Regarding… Vol 2 no 15 – Head Office Blues

Dear Fellow Investors and Friends

Welcome! I do appreciate you taking the time to read this.

I’m Piet Viljoen, and today is Thursday, the 25th of April, the 116th day of the year. There are 250 days left until the end of the year. In numerology, the number 250 represents curiosity, diplomacy, and wisdom. I hope those things characterise the rest of your year.

This is a big week – my business partner, Theunis de Bruyn and my life partner, Amanda, celebrate their birthdays. As does the CFO at the intergalactic RECM head office, Dean Schweizer. Happy birthday to all of you and thank you for being in my life. It’s much better for it.

On this day in 2022, Elon Musk Acquired Twitter for $44bn. As acquisitions go, it has not been successful, as he massively overpaid. But then again, most corporate transactions fail to create value. Musk was widely criticised for the transaction, but X, as it is now known, is a better environment than before the acquisition. Not perfect, but better.

Over the past while, I have also received a lot of criticism on social media about a corporate transaction with which I am (very) tangentially involved.

It got me thinking that people often apply muddled thinking to corporate finance, also known as Mergers and Acquisitions (M&A), and especially around the incentives that drive it. As a result, minority shareholders – and outsiders – are sometimes quite vocal about what they perceive as unfair treatment.

M&A is when one company either merges with or acquires another company. The reasons can vary, but are commonly of the following variety:

• To extract value through synergies, where you retain the combined volume of business when putting two firms together and eliminate duplicate costs.
• To expand the business’s geographic footprint, providing the opportunity for increased sales.
• To diversify and expand the product range, thereby increasing negotiating power with suppliers or distributors and reducing your cost of sales.

A way to think about the components of a transaction is:

1. The existing value of the acquiring business, pre-deal.
2. The existing value of the target business, pre-deal.
3. Additional potential value created by the deal in the form of synergies, scale advantages, geographic reach, or pricing power with suppliers and customers.
4. The timing of when the potential value will accrue.

If the buyer is a good negotiator, they will look to pay the fair value of the pre-deal target and thus receive the additional value for free. Conversely, the seller, or the target, will try to include the additional value in its “fair value” and induce the buyer to pay that higher price, thereby grabbing the additional value for its shareholders. So, you can understand why M&A negotiations can be tense and drawn-out affairs. Each party naturally wants to claim most of the potential benefits for its constituents.

There are more than a few issues to consider in these negotiations:

1. There is an incentive for the management team of the acquiring party to overpay. Management wants to run a more significant business, no matter the cost, as more prominent companies can afford to pay bigger salaries and have higher status. After all, shareholders are paying for the acquisition, not management.
2. Conversely, there is an incentive for the target’s management to be obstructive: after all, their jobs will become redundant. And no one fights harder or dirtier than the one whose job (and ego) is on the line.
3. Valuation is a significant problem area. What is the actual fair value of the target? And what is the additional value created by the acquisition? And how long will it take before the additional value materialises? Like beauty, valuation is always in the eye of the beholder. There are so many unknowns when you acquire another entity; a fair bit of “fat” needs to be built into your price for the uncertainty. Proper due diligence reduces uncertainty but never eliminates it.
4. Another risk is bad luck. Suppose you sell your car to a buyer willing to pay your price. As you pull out of your garage, you crash into a wall. Can you still expect to receive your asking price from the buyer? In M&A, this sort of thing happens all the time.
5. Buyers also need to be sensitive to the time value of their capital, which could be stuck in a situation where regulatory processes take an unexpectedly long time.
6. Matt Levine, in his Bloomberg column, recently pointed out another interesting aspect: “I worry that perhaps nobody knows how mergers work. Not in like a “let me tell you” sense, but like in an “everything is fundamentally unknowable” sense.

So yes, there is a lot of fuzziness in a transaction. Buying a company is like the old money or the box game – you never know what’s in the box until you open it. And what’s in the box is almost always less than you think, so the money you give up for the box is almost always too much.

This is just another way of saying the base rate of successful M&A is extremely low.

Any sensible valuation must consider this fact, so “fair value” is often a tenuous concept. It depends on where you stand, and it is most definitely not a single number.

Of course, the negotiations around the value of the different parts of the transaction are just appetisers. The main course starts when all the paperwork is done. Then, someone has to put in the work to extract the value. This can be hard, unpleasant work.

