• riccardo

Three business-administration technical lessons: rates, spin-offs, and M&A



 

At the end of last year, we published a post discussing three corporations that had just disclosed three important pieces of information in their latest earnings releases. Those topics were believed to be essential material for people interested in effective business administration. The post was structured as a collection of three business cases ending with questions hinting at possible conclusions - while everything important for the discussion will be summarized immediately below in this post, the interested reader can find last year’s post here. We will examine now how events unfolded during the last twelve months, providing essential real-world feedback on dynamics we consider enlightening. While we had some confirmations, we were also caught by surprise; in particular by the last case as we will discuss. At the end, the three cases should all connect, and that could be extremely rewarding if framed within the latest macro events and their possible future developments. We will again provide possible takeaways through [biased] questions at the end of each paragraph.


The original post was divided into three parts, each one discussing a corporation of interest and the relevant topic. Here is a summary:

  1. (PFG) Principal financial group, a Financial Services company trying to handle the tough interest rates environment.

  2. (IBM) International Business Machines, an IT company trying to improve its public market valuation through a spin-off.

  3. (KKR) KKR & co, an Asset Management company (originally a private equity firm) trying to increase its presence within the insurance business through an acquisition.

The three business cases are listed in the order of the strategic importance we assigned them:

  1. The first case constitutes the base for any business decision which always involves interest rates in some way – even when we do not realize it.

  2. The second case focuses on the importance of continuously monitoring how the external world (market, customers, shareholders, stockholders, etc.) perceives our company to ultimately leverage that understanding for strategic decision-making and actual financial return – assuming we are talking about a for-profit business.

  3. The third case is about anticipating to some extent the external world and its needs, allowing us to be the first entrants within the market we anticipate our industry is evolving into – we could think about the automotive industry and the possible need to reshape part of its business model because of structural changes.

At the end of each of the three cases, we will not only highlight the specific possible takeaways by presenting new questions but, being those arguments all connected in series, we will also share a thought on how a case relates to the previous ones.


This post will not say “invest” nor “not invest in this business or stock”. This post will focus on business dynamics and initiatives believed to be extremely insightful for the interested reader if strategically examined. A final judgment is left to the reader and only time will be the judge. For us, this post was a clear example of how, writing about something is one of the best ways to gain a better understanding of it.


1/3 How it went: PFG and interest rates


In the previous post, we discussed the negative impact on the financials of PFG of the sudden drop in interest rates experienced right after the pandemic burst in 2020. Being an insurance and retirement-solution company, PFG usually carries on its balance-sheet assets and liabilities representing actualized values of credits and potential future disbursements to clients. A sudden movement in interest rates causes immediate variations of those present values. While the net result depends on the specific structure of the balance-sheet (e.g. bonds could benefit from a drop in rates while a fixed future insurance disbursement could be hurt from the same movement), if higher liabilities have the dominant effect, they are balanced by a loss the company must report in its P&L. Last year we used the [non-GAAP] pre-tax operating earnings (figure 1) to show PFG’s 3Q-2020 numbers dropping from $510M to $277M after applying the actuarial variances assessing the impact of the rates’ movement (including “other” variances $90.9M on top of the actuarial ones $142.3M, figure 1).


Figure 1

At the end of PFG’s discussion in the previous post we noted that, because of the lower earnings, the price of PFG’s share had dropped from a $45-ish level (pre-release) to $40.8 (post-release). Investors were still maintaining the same valuation multiple (price over earnings of about 9+) but they were applying it to the new and lower earnings. Our ending questions last year were about the possible accidental character of those adjustments and the possible recovery after that first big actuarial impact. In that case, investors would have been not too strategic in discounting that much the company and its stock based on earnings being low only momentarily. Moreover, we reasoned about the possible future developments considering the exposure to possible further rates movements at the time – not necessarily in the same direction of the post-pandemic burst.


Looking at the latest results of PFG from the release in October 2021, we can see in figure 2 below that the actuarial adjustment this year is only ($32M) vs last year’s ($142.3M) – “other” variances have a positive impact too, being $50M vs last year’s ($90.9M). The resulting pre-tax operating earnings are back to PFG’s usual level, $568M vs last year's $277M (figure 3). More precisely, they even show an improvement on a pre-adjustment level, signaling good business traction: $568M + $32M – $50.4M = $549.6 (figure 2 and figure 3) vs last year’s $276.9M + $142.3M + $90.9M = $510.1 (figure 1).


