PFG - IBM - KKR _ About rates, spinoffs, and M&A
Updated: Nov 6, 2021
This post is meant to discuss three business cases that are developing right now. They are strategically challenging and could positively stimulate people interested in strategically reduce and frame situations. We will lay down below the critical, strategic, and quantitative bases possibly constituting an effective approaching method. Each case will have some details on the dynamics of the respective industry, and it will end with questions rather than conclusions.
We will discuss three publicly traded corporations which in recent financial reports disclosed three big pieces of information that in the long term are likely to determine the fortunes of their businesses. A stockholder - not necessarily a shareholder - of those corporations should focus and possibly act on those disclosures because the impacts are likely to dwarf all other processes going on within the businesses. We will characterize those three situations with a focus on the valuation of the business: we will use the current Price over Earnings ratio (PE) of each one of those companies [and stocks], we will figure the possible impact on annual earnings, and we will estimate the effect on valuation.
To be clear, this post will not say “invest” nor “not invest in this stock”. This post will focus on those three companies because they are believed to have major dynamics and initiatives under development that could be intellectually rewarding if strategically examined. A final judgment is left to the reader.
PFG and interest rates
PFG is the trading ticker for Principal Financial Group, a US company offering retirement, insurance, and asset management solutions. We can consider PFG a financial services company, usually involving having books (i.e. balance sheets) loaded with assets and liabilities from and to clients.
We could reduce financial services companies by saying that what makes them tough to handle is the uncertainty about the future. If a bank can lend [say] $10 for each $1 it holds, it is important to constantly evaluate the potential claims on that $1, which is covering the $10 outstanding. Insurance businesses take that a step further by having to hold enough cash to match possible future claims on underwrote policies. Say an insurance company agrees to cover five customers for a maximum of $10 M each for the next 10 years, it would not be efficient to just hold $50 M for the entire time to just be prepared in case something bad happened. Everything relies on good discounting of future events: first, we must correctly account for the probability of a specific event happening in [say] one year from now (like the probability of having to match a claim from an insured house against fire); second, we must correctly compute the present value of that possible and future claim. If we think we have to pay $1 in one year (probability discounted outflow in one year), we won’t hold today $1 because a lower sum invested at risk-free rates (e.g. invested in a one year Treasury) would do the job by maturing in one year to that $1. So, interest rates play a major role by representing the risk-free base opportunity. It is important to note however that, rates going up and down can have opposite and mixed results on companies like PFG: a bond an insurance company may be invested in could gain from a drop in interest rate. The net and overall results of rates’ trends depends in big part from the underneath structure of a specific company’s balance sheet and holdings.
Readers may have noticed that the unfortunate events of 2020 have forced central banks to drastically hold rates down, and while that has impacted almost any business endeavor, it is certainly so for companies like PFG. Even if Principal Financial has not substantially modified the projected future claims from coverages, the required present value (i.e. amounts) of the holdings required to withstands those future claims have substantially increased because of the lower discounting – the same goes for retirement solutions. All that resulted in PFG taking a hit in recent months and reporting an actuarial loss in its recent earnings – that actuarial adjustment happens annually, however, this time it was particularly severe.
Focusing on PFG price and price over earnings ratio (EPS), the stock was trading at about $42 per share before the latest earnings release in September, or about 9.2 times the $4.54 EPS of the last four quarters (figure 1 – from PFG financial reports).
Considering the last quarter ended September 2020, the trailing earnings drop to $4.41, and if we used the same valuation metric, the implied price per share would decrease to $40.8. Among the factors contributing to that drop in earnings, there were different dynamics related to the pandemic: extraordinary withdrawals, different expenses (for some accounts reduced), etc. However, the actuarial effect of rates is critical in this release, and that is evident from the slide shown in figure 2 and released in September. Operating earnings for Q3 2020 were in line or even higher than Q3 2019 before the actuarial variance; then, considering the adjustment, they drop from $510 to $277.
Readers might focus on the trends across business lines (e.g. retirement, insurance, etc.), however, a stakeholder should first decide how to evaluate the overall impact of interest rates. Will that kind of actuarial impact continue in the following quarters and take the implied value per share even lower than $40.8? Or, should we consider that actuarial adjustment a one off event not impacting the following quarters and the intrinsic value of PFG business? What is the current exposure to lower levels of rates and actuarial adjustments considering current rates and the duration of PFG holdings? – the "duration" gives an idea of the extension in time of the policies and commitments, with the longer durations being more heavily impacted by actuarial adjustments because of longer compounding.
IBM and spinoffs
IBM is the trading ticker for International Business Machines Corp (or just IBM). After having transitioned toward services in the past decades, the company has more recently transitioned back toward products. Products are not laptops anymore, they are IT infrastructures, and more specifically, cloud & AI solutions. Related to that strategy, among the numerous acquisitions a company like IBM goes through in any given year, IBM recently bought RedHat, a company specializing in open-source cloud solutions – a deal reported to be valued at about $34 Bil.
IBM has been struggling to maintain sales at the $80 Bil/year level of the last few years, and the only business unit showing growth is the one named Cloud & Cognitive Solutions (cloud & AI solutions) – the others being all focused on services and related. Numbers are not fully disclosed, but if we accounted for 2018/19 pre-acquisition revenues and growth of both IBM cloud business and RedHat (respectively $5.5 Bil/quarter +2% YoY, and $880 M/quarter + 17% YoY), we would be inclined to think that the majority of the current growth within IBM’s cloud business is related mostly to the RedHat non-organic addition. Actually, RedHat may be offsetting some decline of the original IBM cloud business: Q2 2020 tot IBM cloud revenues $5.7 Bil, only +3.6% over the $5.5 Bil/qrt pre-acquisition, and with RedHat assumed to be contributing something like $1.1 Bil/qrt (considering 2018 sales and growth reported above). It is worth noting that in the future the old IBM cloud business and the RedHat addition may start generating commercial synergies growing altogether.