Extracting synergies means reducing headcount (read: fire people) and cutting costs, which is unpleasant. Expanding geographically means a travel schedule from hell. Negotiating better terms with a distributor requires skin like a rhino.

In short, life is less pleasant for the buyer after the transaction.

The questions that shareholders, specifically minorities in the target company, need to answer are:

1. Who would want to go to all this trouble if the terms of the deal are not favourable enough to make it worth their while?
2. How do you build that into a “fair value”?
3. And, in the absence of synergies extracted by such sufficiently incentivised parties, what is the “fair value” of the target?

There is, of course, no single correct answer, but these are at least some important aspects to consider.

Untangling the “sound and the fury” from reality is hard, even for those inside the negotiations. And for the spectators on the outside, it’s virtually impossible. But as a spectator sport, it’s pretty entertaining.

Both stocks have a lot in common. Both are suffering from a margin-reducing move from voice to data. The competition from alternate data providers is also getting stiffer, and to top it off, the regulator also thinks they are charging too much for data.

They are selling a commodity – airtime – which is highly capital-intensive. MTN and Vodacom have operating margins in the mid-20 % range and are declining. This does not leave much for capex. By comparison, capital-intensive commodity producer BHP has 30% to 50% margins, depending on where they are in the cycle.

On top of that, both companies have made acquisitions in countries that have suffered significant currency depreciation. MTN is in Nigeria, and Vodacom is in Egypt. So, what was supposed to boost profits has now contributed to reducing them.

And finally, both companies’ share prices are around multi-year lows this week.

Here’s MTN:

And here’s Vodacom:

My take: I wrote about MTN in Regarding…Vol 2 Nr 5. It’s now almost 20% lower, and my view has not changed. I still do not own it. Mining companies offer a better risk/reward ratio, which is saying something.

Our old, perennially mismanaged friend makes another comeback to the new low side of things. Welcome back, Sasol, you old dog! I wrote about Sasol back in January in Regarding…Vol 2 Nr 3, where I shared a picture of their very lovely new head office. Since then, the share price has declined by a further 20%.

Sasol used to be a favourite stock amongst institutional investors in South Africa. You know, Rand Hedge what-what. I would hate to see what this chart looks like in US$. The latest decline is due to a trading update, which indicates things are not improving despite numerous management changes, more positive statements of intent and a weak rand.

My take: For me, Sasol is a “show me” stock – show me the money, and show it to me consistently, and I will become your biggest fan. Until then, I remain on the sidelines.

They say copper is a commodity with a doctorate in economics; it is so good at forecasting. If that’s true, the good doctor is somewhat optimistic about the future economic environment.

Here’s what she’s saying:

Market commentators say copper has surged in recent weeks on investor optimism over a recovery in global manufacturing and the prospect of tightening mine supplies.

An inflationary boom scenario – at least in developed markets – is likely. Debt levels are way too high, and inflation is the easiest way for policymakers and politicians to solve the problem.

My take: I have never met a politician who wouldn’t take the easy way out. And Dr. Copper seems to agree with me.

The credit card company for high-net-worth individuals hit a new high this week. Inflation is effectively a tax on poor people who can’t hedge against it and a boon for the rich who can, which is exactly the target market that Amex serves.

Last Friday, American Express reported revenue of $15.8B, growing 11% year-on-year, and EPS of $3.33, growing a substantial 39%. Blowout numbers! If we are, in fact, heading into an inflationary boom, this company will continue to do well.

It also happens to be one of Warren Buffett’s favourite stocks. And here’s why:

My take: Mistakenly, I don’t own it, but maybe I should – it’s only on a 20 historical P/E – which isn’t rich for a stock that benefits from the current economic environment. With Visa and Mastercard each on around a 30 P/E, maybe Amex is worth a second look, as it’s outperforming them.

The FTSE 100 is the index of the 100 biggest stocks in the UK. These stocks have been portfolio killers over the past 15 years or so. In his Bloomberg column this week, John Authors shared this chart:

No wonder the Brits are so depressed – I always thought it was the weather that got to them. That, and their inability to win a World Cup of any kind.

Now, I understand the depression is actually caused by their stock market, which has become a worse place to invest in than South Africa!

But this week, the FTSE hit a new all-time high in absolute terms:

As John points out: “Resources companies and multinationals dominate it, so it tells us relatively little about the UK economy. Once put in an international context, the performance looks far less impressive and owes much to the long-term deterioration in the pound.”