Figure 2 - actuarial adjustment Year Over Year

Figure 3 - Pre-Tax Operating Earnings Year Over Year

While we do not report the whole calculation for sake of simplicity, the actuarial adjustment last year had brought earnings per share (Net Income of the company divided by the [diluted] outstanding shares) down from $4.54 to $4.41 on a trailing twelve months basis. The same metric is now at $6.22. Using the same valuation metric we used last year, which was Price-Over-Eearnings (PE) equal to 9.2, it would result in a value per share of about $57 - last year’s value was $40.9 after the release. At the time of the writing (November 5th 2021) PFG share is at about $69 or about x11 PE, reflecting investors’ possible good outlook for PFG and its earnings, possibly fueled by the good traction we showed above by comparing the pre-adjustment results $549.6 (2021) vs $510.1 (2020).


We can now go through the important takeaways possibly teaching us a lot about exposure to interest rates, and to which we hint at through additional questions:

  • How is this year's limited actuarial impact related to the interest rates’ trend so far in 2021? As a possible hint, figure 4 presents the 3-months (left) and 10-years (right) US treasuries and bonds in the last 5 years – note, while a big swing occurs during 2019, the change in 2020 is still higher than 2021. As we said, the net result of rates fluctuations on a company like PFG depends on the underneath structure of the balance-sheet … do milder and more predictable fluctuations (being them up or down) provide a scenario easier to handle and hedge (by selling and buying investments) for an insurance and retirement-solution company?


Figure 4 - 3 month and 10 year US treasuries and bonds rates
  • Is it possible that considering the already big drop in rates during 2019 (pre-pandemic), a company like PFG had structured its balance-sheet for 2020 slightly in favor of increasing short-term rates – the opposite of what happened right after the pandemic’s burst – being then caught by surprise by 2020’s events? Is it possible that that did not repeat in 2021?

  • How would possible imminent scenarios of inflation and increasing rates fit within PFG outlook?

2/3 How it went: IBM and spin-offs


Last year we discussed how IBM was probably trying to extract a higher valuation from investors through a spin-off of part of its business. IBM had recently acquired Red Hat, and it was planning to spin-off its service business into a newCo “Kyndryl” (new ticker KD) while keeping within IBM (same ticker IBM) its cloud business including Red Hat. Back then, we compared Microsoft’s valuation at about 35 times its annual earnings (valuations range of Tech Infrastructure companies) to IBM then multiplier of 14 (perceived still as a Tech Services company, usually associated with lower valuations). IBM was planning to separate its business-units allowing each one to be valued at more favorable terms, something usually happening when investors perceive that a business is focusing on specific sectors within industries – in fact, diversified conglomerates carry in general lower valuations; given that we ignore those one-in-a-kind exceptions which are in leagues of their own.


Let us go straight to what happened.


3rd quarter 2020 earnings release - Oct 2020:

  • IBM market cap = $111 Bil (price per share $110)

  • TTM Earnings per Share = $8.83 (trailing twelve months earnings per share)

  • Price over earnings multiple = $110 / $8.83 = 12.45

Despite weak earnings during 2021, investors showed some faith in the spin-off, as the good PE multiplier was still showing in September/October 2021:

  • IBM market cap = $122 Bil (price per share $135)

  • TTM Earnings per Share = $5.93 (trailing twelve months earnings per share, before the latest release in Oct 2021)

  • Price over earnings multiple = $135 / $5.93 = 22.76

Let us now look at the latest earnings release happening at the end of October 2021, a few days before IBM would spin-off the new Kyndryl at the beginning of November 2021. IBM in its 3rd quarter 2021 earnings release at the end of Oct 2021 reported EPS of $5.29 on a Trailing Twelve Months base - that was the last quarter in which IBM was reporting consolidated earnings altogether as a unique entity of what would then separate into the new IBM and the newly created Kyndryl. In the following days, the stock fell from about $135 to about $120, which would still represent a PE multiple of $120 / $5.29 = 22, close to the pre-release value in September/October of 22.76. We could say that most of the investors were not that negative after all. While IBM was not too strong in earnings, investors were still willing to grant a PE multiple of 22. That is not an exceptional number, but at least it was not much below the value preceding that not-to-strong release. Note that in 2019 and 2020 IBM had usually traded at lower multiples in the 10 to 15 range.


