11 December, 2019
Ongoing saga in shares of Xerox and HP makes many investors think about potential outcomes of this situation. HP’s market cap is almost four times larger than Xerox’s. HP’s annual sales are $59 bil compared to Xerox’s $9 bil, almost seven times larger. The offer proposes HP’s shareholders to receive most of current market value of HP shares in the form of a cash payment (77%) while the remaining part will be turned into shares of the combined company. From the outside, all this looks like an attractive deal: HP shareholders will obtain a 48% stake in the new company and jointly with Xerox will enjoy the fruits of synergies and cost savings. Paradise, is not it?
If you look at it with a more critical eye, things don’t look so rosy. First, who told Carl Icahn that HP shareholders need an outside third party to provide banking or cash-in services to them? They are investors in business, not a grandmother holding all her savings in cash under the mattress. If they will want to cash-in, they will find a way to do it – by selling at the open market, for example. Maybe some large shareholders have little less flexibility, but company’s (HP’s) management can always help here and return excess cash to shareholders in the form of a buyback. In fact, they confirmed that they are willing to do it.
On October 3rd, 2019, HP announced that on September 30th, 2019, its board of directors increased share repurchase authorization amount by $5 bil, bringing it to $6.7 bil. And the company indicated that it expects to generate at least $3 billion of free cash flow in fiscal 2020 and return at least 75% of it in the form of dividends and share buybacks. And let’s not forget that shareholders get flexibility not only with Icahn’s offer but under do-nothing scenario as well: once company returns the cash through dividend or buyback, shareholders can always make their choice and “cash-in” or keep the shares and stay with a more “leveraged” company.
HP shareholders should understand that not them, and not company’s management need the help of an outside third party. HP’s management is capable to recap the company and increase leverage, and they don’t need anyone’s help with that. Especially the help of someone who charges pretty high fees for his services: give up 52% of your business.
In my book Risk Investing I argue that one of the ways for investors to address the risk problem and “the observer and the observed paradox” is to look at investment situations where there exists a certain “risk-structure” at the level of the equity and company itself. If investors can make themselves and stocks they invest in less dependent on general market, for example, the risk profile could be improved. I think that current situation in shares of HP presents such an idiosyncratic opportunity: buyout offer in place (which might be increased), share buybacks, ongoing restructuring and cost-savings process.
I believe that HP shareholders should be aligned with HP’s management and say firm NO to Xerox and Icahn’s proposal.
The simplest way to see that this is a right decision is to look at the same type of deal but in reverse. Offer price of $22 currently represents 9% premium to recent price of HP’s shares. Applying the same premium to Xerox’s recent share price of $36.76 gives a possible purchase price of $40.03. If HP would finance the deal similarly, Xerox shareholders would get 77% of purchase price in cash ($30.82) and 23% in stock (value of $1,989 million). At HP’s recent share price of $20.2 this represents 98.5 million shares or 0.456 HP share for each share of Xerox. The combined company will thus have approximately 1,578 million shares outstanding. So, Xerox shareholders will remain with a stake of only 6.24% percent in the combined company.
So, the bottom line is clear: HP shareholders should say a firm NO to an attempt to turn them from investors and business owners into decorations in someone’s else theater.