My take: Maybe the point is that it is telling us something about resource companies and multinationals. The MWI Worldwide Flexible Fund (aka the cockroach) has a decent allocation to the FTSE 100 in the fund’s equity portion. It’s cheap and starting to pick up its head. Today, this was confirmed by BHP’s potential offer for Anglo-American. Both are significant constituents of the FTSE 100 index.

And as a corollary, developed market bonds are failing as stores of value. Here is how EM bonds have fared relative to developed market bonds since the Covid mania hit 4 years ago:

As a generalisation, developed markets started printing money when the mania exploded, while EMs were much more restrained. Now, the chickens have come home to roost. Even South Africa’s government bonds have done better than US government bonds – by quite a lot!

The high running yields on emerging market bonds provide quite a tailwind for returns, even in US$.

In a recent report, Gavekal Research poses the question: “Is the growing message from the markets that the value of the “credit” of the US dollar and euro systems is now collapsing, as the credit values of Turkey, Brazil, Argentina, and so many other emerging markets have collapsed over the years, and that equities – along with gold – have become one of the few potential refuges left to investors?”

My take: In the bond portion of the MWI Worldwide Flexible fund (aka the cockroach), there is virtually no developed market bond exposure, apart from some shorter-dated US bonds, which were acquired within the past 6 months, at attractive yields. The bulk of the bond exposure in the fund (which is always around 25% of fund assets) is in South African long-dated government bonds, currently yielding around 13%.

Just clip those coupons, baby!

The FT reports, “Shares in Portuguese company Galp are up a quarter this week after it reported a huge oil find offshore of Namibia. So far, the explorer estimates that 10bn barrels of oil equivalent are in place, but it will drill more wells this year. Of the 10bn barrels, not all will be oil; some will be less valuable natural gas. Galp will probably only extract a third of that available oil. Haircut the total by these factors, and Galp could sit on more than 2bn barrels. After costs, each is worth about $5 (based on $65 a barrel oil prices), says energy consultant Wood Mackenzie.”

That is valuable, on par with HCI’s find via Impact Oil and Gas. It’s no surprise that Namibia is ranked as one of the top 10 emerging markets for investors and expects massive growth in FDI:

My take: I have been building some exposure to Namibia by accumulating their government bonds, which yield even more than South African government bonds of a similar maturity. If this oil finds pan out, Namibia’s government coffers will overflow.

TechCrunch reports that Microblogging site “Post News” is shutting down just a year and a half after launching in beta. Founder Noam Bardin said the service is not growing fast enough to become a real business or a significant platform. Post was backed by Andreessen Horowitz and that fast-talking guy, Prof Scott Galloway from NYU.

Post’s strategy was to harness Twitter’s reputation as a virtual watercooler for journalists, then build on that further by creating a new way for publishers and writers to monetise.

Around the same time Post sprung up, several other Twitter alternatives threw their hat into the ring to capture the population of users who would be dissatisfied with Musk’s ownership decisions. One of them – called Threads – was even launched by Meta.

It didn’t work. X is still the dominant force.

My take: It’s hard to unseat a dominant platform in social media. Even Threads launched to great fanfare a year ago but has slipped quietly off the radar since then.

It’s always fun to speculate about macro-economics. When discussing markets, most people want to know where the Rand is going, what’s happening to interest rates, how the economy is doing, and the outlook for gold. These are easy things to talk about but very hard to predict accurately. Hard? No, impossible.

But this week, financial advisor Joanne Baynham (follow her on X, @madaboutmarkets) posted a thread on X which I thought illustrated the potential macro trade-offs the world faces very well.

You can find it here.

You should also follow the thread’s originator, @urbankaoboy, for some good macro talking points.

My take: Macro is complex. That’s precisely why the MWI Worldwide Flexible fund allocates roughly a quarter of its assets to each of cash, bond, equities, and gold / hard assets.  Because I just don’t know. However, each of those assets protects against certain outcomes and gains from other outcomes, providing a reasonably stable real return in US$ terms, without making any macro forecasts.

Remember “Creep” by Radiohead? That glorious guitar crunch in the bridge between the wistful verse and the angry chorus? What a special song. Especially for those of us who suffer from a bit of imposter syndrome every now and then.

Here is one of the best videos I’ve seen of one of my favourite Radiohead songs:

And here they are, thirteen years later, playing it live to a slightly bigger audience:

That’s all for this week! And remember, it pays to be careful out there!

Piet Viljoen
RECM