Let us now go one step further and look at how the situation above (Oct 2021) evolved a couple of weeks later (in Nov 2021) when the actual spin-off was executed and the old IBM’s shares were separated into the new IBM and Kyndryl – investors receiving 1 share of the new IBM for each share of the old IBM, and 1 share of the new Kyndryl for every 5 shares they owned of the old IBM.


New IBM (cloud only):

  • New IBM (cloud-only business, including the acquired Red Hat) market cap = $109 Bil (price per share $122)

  • Earnings per Share = $5.29 (trailing twelve months' earnings per share). Note: the unit including the cloud business was the only one contributing positively to earnings in the old IBM, therefore we are considering earnings of the new IBM [almost] equal to the old IBM at the latest release in October 2021 – they are probably higher, but we are ignoring the negative historical impact (probably something more than -$1 EPS) of the businesses spun-off into Kyndryl.

  • Price over earnings multiple = $122 / $5.29 = 24.38

New Kyndryl:

  • Kyndryl market cap = $6.38 Bil (price per share $25)

  • Earnings per Share = $0 x 1/5 (they are negative but, we do not want to consider now negative value, which could represent cash-burning and value-destruction. They are multiplied by 1/5, because that is the value going to an original investor in the old IBM); depending on what the readers want to focus on, it may be a needed adjustment.

  • Price over earnings multiple = $25 / $0 = ?!

This is a very important result. The financial engineering involved in the spin-off has indeed paid off to some extent so far. The valuation investors are assigning to the new IBM seems to hold despite weak earnings from the company. Now, a lot could still change shortly. The situation could be interpreted as if investors were willing to give the new IBM some time after the spin-off to focus on the cloud business and realize its previously untapped potential. The new IBM may be able to behave as a new tech company able to defend its market share (i.e. not shrinking further) and even grow thanks to the increasing contribution of Red Hat within itself – therefore valued more closely to Microsoft and its peers. Additionally, they may be also waiting for the new Kyndryl to possibly reach profitability and provide additional value. In one of its first releases, Kyndryl indicated it wants to go after an addressable market that it believes has doubled after the spin-off (figure 5 – full presentation here). Economies of scale would play a major positive effect in that case. If both scenarios materialized, investors would indeed gain by having the new IBM valued at higher multiples, and the newly created Kyndryl able to grow by itself and possibly providing additional – and previously untapped – value. Note: the new IBM is retaining about 20% ownership in the spun-off Kyndryl.


Figure 5

The two problems investors may focus on could be the following:

  1. As we pointed out last year, IBM cloud business (constituting the new IBM) seems to be shrinking in time – despite the good traction cloud businesses are having in general - and it seems to keep growing at 1-2% per year only thanks to the Year-Over-Year 17% growth of Red Hat within itself (data from the release of October 2021).

  2. Kyndryl on the other hand has the problem of profitability, and it also must show the addressable market has indeed doubled as per its presentation.

The following questions provide possible hints for strategic reasoning about those two issues:

  • At the time of the writing (Nov 5th 2021) Kyndryl is losing 10% in one day on the market while the new IBM is holding on; does it signal investors have different outlooks for the two entities and they do not consider their respective positive scenarios equally attainable? What kind of profit may investors be trying to lock-in by keeping the new IBM share and selling Kyndryl’s one?

  • Why is now Kyndryl, as a stand-alone entity, free to go after a much bigger market as promoted by the company through its slide in figure 5 (full presentation here)?

Bonus takeaway on how this second case relates to the first one: usually, if we have to sell something to the market, we want to do it when prices are high. In general, prices are high when rates are low. Considering the recent trends and discussions on inflation and rates – and their possible future trends – was IBM better to wait to implement the spin-off, or, that would have not positively exposed the sale to the possible future rates? (we can think about the spin-off as a sale if we focus on investors having then to decide whether to keep the received shares)


3/3 How it went: KKR and M&A (mergers & acquisitions)


We discussed last year the acquisition by KKR of the insurance provider Global Atlantic (GA) which would bring about $0.5 Bil in additional annual earnings to KKR $2 Bil earnings range. On top of the additional earnings, revenues from insurance premiums and alike would give KKR a more stable source of assets to then reinvest. Conversely, common capital-raise processes within the private equity and investment management industry are usually more volatile – some may say KKR is increasing its asset manager character and decreasing its investment manager one.


Our main point last year was that whereas KKR was at that point valued at about 22 times its earnings, the acquired GA had been usually valued with a multiple of 10. Therefore, KKR could be counting in part on the fact that once integrated within its group, GA’s earnings would be associated with a higher valuation too, representing the reinvestment potential of those additional earnings across the other KKR’s businesses historically yielding higher returns. The multiplier on the $0.5 Bil earnings passing from 10 to 22 would provide an additional $5+ Bil value to KKR stockholders.


