on austerity versus stimulus rather than China’s mercantilist policies (see Agreeing to Disagree).

In this sense then, China’s strategy of publicly announcing a more flexible yuan policy in the days leading up to the G20 summit effectively deflected the debate away from the yuan. What’s more, China’s announcement was seemingly rewarded by a Treasury now more reticent to label it a currency manipulator. And the timing of the report’s release (after months of delay) seemed rather coincidental: It was released after the conclusion of the G20 meetings, and only after China seemed to mollify critics with its announced policy shift.

The interesting thing to me about the whole thing is that the yuan has barely budged since the announcement, rising less than 1% since late June. For a currency that some claim is undervalued by as much as 40%, that’s not likely to make much of a dent in persistent trade imbalances.

Now I’m as much a proponent of free trade as anyone (see Globalization Revisited and Globalization Discontents), but my view is that trade should be allowed to take place in an environment in which economies adjust as a consequence. Explicit policies that prevent such adjustment can be damaging to all parties.

With my bias now laid bare, it seems to me that China is simply paying lip service. It wants to appear accommodating, publicly declaring its intention to allow the yuan to strengthen against the dollar, while continuing to rely on exports to the US as its main growth engine.

Given the recent turmoil in Europe (China’s second largest trading partner), maintaining its exports to the US has taken an even heightened importance (see Revaluation Postponed and Revaluation and Euro Weakness). And in a world where everyone suddenly wants to play beggar-thy-neighbor (China, Japan, and now even Europe), the US is now everyone’s neighbor (for a brilliant treatment of the issues see Capital Tsunami).

This cannot continue indefinitely.

Against that backdrop, don’t be surprised if the trade deficit and cries of unfair trade practices begin to occupy a more prominent place in political discourse.

It’s been a long time since I’ve thought about the JP Morgan/Bear Stearns shotgun wedding (see Rescue for Bear? and Rescue Update for background). Back when I wrote those blog entries, I wondered aloud whether, in addition to preventing Bear’s collapse, the Fed also orchestrated a backdoor bailout of JP Morgan in the process.

Anyhow, as part and parcel of the JP Morgan/Bear Stearns deal, the Fed acquired a host of assets that were packaged into what would become known as the Maiden Lane portfolio. The Maiden Lane portfolio housed approximately $30B “worth” of assets, with JP Morgan agreeing to assume the first $1B in losses associated with the portfolio, and the Fed assuming any losses thereafter.

Last week an interesting article in Bloomberg questioned when the Fed knew about the poor quality of the assets it acquired in the Maiden Lane deal, and how it communicated what it knew about those assets (see Fed Made Taxpayers Unwitting Junk-Bond Buyers).

According to Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and then-New York Fed President Timothy Geithner told senators on April 3, 2008, that the tens of billions of dollars in “assets” the government agreed to purchase in the rescue of Bear Stearns Cos. were “investment-grade.” They didn’t share everything the Fed knew about the money.

The so-called assets included collateralized debt obligations and mortgage-backed bonds…that were so distressed, more than $40 million already had been reduced to less than investment-grade by the time the central bankers testified.

At the time Maiden Lane was created, the Fed claims that the assets were solid, credit-worthy, and investment grade.

“As was noted in testimony, all of the cash securities in the Maiden Lane portfolio were investment grade on March 14, 2008, when the deal was agreed to in order to facilitate the acquisition of Bear Stearns and to prevent the systemic consequences of its sudden and disorderly failure,” Michelle Smith, a spokeswoman for the Fed’s Board of Governors, said in an e-mail.

“The Federal Reserve considered not just credit-rating valuations, which have varied some over time based on economic conditions, but also relied on a separate assessment from an independent investment firm, which advised us that over time, we would likely fully recover our principal and interest,” Smith said. “We continue to expect the loan to Maiden Lane to be fully repaid.”

“You’ve got about $30 billion of collateral. And some comments have been made that you feel comfortable because it’s highly rated,” Senator Jack Reed, a Rhode Island Democrat, told Bernanke, according to a transcript. “But a lot of highly rated collateral these days is being subject to questions.”

“Senator, as was mentioned, it is all investment-grade or current performing assets,” Bernanke responded. “We do not know for sure what will transpire,” he said. “But we have engaged an independent investment-advisory firm who gives us reasonable comfort that if we can sell these assets over a period of time that we will recover principal and interest for the American taxpayer.”

That was then. This is now:

More than 88 percent of Maiden Lane’s CDO bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade, according to data compiled by Bloomberg based on holdings as of Jan. 29.

