Thursday, October 05, 2006

Hedge Funds: Game Over, Part II…When “It” Girls Don’t Read the Fine Print

There’s a company with which I’m familiar that’s been around a long time. It has good management and a nice portfolio of products generating reasonable sales growth at healthy margins, year after year.

On top of that, the business throws off more cash than it requires for plant and equipment, so the management team does what it has been doing for decades: it finds businesses or individual product lines that fit the existing franchise, and buys them at prices which make sense. And if the company can’t find the right fit at the right price, the company doesn’t buy.

Since the stock of this company is owned by the founding family as well as public shareholders, management isn't pressured to do the wrong thing for a short-term pop in the stock: instead, it has the leisure to think about, and act on, the company’s long-term interest.

So it was a bit of a head-scratcher when a hedge fund showed up a couple of quarters ago suddenly owning almost 10% of the company’s stock and presenting itself as one of those ‘activist’ shareholders who stirs things up by prodding management into making stock-moving business decisions for the benefit of public shareholders.

After all, ‘activist’ hedge funds tend to target woefully mismanaged companies whose executives spend money egregiously on themselves or their own pet projects at the expense of public shareholders. They don't tend to go after good companies with happy shareholders.

My own view of ‘activist’ hedge funds is that they are—aside from a handful that have been doing it very well for many years (my old pal at Third Point, Dan Loeb, comes to mind on that score)—the “It” Girls of Finance in the Year 2006.

Seems anybody with a billion dollars of nervous, we-will-withdraw-in-a-heartbeat-if-you-have-two-bad-days-in-a-row money, a Bloomberg terminal and a publicist can be an activist hedge fund nowadays.

And, indeed, the shallowness behind the bluster of the activists agitating for change at the company in question was amply demonstrated on the company’s very next earnings call, when the “It” Girl’s Chief Activist queried management what it planned to do about the company’s “incredibly unleveraged” balance sheet.

For those of you not fluent in the code of activist phraseology, “incredibly unleveraged” means the balance sheet is simply too healthy.

The most obvious way to fix this apparent deficiency, in most activists' playbooks, would be for the company to act like a private equity owner by loading the balance sheet with debt in order to return cash to the shareholders via a share buyback at a fancy price well above the activist’s cost, leaving the company with a crippled balance sheet and reduced growth prospects while the “It” Girl moves on to the next “incredibly unleveraged” target.

Sort of like being a Miami condo flipper, until that game ended last fall.

The only problem in this particular “It” Girl’s case is that the company in question has a Class A/B stock, in which one class of shares has voting power while the other class does not.

Guess which stock the founding family controls? That’s right: the voting shares.

Apparently our “It” Girl activist friends never read the fine print. Or, if they did, they decided that the current environment is so activist-friendly that their powers of persuasion and displays of righteous indignation would cause management to throw forty years of careful stewardship out the window for the sake of a brief pop in the stock and the opportunity for the knuckleheads in question to sell out and move on to the next “incredibly unleveraged”—i.e. healthy—company.

They were wrong.

And having been proved wrong, they are, according to my Bloomberg, selling.

Maybe they'll read the fine print next time.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


hundredyearstorm said...

Fantastic piece Jeff. The activist "prescription" for every situation is the same: sell off assets, lever up, buyback stock. Basically they are saying, buy my stock back at a higher price, future growth be damned.

The fun will come when the activists and their tag along followers get stuck in the small cap illiquid situations where they've graciously chosen to "add value".

BaronofBanks said...

Great post. I will remember activists as "It" girls of finance 2006 for some time. said...

Jeff, give us readers more rope... which activist was it?

BTW, I believe you would also like Bob Chapman's definition of a related activist type (CANI's 13d): "activist remora"

wsf said...

Good article. Why all the secrecy on who the good guys/bad guys are?

voiceoftheemployee said...

ill wager a guess:

heinz vs nelson peltz?? said...

(Probably) NOT Nelson Peltz and Heinz.

Peltz got about 5% while jeff mentioned 10%. More importantly, Heinz is highly leveraged (debt=~75% of capital) - not a company you'd call "incredibly unleveraged".

Common Jeff, stop playing with your readers... throw in a rope (please)

Sam S. Park said...

Yeah Jeff, throw a bone or something.

Is this company looking to buy another firm (perhaps one in which this hedge fund has stake)? Also, does he have a put option on this increadibly unleveraged company? Maybe the dude is in it for the vote buying... or not.

If he is an activist like Dan Loeb... does he write wonderfully uplifting letters like him as well?

Sam S. Park said...

Oooh I know... It's Pelz and Wendy's you're talking about.

Not quite 10%, but 6.8% is close. WEN only has .36 D/E.
Not sure how much of the family owns the company... but it was named after Dave's Daughter Wendy...

RichL said...

Just wait until the next bear market, when the "paint yourself into a corner" style of investing will have the flaws truly revealed. This tactic works much better in cheap markets where there are more obvious overlay bets. Now small cap stocks are largely more expensive than their large cap brethren, so the hope is for a greater fool (otherwise known as private equity) to buy the raider out. For the investor outside the 13-D group, you now have to do your own value work rather than passively play process.

The Irrational Investor said...

very "Money of the Mind". Arrrr.

Aaron Koral said...

So Jeff, do you think the analyst who "pounded the table" for that trade is still working for the hedge fund alluded to? I doubt it! You made me laugh again with another excellent post "Professor"!

finanz101 said...

Great post Jeff, but I'm a little surprised you single out Dan Loeb as one of the good guys. Certainly, he's been guilty of targeting underleveraged companies and bullying them for a little financial engineering in favor of equity holders. No playing favorites.

Sam E. Antar said...

Your comment:
Apparently our “It” Girl activist friends never read the fine print.

My Response:
If their accountants were charged with the due diligence I refer you to my previous comments in your blog about the lack of education, training, skills, and experience in the accounting profession.

In the Crazy Eddie fraud I changed our accounting policy with regards to trade discounts and allowances and the auditors “claimed” to never have noticed the change in the footnotes. Massive fraud resulted.

If their accountants did not participate in the due diligence then there is another answer which the following phrase is used in conjunction with the problem of education in America today – “Why Johnny can’t read”

Market Participant said...

Pelz and Heinz, mostly had to do with the great historical mismanagement of Heinz.

===== As Pelz noted:

While Heinz’s management may argue that the Company’s SG&A spending as a percentage of net revenue is not out of-line with its peers, we also believe that the cost structure at Heinz is symptomatic of a broader and unnecessary theme across the food industry – that of excessive costs and inefficiency.

The only reason that Snapple didn't bankrupt some other major food company is that Quaker bought it first.

Ultimately activist investors will be sucessful only to the extent that they can make a case for their existance. Annoucning that every public company needs the PEQ treatment isn't helpful. Management will ignore such activists, and they will go away.

People like Nelson Pelz have bright future because they are in for the long run and in for real value creation.