However, last year we were probably too simplistic … KKR was indeed trading at about 20 times its earnings, however, being earnings quite volatile within the private-equity and alternative-investments industry - because of assets liquidation and accounting principles on participated investments – we were not right in taking a snapshot of earnings and valuation in the middle of the year. At the end of the year (a few months after our post) KKR was back at Full Year (FY) $2 Bil earnings therefore back to about 10 times its earnings as market cap, similarly to GA’s valuation. Indeed, a multiple of 10 is probably a better reference for companies like KKR (e.g. Apollo, Carlyle, BlackStone), as well as for many banking and insurance companies (i.e. GlobalAtlantic). Our framing KKR’s acquisition of GA in terms of a mere up-valuation of the additional revenues and earnings coming from GA was not accurate last year. It is true, that kind of dynamic could indeed materialize in part, however, it seems KKR’s intention was more strategic. We can have a look below at KKR last year’s slide motivating the acquisition of GA (figure 6; full presentation from KKR here).


Figure 6

As per the slide above, higher and more stable assets under management were among the main reasons for KKR to acquire GA. Premium paid by customers to the insurer would fuel the assets KKR could then reinvest across its various businesses.


While figure 6 presents also other strategic reasons for GA’s acquisition, a new perspective on the acquisition allows us to add something that could be extremely important. In general, when we raise capital, our return is impacted by the required return our investors want to receive back on top of their invested capital. If we raised $100 and we invested the money obtaining a 10% return, therefore gaining $10, we would have to return our investors the initial $100 plus their required return. If that return was 5% per year, we would return $105 in one year. In that case, we would be left with a $5 net gain ($10 gain - $5 investors required return) if we ignored the management fee we would probably charge. Say, in general, we can decide who will be our investor: a common private equity limited partner (LP) usually requiring a return of 20-30% per year, or a customer of our insurance business looking for annuities paying something close to risk-free rates and arguably much lower than the LP’s required return. We probably may want to choose the latter over the limited partners. Truth be told, in that case, we would probably not be able to charge the same management fees we could charge the LP; however, for KKR that is an additional capital source, not a substitute one. While a lot could be added to the argument, we can frame some critical points in terms of closing questions:

  • Other than all the benefits of figure 6, does the argument that KKR is leveraging the additional assets under management carrying a cheaper cost of capital make sense?

  • It seems KKR is also looking for more “stability”, meaning a longer duration of their AUM (KKR having to return the money further away in the future - look at figure 6, next to “Assets Under Management”). Would going after more stable AUM (figure 6 shows 8+ years) be also a way to lock-in current interest rates (in case we thought they were likely to be lower than what we may experience in 5 or 10 years; think about current inflation news and discussions)? Hint: raising capital during low rates, while not straightforward to frame, can be cheaper because investors would start from a lower base in computing their required return. While at the beginning lower rates would probably also offer lower-return investment opportunities, if the duration of those investments is long (say 8+ years), and rates rise, it becomes easier for us to find investment opportunities offering returns above the required return of our investors.

Bonus takeaway on how this third case relates to the first and second one: the connection of this case with the first one (i.e. interest rates) should be by now evident – at least, the questions above should signal we think so. The link to the second case is similarly straightforward; investment management 101 classes to some extent deal with the importance of the acquisition price. Not only the price is important, but also the valuation it can then carry is important. KKR paid GA about 10 times, which seems a good price for that kind of business (as we discussed through the 10 PE multiplier); a fair price would yield additional value in case, once integrated, GA would provide commercial and/or operational synergies – we mainly discussed commercial one. The additional AUM GA would bring, the reinvestment potential across the other KKR’s investment management businesses (e.g. private equity), and the lower cost of capital those additional AUM would carry, could altogether represent the way to KKR’s value above the fair price.


We hope all the above will constitute interesting material for further personal reasoning. In case You want to connect and discuss, please feel free to reach out in any way You may prefer:

  • LinkedIn profile (please, feel free to connect)

  • riccardo@m-odi.com (please, feel free to inquire)

  • Medium's blog (if interested in financial, quantitative, and engineering posts)

I will be in between Asia and the United States in the foreseeable future, I hope there will be a chance to meet and chat.


Please note: this post does not constitute in any ways investment recommendation.