Casablanca moment: I’m shocked, shocked…

Needless to say, I’ve been stewing over that article for the better part of a week now, and several thoughts came to mind:

1. The Fed was fleeced. It was in over its head – unable, and unequipped, to properly value extremely complex derivatives – and as a result, was on the wrong side of the Maiden Lane trade.
2. The Fed knew best. It was a liquidity problem and not a solvency problem. The Fed bought assets that no other party was willing to buy because potentially interested parties were scared (wrongly pricing Armageddon). The assets still had value and the Fed paid a fair price. To its credit, even the CBO estimates that the Fed will end up realizing a $200 million return on its Maiden Lane investment. So the Fed was on the right side of the trade.
3. It doesn’t matter whether the Fed made a good or bad trade. It failed to properly disclose information about the true state of the Maiden Lane assets. That is, the Fed knew that the assets were largely junk but bought the assets anyway in an effort to wind Bear down in an orderly manner and stave off the risk of a systemic collapse.

I hope the answer doesn’t lie behind Door #1. It oughtn’t. There are some pretty sharp minds at the Fed, so I highly doubt they got taken. If the Fed executed a horrible trade, then how could it possibly be seen as a credible central bank, especially in light of the increased regulatory powers that the financial reform bill looks set to grant it? And as Kevin Warsh stressed in a recent speech: “The Fed’s institutional credibility is its most valuable asset…”

I am also skeptical that the answer lies behind Door #2. I keep coming back to the absence of suitors for Bear (and/or those assets). Why was there no market for Bear? Why was nobody interested in what were then largely “investment grade” assets? Did the market really have it that wrong?? As the Bloomberg article notes:

“Why wouldn’t JP Morgan want a bunch of AAA assets?” said Mark Calabria, a former Senate Banking Committee staff member…“The answer is it was all borderline junk.”

The CBO even leaves a wide range for expected returns on Maiden Lane’s assets recognizing in its report that, “the returns realized on asset-backed securities such as those in the Maiden Lane portfolios could deviate significantly from what is expected…”

And so we come to Door #3. Whether the Fed executed a good or bad trade is, in some ways, immaterial. It’s about the way it was handled.

I understand the desire, and the urgency, on the part of the Fed to step in and wind down Bear, much as the FDIC acts as a receiver to failed banks. I am one of those who believes that the alternative (letting Bear fail in a disorderly manner) might have had catastrophic consequences for the global financial system. Of course, we will never know, not having the opportunity to observe the counter factual.

But to me, this is starting to look like a case in which it’s debatable whether the ends justify the means.

As I understand it, the issue is that the Fed did not (at the time) have resolution authority over non-bank financial institutions such as Bear. Therefore, it invoked Section 13(3) of the Federal Reserve Act, which enables it to provide credit to corporations like Bear in extraordinary circumstances, but only in exchange for high quality collateral. Moreover, whereas the FDIC is funded by the premiums collected from member banks and draws upon the Deposit Insurance Fund when winding down a bank, in this case the Fed put taxpayer money directly at risk.

And therein lies what bums me out so. It’s not the kind of assets acquired by the Fed. It’s not the price at which the Fed acquired the assets. It’s not whether the assets will ultimately get paid back, though that’s important (and debatable). It’s not even whether the Fed, through its actions, effectively rescued the financial system from the brink.

In the end, it’s about what the Fed knew about the quality of the assets when it structured the rescue, and the possibility that the Fed put taxpayer money at risk in violation of Section 13(3) of the Federal Reserve Act, perhaps knowing ex ante that it was acquiring collateral of dubious quality.

This is why, in my opinion, Bernanke was so careful with his language in his April testimony. Yes, technically, the assets were investment-grade rated and/or performing assets when Maiden Lane was created. Therefore, at the time, the assets were likely meet the “indorsed or otherwise secured” criteria. Brilliant really, if you think about it.

But did the Fed anticipate that the assets would remain high quality? That’s another story.

If the Fed knew that the Maiden Lane assets were likely to become junk assets irrespective of how they were rated at the time (and we might never find out), it would be eerily reminiscent of a “You can’t handle the truth” kind of moment, …which speaks to a whole different kind of credibility.

In January I predicted that “major” bankruptcies in 2010 would number around 300 (see Notable Bankruptcies of 2010: Q1). According to Bankruptcydata.com, there were 59 “major” filings in the first half of 2010. Assuming that bankruptcies are equally distributed throughout the year, this puts us on pace for around 120 bankruptcies. Again, this would be well shy of my prediction.

In previous posts I discussed why I believed “major” business bankruptcies were tracking below expectations (see Notable Bankruptcies of 2010: Q1 and Notable Bankruptcies of 2009). The candidate explanations include: an improving economy; massive government stimulus/liquidity programs keeping structurally weaker firms on artificial life support; and the recovery disconnect between Main St. and Wall St. (i.e., small-firm bankruptcies are on the rise even while major bankruptcies have declined).

Personally, I continue to believe that the significant dip in “major” business bankruptcies that we have witnessed over the past year has a lot to do with the extraordinary government stimulus and liquidity programs. Nowhere has this been more evident than in the disconnect between the bankruptcy patterns across small and large corporations (see Notable Bankruptcies of 2010: Q1 for details). And as I’ve maintained all along, absent a second round of stimulus, we will find out if my hypothesis is correct as the stimulus and liquidity programs begin to wind down. In this sense then, the true test for corporate balance sheets (and by extension, the economy) will come in the second half of the year.

