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M&A: When Is the Bite Too Big to Chew?

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. As we've seen some high-profile M&A deals come across the newswires recently, we decided to check in Dave Sekera, a senior securities analyst, and Mike Hodel, associate director of equity research, to talk about what these deals might mean to the financial health of companies, how they assess the financial health of companies in these deals, and also the ability of companies to get credit and get deals done?

Thanks, for joining me guys.

Mike Hodel: Thank you.

Dave Sekera: Thank you.

Stipp: First question for you. You recently did an analysis on the 3PAR, HP, Dell fight, the battle that they're having over that acquisition, right now. It's an interesting one, because I think it started out at $18 per share offer, and now it's close to double that, which potentially seems like, that's a lot bigger price tag than before.

When you ran the numbers and looked at the effect of this potential purchase on either HP or Dell, whoever happens to win, what did you see, is it becoming too big of a bite to chew?

Hodel: Looking at the bidding war that's going on right now for 3PAR, we think it's really more of an issue for equityholders than debtholders, and even on the equity side, it's not a huge deal, simply because 3PAR is pretty small relative to HP and Dell. It's a $2 billion type acquisition right now given where the bidding is at and these are companies that have immense amounts of cash in their balance sheet. Dell has about $13 billion in cash sitting around. HP has about $14 billion, so both of these companies can complete this deal without having a material impact on their balance sheets.

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And also again from the equity side, the deal is just simply too small relative to the overall value of these two companies. At the same time, we do think it is somewhat of an issue for equityholders because there is a bit of winner's curse going on here. The company that does end up acquiring 3PAR probably will pay a little bit too much, but that said, we've seen companies have pretty good success with small storage technology acquisitions in the past, and we think that either HP or Dell will be successful in integrating 3PAR into their existing product line ups and will do well with the acquisition. It really is just a matter of valuation.

Stipp: Dave, taking step back and looking at the environment for M&A. I think that some folks who have talked about how cash has kind of being piling up on some balance sheets, we're still not seeing a lot of hiring coming out of companies. So it seems like maybe they are not spending their money in certain areas, but M&A might be an area that they are spending their money. And do you see a lot of dry powder out there that we might start to see more deals happen or do you think that this heating up of the M&A is just sort of a little burst of activity right now?

Sekera: On the M&A environment, I do think there is definitely dry powder for the strategic acquirers. Over the course of the past year, companies have been building up cash on the balance sheet. They do have debt capacity. The public debt capital markets are definitely open and able to go out and get some very cheap financing. Treasury spreads are close to all time lows. Credit spreads probably in the middle towards bottom of the range right now for what we've seen over the past couple of months, their all-in coupon rates are pretty cheap.

Stipp: Speaking of, if we do start to see some more deals happen, obviously, not all deals are good, in fact, a lot of M&A deals turn out to not only really add a lot of value. Are there any situations where you would look at it from a credit perspective or balance sheet perspective and really start to have concerns about whether a deal should really happen or not if you were an existing shareholder. What red flags would go up to indicate that maybe this deal [is something] you should really be concerned about?

Hodel: Well, clearly, the key thing we look at is what a company's credit metrics will look like after a deal relative to what they look like before completing the deal. And anytime you have an acquisition that significantly alters the credit profile of a company, as a creditor, you have to be concerned.

One situation that we've seen recently is with CenturyLink and Qwest where we thought CenturyLink was a pretty solid company as a stand-alone; we're not nearly as favorably disposed to Qwest, and we think it's a fairly weak credit. CenturyLink merging with Qwest we think results in a combined company that's weaker than CenturyLink was in a stand-alone.

So, again, from a creditor perspective and looking at what the company will look like post-deal versus pre-deal, we think that that, in particular, is a concerning situation for creditors, and it really comes down to looking at what the company will look like after the acquisition is done.

In the cases of some of the tech acquisitions we've seen recently, most likely these deals will be favorable from a credit perspective. You have companies like Intel deploying cash to buy McAfee, Dell or HP buying 3PAR. The deploying cash, otherwise, would have been sitting on the balance sheet and earning a very low return. By going out and making acquisitions, hopefully, you'll be picking up assets that will generate nice cash flow that will enable these firms to better service their debt load over time.

Stipp: Dave, last question, as you are thinking about the different avenues that companies have available to finance an acquisition, what's it looking like from a broader perspective of company's ability to raise capital? What avenues are open to them, what avenue is still a little bit tight and how might that affect the situation and the way the companies can raise money and then ultimately deploy it?

Sekera: For the strategic acquirers, as we mentioned, we think the markets are open. As long as the pro forma credit metrics really don't deteriorate, very much, pro forma for the transaction, they should be able to go to the public markets, be able to get the financing. When you look at spreads probably in the 200 to 300 basis point range for BBB issuers, you've got 2.5% Treasury rates, your all-in rates are looking pretty good for your weighted average cost of capital.

The thing that we really haven't seen as much of is the private equity universe coming out and doing LBOs. I think a big portion of that is that the markets right now are still very cautious in taking on those kind of leverage metrics that we saw two, three years ago. Also, the banks just don't have that much debt capacity as far as putting out commitment letters for the senior secured or the bank loan tranche of the capital structure.

So, while interestingly the capital markets are open for public bondholders to be able to issue and take down new debt, it's the banks really that don't want to be out there issuing very much, maybe 2, 2.5 times through the senior secured layer of the capital structure, and then trying to find the rest of that capacity through the public bondholders. But at the end of the day, in order to make the deals work, the private equity sponsors will be required to put up a lot more equity than what they are used to and I think they are having a tough time swallowing that.

Stipp: Well, very interesting insights. Thanks so much for joining me today guys for your insights on M&A.

Sekera: Thank you.

Hodel: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.