Philip Mause
submits:
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When I started thinking about the gap between interest rates and
earnings yields on stocks, one idea that occurred to me was that
the "private market" value of various enterprises should increase
as interest rates go down because the discount rate applied to a
stream of earnings would tend to decline with declines in
prevailing interest rates. This "private market" value manifests
itself in various ways - usually in prices paid in LBO and cash for
stock transactions. To the extent that stock prices reflect equity
valuations that are sharply at odds with the "private market" value
of the underlying enterprises, transactions are likely to occur
which close the gap. These transactions are frequently LBOs or cash
for stock acquisitions at prices higher than the pre-acquisition
market price of the stock. These transactions may tend to close the
gap by reducing the amount of stock in circulation and also by
creating an increase in the price of stocks that speculators
consider ripe for acquisition.
At any rate, in an earlier piece I demonstrated that, with very low
interest rate debt, a company could increase its overall and per
share earnings by making an acquisition in a cash for stock
transaction as long as the earnings yield on the acquired entity is
greater than the after tax cost of debt incurred to make the
acquisition. Of course, for a very large company, the impact of
acquiring a much smaller company upon earnings may not be
significant. That is why EasyLink Services (
ESIC
) is a good case study for this proposition. ESIC has recently
acquired an entitiy which, pre-acquisition, was actually larger
than ESIC itself.
ESIC is a leader in the supply chain messaging and on demand
messaging spaces. Pre-acquistion, it had annual revenue in the
80-85 million dollar range. Its annual financial statements
included accounting entries for tax loss carry forwards and other
non-cash charges and income items and so it is a bit difficult to
tease out normalized earnings. ESIC was steadily retiring debt at a
rate of $10-12 million a year. Making reasonable assumptions about
these accounting entries, ESIC's free cash flow was roughly $12
million a year and its earnings were roughly $6 million a year or
20 cents per share. (ESIC has roughly 29 million shares.)
Last month, ESIC announced the acquistion of the iSend and
iNotify operations of PGI. These businesses are similar to ESIC's
operations and, in fact, frequently bid for business against ESIC
before being acquired. ESIC paid $105 million for the acquisition
and financed it with notes carrying rather complex interest rate
terms under which interest at closing was 4.25%. The acquired
operation has gross income of roughly $113 million, EBIDTA of
$26-27 million and earnings of roughly $12 million. Conservatively
estimating after tax interest expense at $4 million a year, this
transaction produces an enormous increase in both income and cash
flow for ESIC.
ESIC has estimated $5 million worth of synergies and estimates
that the combined entity will produce EBITDA of $40-45 million a
year and earnings of 40 to 60 cents per share(it appears that there
has not been any increase in the number of shares of ESIC
associated with the transaction). Given that the transaction
combines two companies that frequently bid against one another for
business, this estimate may be conservative. The cash flow should
enable ESIC to retire the debt in roughly 4 years.
Of course, as in any business situation, things can go wrong but
the market liked the transaction: ESIC's stock was trading at $2.88
before the transaction and popped up quickly - it is now trading at
$3.95. Assuming that the above projections of earnings are
reasonable, it would not be surprising to see it move up to the
$5-6 range, and possibly higher, after a couple of quarterly
reports of the combined entity. Once the debt is repaid, $8 (or
double the current price) would not be an outlandish
expectation.
ESIC is not Wal-Mart (
WMT
) or Coca-Cola (
KO
) and is not able to borrow at .75% interest. On the other hand,
its ability to bring this transaction in at a 4.25% interest rate
on the debt is an important factor in allowing earnings to shoot up
immediately. Because the acquisition was large in relation to the
size of the acquiring entity, the impact on earnings and the stock
price is substantial.
It increasingly appears that ultra-low interest rates may be
with us for a long time. The Fed likes to make changes step-wise.
Before it targets higher rates for short term treasuries, it would
likely stop QE2, then stop reinvesting funds from maturing agency
bonds, then unwind QE2, then change the "extended period" language,
at which point we may be getting close to the 2012 election and the
Fed does not like to raise interest rates right before an
election.
Corporations may use the availability of low interest rates to
do what ESIC has just done and enhance their earnings through cash
for stock acquisitions. I have been reviewing acquisitions and it
appears that we are seeing more cash for stock and less stock for
stock, but I have not quantified it. At any rate, this is another
kind of transaction which should be monitored to better understand
how the unprecedented-in-recent-years gap between interest rates
and earnings yields will play out.
Disclosure:
Author long ESIC, WMT, KO
See also
Google, The Sometimes Honest Broker
on seekingalpha.com