Given the recent troubles in Europe and the softer economic employment and growth numbers at home, it continues to be my expectation that the pace of corporate bankruptcy filings will increase in the second half of 2010. Will we ultimately reach 300 “major” business bankruptcies? At this point, likely not. But I do not think 200 is out of the question.

If fundamentally weak companies are being propped up by an artificially-stimulated economy that cannot structurally support them, it is only a matter of time before bankruptcies begin to reflect true underlying economic fundamentals.

Anyhow, below you can find an updated list of what I see as the “noteworthy” bankruptcies of 2010, as reported by Bankrupctydata.com. New additions since March appear in RED (please note that this is not an exhaustive list):

• Affiliated Media, Inc. (Newspapers)
• American Mortgage Acceptance Company (Real Estate)
• Anthracite Capital, Inc. (Real Estate)
• Atrium Companies, Inc. (Windows and Doors)
• Beach First National Bancshares, Inc. (Banking)
• Black Gaming, LLC (Gambling)
• Chem Rx Corporation (Pharma Services)
• Community Bancorp (Banking)
• Corus Bankshares, Inc. (Banking)
  
• Electrical Components International, Inc. (Manufacturing)
• EnviroSolutions Holdings, Inc. (Waste Disposal)
• Evergreen Bancorp, Inc. (Banking)
• FirstFed Financial Corp. (Banking)
• Haights Cross Communications, Inc. (Publishing)
• International Aluminum Corporation (Real Estate)
• Mesa Air Group, Inc. (Airlines)
• Morris Publishing Group, LLC (Media)
• Movie Gallery, Inc. (Retail)
• Neenah Enterprises, Inc. (Manufacturing)
• Neff Corp. (Construction)
• Orleans Homebuilders, Inc. (Real Estate)
• Penton Business Media Holdings, Inc. (Media)
• Point Blank Solutions, Inc. (Security)
• Regent Communications, Inc. (Media)
• R&G Financial Corp. (Banking)
• Saint Vincent’s Catholic Medical Centers (Healthcare)
• Spheris Inc. (IT Services)
• TierOne Corporation (Banking)
• The Newark Group, Inc. (Paper)
  
• Uno Restaurant Holdings Corporation (Restaurants)
• US Concrete, Inc. (Construction/Basic Materials)
• Xerium Technologies, Inc. (Paper)

Another G20 summit meeting has come and gone. The heads of the eight leading industrialized nations, the G8, met first on Friday and Saturday, followed by the full G20 complement, representing the twenty most important global economies.

The primary agenda for this summit was the global financial system and the world economy. Throughout the meetings, pronouncements of shared financial goals and economic cooperation were so frequently and publicly communicated as to become cliche, …not entirely unexpected for these kinds of events.

Was meaningful progress made and consensus achieved? It’s too early to tell (see a brilliant version of the communique in the Wall Street Journal, annotated by Marc Chandler, Simon Johnson, and Arvind Subramanian).

The desire for coordinated action on the global financial system and agreement on fiscal policy is certainly admirable, but the fact remains that each nation faces a differing domestic situation, and uneven economic and political pressures at home. Considering their differences, the fact that any consensus could be reached, let alone communicated, must be considered an accomplishment.

However, the most interesting storyline of the meetings was the tension between U.S. and European approaches to fiscal policy: spending versus austerity.

The U.S. position has always been that “pulling back spending too quickly could choke off the economic recovery.” On this count, Obama’s entreaties were acknowledged, “We must recognize that our fiscal health tomorrow will rest in no small measure on our ability to create jobs and growth today. In short, we have to do everything in our power to avoid a repeat of the recent financial crisis.” Meanwhile, agreements on targets for getting economic deficits under control, credibly committing to reducing deficits in the medium-term, and pledging to cut them in half by 2013, appeased European austerity proponents.

Although the gathering did not produce a uniformly agreed-upon fiscal solution, the consensus achieved could be described as one of “broad commitment to sensible long-term austerity.” Basically, participants agreed to ease into austerity – with some advocating for a quicker pace than others, …and plenty of room for individual interpretation.

At the end of the day, growth is the primary challenge for struggling economies around the world. Renewed growth will lead to increased tax revenues and the cash flow necessary to curb deficits, and ultimately, pay down debt. Although aggressively reducing government spending and increasing taxes seem intellectually appealing as solutions to deficit problems, reducing unemployment will be a real challenge for those countries that adopt austerity measures too soon. At the end of the day, the mechanism through which painful near-term austerity measures will increase employment and foster growth remains unclear, and threatens to derail whatever fragile economic recovery is currently underway. So countries with no immediate market-mandated need to impose austerity ought tread carefully.

Regardless, the paths to which the U.S. and its European counterparts have committed will, in the end, provide ample opportunity to observe, and debate, the long term economic consequences of their divergent fiscal approaches.

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Parts of this opinion piece were co-written with Tom Cleveland, market analyst at Forex Traders, and I thank Tom for his contributions.