IBM to buy Redhat.

An interesting deal.  IBM has a strong presence in this area, and of course Redhat is a Raleigh based company.   Details of the deal are here: https://www.marketplace.org/2018/10/29/business/ibm-bets-34-billion-cloud-computing-red-hat-purchase.

A back of the envelope analysis suggests that there's about $7bn in merger gains.

Surplus cash, managerial discipline and Instagram

So Facebook just dropped a cool $1 billion for Instagram (the app that turns your 5MP iPhone 4S camera into a crappy 1970s Polaroid).   Apart from the fact that posting faded pictures of your dog on Facebook is going to get old pretty soon once everyone does it, there is actually a finance issue here.

Back in 1986, Michael Jensen argued that excessive free cash flow can lead to agency problems where managers use the cash to expand their empires (American Economic Review).  This seems to be applicable in this case.

Instagram has no revenue to speak of, although it does have 30 million users (actually 30 million downloads of the app).  There are currently 12 people working there (12 very rich people).  While it is clear that Instagram must be worth something, $1billion seems a very convenient round number, and a rather high one at that.

When I consider other companies currently worth about a billion dollars:  Strayer, Scholastic, Cooper Tire, I am forced to conclude that Facebook overpaid.  But I am not surprised.  Facebook is a classic case of what Jensen talked about in his seminal paper.  The company has a huge amount of cash, it has no need to go to the market (and thus face market discipline), and the CEO has few limits on his decision making.  As a result it will continue to burn money like there is no tomorrow.

Here's my Instagram tribute to the deal.  A $10 bill (1/100,000,000 of the deal) on my copy of the classic corporate finance text that discusses managerial agency issues.

Merrill Lynch and Lehman buyouts, 3 years later.

New York Times discusses how a couple of marriages from the financial crisis are working out.

Worried Retirees

My local paper, the News and Observer, published a letter from a worried retiree of Progress Energy.  For those not following our local news, Progress Energy (NYSE:PGN) is merging with Duke Energy (NYSE:DUK).  PGN is located here in Raleigh and so there are many folks in the area who have worked for the company and are now retirees.

The letter expressed concerns as to how the merger would affect the retirees dividend stream from her PGN stock, which was presumably bought as part of some company employee stock ownership plan.

For students of finance, and in particular corporate finance, see if you can spot the major misconceptions held by the letter writer.  For bonus points, advise the writer as to whether or not she might want to diversify her portfolio.

The link to the letter is here.

The text is here:

The Fortune 500 company was once CP&L, and then it became Progress Energy. Now that the company I loved is going to be Duke Energy, I wonder what is in store for the employees - especially for the retired employees.

When I worked at CP&L, the company valued its employees parallel to safety and the bottom line. This change is a major worry. How will Duke treat CP&L's vested retirement plan? What about dividends paid? Will they be paid at Duke's rate or Progress Energy's rate? Will dividends be increased from time to time as before?

Enhancing our stock value by 6.4 percent may be good news for some, but for us who reinvest dividends, the enhanced value is not exciting - we will be buying fewer shares.

I am in shock and saddened that "my company" is being sold. When I joined CP&L, the personnel representative told me if I worked hard and kept my nose clean, I could retire there. I wonder what he would say now.

The buyout, or merger, whichever it is, may be a sound business transaction, but retired employees, who are nostalgic, feel a great loss of connection and of pride, and we are concerned for our future financial security.

Retired CP&L 1994

How Buffet values mergers

Warren Buffet is the largest shareholder of Kraft and he's not happy that Kraft is buying the UK chocolate manufacturer, Cadbury. He thinks Kraft is paying too much.

A couple of bloggers have posted his comments and tried to analyze them. As usual with Buffet, he doesn't do rocket science. Well worth a read.

Check the links here, here.

Trouble with stock options, part deux

We've heard plenty about the option backdating scandal in which firms retroactively awarded stock options at the lowest stock price of the quarter.

Well now there appears to be a new, but related scandal brewing. The WSJ discusses a new study by Fich, Cai and Tran at Drexel U. who find that firms that are in merger negotiations are pretty liberal with their option grants.

They allege that when negotiations about a merger are being quietly made, the target firm grants options to the CEO of the target. Then, when the merger is announced the stock price will most likely go up and the CEO makes out.

One possible explanation is that you want to incent the CEO to get the best possible price from the merger, and options will do that. But as is pointed out in the article, the CEO's pay package should already provide the correct incentives if it is well constructed.

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