IBM has recently announced that it will spin-off (i.e. sell separately) the older Services divisions into a NewCo – new name not yet defined – and it will keep under the old IBM name and entity only the promising Cloud business, of which RedHat is now part of (figure 3 below summarizes the transaction). That is not unusual for corporations having developed from within business units believed to have growth potential higher than the rest of the business (a different example from the recent past is Baxter spinning off the biopharma division into Baxalta … then almost immediately acquired by Shire … then acquired by Takeda).
Note, below we will assume a spin-off, but the concepts would apply with some tweaks even if the final implementation resembled more a split-up/off or other forms; major differences would likely pertain to taxes and how investors would realize the possible gains.
We could consider IBM as being part of the Technology sector and more specifically of the IT Services industry. Again, using Price over Earnings ratios to summarize the current valuation the market is assigning to the stock, we can quickly realize how IBM is currently not favored by investors: while the average Price over Earnings of the IT sector is around 58, IBM is trading at about 14. That means that the same investor who is requiring Microsoft to yield only 2.8% on the investment (Microsoft’s PE being 35), requires IBM to return more than 7%. Part of that could be related to Microsoft being and being recognized a Technology Infrastructure company and IBM being still considered a Technology Services company. Indeed, that is likely to be the reason why IBM wants to make its cloud (i.e. infrastructure) business independent. Say IBM sold that business unit to the market for 50 PE multiples similarly to the IT’s average, it would capitalize together with its shareholders on the difference with the current valuation. Someone buying the stock today at about the current $125 per share (14 times the trailing $8.9 earnings per share) would capitalize on ($8.9 x share of Earnings coming from the Cloud business) x (50 – 14). Will the market recognize that independent business as a cloud infrastructure business, and increase its valuation to a multiple of 50? Will investors believe that the Cloud business has indeed a growth potential similar to Microsoft and its peers? Or, is IBM selling to capitalize before the positive RedHat effect on revenues will soon be negatively offset by the decline of the original IBM Cloud business and take even the new cloud-focused IBM to negative territories?
KKR and M&A
KKR is the trading ticker for KKR & Co Inc. (those are the initials of the three founders of the company). KKR is one of the leading private equity firms and probably one of the few that have defined the business - at least until recent when both the private equity business and KKR have probably departed from that original concept and developed independently. The company makes money through fees charged to investors for investing their money, and through the gains [and losses] on the actual investments – it retains part of the profits it generates for investors.
A lot could be said about strategies in private equity, however, the bottom line is that investment managers would like to gather an ever-increasing amount of assets under management (AUM) to capitalize on managing fees, the base revenues of the business. One way to gain a first idea of the potential of the business is to figure the potential growth of the managed pool in time and consequently, the earning capability through the charged fees - in the case of KKR, fees can be below 1% of AUM, mostly because of the large amount of assets under management. On top of that, we could add a historical capital gain on the investments and the historical share that KKR retains on that. Of course, valuing KKR is not exactly that easy considering the complexity of the firm across funds, specialties, and regions, however, if we were investors comfortable with investigating that type of companies, we should focus on the recent announcement of the acquisition by KKR of Global Atlantic (GA), a business offering insurance and retirement solutions.
The investment of KKR in Global Atlantic has deep strategic reasons in part disclosed on the public material of the acquisition. Simplifying the financial events, GA is acquired at about 1 time its book value, about $4.4 Bil. That kind of valuation is common for financial services firms which are tough to value in terms of cash flows and are often sized in terms of Book Value = Assets – Liabilities (what investors would get in an optimal liquidation); it is good to always compare it with Tangible Book Value = (Assets – Goodwill & Intangibles) - Liabilities. In terms of PE multiple, those $4.4 Bil represent about 10 times earnings, considering GA’s $0.4 - 0.5 Bil in annual earnings. On the other side, KKR trades at more than 22 times its earnings of about $1 Bil, being considered a business with different fundamentals and growth potential - note: in the case of investment firms it is useful to compare earnings with "distributable" earnings, and that is because of realized and unrealized gains form carried investments that must be included in normal earnings but not necessarily affecting cash. Figure 4 shows the growth in Assets Under Management of KKR (on which KKR earns $1+ Bil/yr in fees, or something between 0.5 - 1%), to which GA will add about $70 Bil. The additional AUM from GA is not only more money added to the pool, it is also a strategically more stable base to the total AUM of the new KKR, and that is because of the different nature of the investors behind that. Moreover, it is worth noticing that KKR already manages assets for insurance businesses, it is therefore already used to that different investing practice characterized by a different life cycle.
What do you think will happen to the valuation of that $0.5Bil in annual earnings from GA once they are incorporated into KKR? As stockholders, should we increase their valuation from the old x10 of GA to the new x22 of KKR? Would KKR act as GA’s investment manager giving part of GA’s assets the potential return of KKR’s investment vehicles and exposing GA to the higher valuation currently assigned to KKR? Or the other way around, could GA’s current valuation negatively affect KKR perception to investors? Will the current growth rates of the Asset Under Management at each firm continue, or even benefit from commercial synergies?
By nature this post is not supposed to have conclusions, however, being these three cases actual dynamics currently developing at those businesses, the interested reader might want to formulate a couple of personal takeaways and thoughts. It will probably be interesting to go back to those mental notes in one or two years and see how they compare with the actual events that will have unfold.
This post does not constitute in any way investment advise