My Thoughts on the KKR and FDC Deal

So let’s start with the stock chart of FDC:

Notice in October of last year the FDC stock price took a huge dive of about 50%. Since then the stock price has moved up slightly. KKR is willing to pay 34 USD per share, which puts the price half way between the beginning and end of the drop. A good deal, right? After all the price KKR is willing to pay is less than the high of April 2006.

Though, you have to ask yourself what happened in October? In October FDC let out the news that they spun off the Western Union division, and companies like Goldman Sachs rerated FDC from a buy to neutral:

LONDON (MarketWatch) — Goldman Sachs cut I.T. services provider First Data Corp. to neutral from buy, saying that following the spinoff of Western Union, it finds valuation less compelling given the stand alone company’s lower return on capital and long-term growth.

I can understand the comment, and can understand why the rating should be neutral. But, somehow these comments are in contradiction with text from the first referenced link.

Citigroup, Credit Suisse, Deutsche Bank, HSBC, Lehman Brothers, Goldman Sachs are providing debt financing and advised KKR.

Look at what is underlined, Goldman Sachs! So what happened to your October assessment Goldman Sachs? The Business Week article mentioned the hypo-critical attitude of Goldman-Sachs and said a report issued by Goldman Sachs addressed the dual attitude as a good thing. The report said that bad stocks often make good buyouts.

Let’s recap this. One division in Goldman Sachs said FDC bad, another division said FDC good, and a third division said, “its ok to say bad and good at the same time because of x.” Yeah, really? Explain this one to your kids and see how their faces cringe. I could believe this report if a stock investor and private equity investor had different investing goals. But the reality is that public stock investors and private equity investors have the same goals and that is to create value. Even though some in the industry would have you believe otherwise (eg stock investors are grubby, etc). So somebody in Goldman Sachs is right and somebody is wrong. I saw a study on European M&A activity that has me leaning towards person who did the rerating of FDC from buy to neutral. The study found only 9% of all mergers and acquisitions proved completely successful. This attitude of buying dog companies I find funny because it runs counter to what tech companies do. Google bought YouTube, EBay bought PayPal, and SKYPE. All purchases were best of breed purchases, not dog companies.

Getting back to looking at the overall deal, I don’t understand this deal because the math does not seem to add up. I looked at the financial’s of FDC (1,2) and was not impressed. In Dec 2005 FDC had revenues of 10 billion. Due to the spin of Western Union revenue dropped to 7 billion. But what is worrisome is that gross profit was halved. The net income does not show the drop because they are adding in 665 million of Western Union monies. Without it net income would be almost halved. Revenue dropped by a quarter, profits by a half, and it tells me who got the better side of the spin off. Revenue and profit wise this does not look like a good deal.

Assuming as per the Business Week article cash flow is good, are the pure financial’s sound? Let’s say I was to loan KKR 30 billion. Using plain vanilla pricing FDC has to earn me more returns than putting my money in an fixed income account. Right now interest rates are about 5.25% meaning FDC has to return to me at least 1.57 billion per year. Looking at their gross profit per year of 2.2 billion it should be no problem, right? Well I am not so sure. Gross profit is a very crude measure of profitability as there are many expenses that need to be accounted for. If you look at their operating income which is about 1.0 to 2.33 billion FDC is going to struggle trying to earn more money than what I can make by buying Treasuries.

Ok, so how does KKR make money? After all, FDC is barely making more than T-Bills. You could take the long term view and say that eventually you will get your money back. Hmmm…. I found the following on the KKR site.

Our deals, though far from formulaic, share some basic features: KKR provides equity dollars and borrows money for the friendly acquisition of a business with predictable cash flows and strong management. The capital structure of the acquired business depends on the strategy for value creation, which is jointly developed by management and KKR. We work with our portfolio companies to design and execute plans for improving operations in such areas as manufacturing, sales, and marketing. Over time, generally several years, we exit our investments through IPOs, secondary offerings, and sales to strategic buyers. When investments are sold, profits are distributed to our investors, which include corporate and public pension plans, financial institutions, insurance companies, and university endowments.

Ah, I see. You take a company private then “create value” over the span of “several years” and sell it again letting the new buyers believe that they are getting a “good deal.” Several years are not enough to create value and this has me thinking somebody is getting the short end of a stick. I am guessing the individual investor who was duped into a “good deal” is getting the short end of the stick.

Unless I read the numbers wrong, or am not seeing something that others are seeing I feel the FDC deal is a bad deal. Or let me put this succinctly, for the amount that KKR is paying FDC is a bad deal. Looking at the numbers I think a fair valuation would have been 15 to 20 billion.

So why did KKR buy FDC? I think a quote from Business Week sums it up.

By that measure, First Data is plenty attractive. The company had solid cash flow of $1.1 billion in 2006. The company also has the ability to enter new markets, which can reward private equity investors who have a longer time horizon than many public shareholders. “This is a textbook private equity deal,” says Phillip Phan, professor of management at the Lally School of Management & Technology at Rensselaer Polytechnic Institute in Troy, N.Y.

I guess I am the idiot! Oh yeah I am not considering the “cash flow” of 1.1 billion that would barely cover interest payments. It’s not that I don’t look at cash flow, but I feel cashflow is too optimistic for me, and it hides management errors all too well. But hey, private equity is smarter…

In the First Data deal, the biggest risk for KKR may be the prospect of a rival suitor. The deal includes a “go-shop” provision that allows First Data several weeks to consider a better offer, should one come along. That’s an increasingly common technique that allows boards to argue that they are accepting the highest possible price (see BusinessWeek.com, 2/12/07, “Private Equity Slugfest”). Should that happen, a bidding war could raise the price of a deal and make a First Data buyout less attractive.

I have a personal rule, never engage in a bidding war because even if you win you lost!