Breakingviews

Kellogg rescues P&G from over-cleverness

By Rob Cox The author is a Reuters Breakingviews columnist. The opinions expressed are his own. “Half the cleverness, none of the risk” makes an apt cereal-box slogan for Procter & Gamble’s sale of Pringles to Corn Flakes-to-Froot Loops giant Kellogg. By offloading the chips business for $2.7 billion in cash, P&G swaps a complex structure that, while it would have saved on payments to the tax man, put the consumer giant’s corporate finance competencies to a severe test.

And what may be P&G’s loss looks like Kellogg’s gain. While the cereals group is plunking down 15 percent more in cash than Diamond Foods had originally agreed to pay in new stock, the accompanying cost savings more than justify the premium. In a nutshell, this is a reasonable outcome, not least because P&G emerges with a valuable lesson the rest of Corporate America would be wise to observe.

The Kellogg deal makes it easy to see why P&G was tempted by a more complex transaction with Diamond last year. After paying taxes of as much as 48 percent of the value of the deal, P&G will bring in as little as $1.4 billion from the Pringles sale. Accepting a lower offer of $2.35 billion from Diamond would have avoided handing over a big slice of shareholders’ booty in the form of capital gains. Rather than the earnings per share gain of as much as 65 cents it predicted from the Diamond deal, P&G predicts it will reap a 50 cents-a-share gain from the Kellogg arrangement.

As in life, however, there’s no free lunch in the snack foods business either. The so-called “reverse Morris trust” structure required P&G shareholders to elect to receive Diamond stock. And as catalogued and brought to light by Breakingviews, Diamond’s finances turned out to be pretty nutty. The salty snacks purveyor last week came clean on about $80 million of bad accounting and replaced its chief executive and chief financial officer.

Despite having used this structure before, P&G clearly failed to adequately crunch the details on its Pringles partner. The scale of Diamond’s revelations suggests P&G, its accountants and advisers at Morgan Stanley and Blackstone missed, or simply chose to ignore, some warning signs. That should be a lesson to all companies contemplating serving up another firm’s equity to their own shareholders.

Alibaba and Yahoo could live unhappily ever after

By Wei Gu

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Talks on Alibaba buying back Yahoo’s stake in the Chinese e-commerce giant seem to have faltered. Valuation, structure and financing appear to be the key roadblocks. With more strain added to the unhappy relationship, Yahoo and Alibaba need to rebuild trust before heading back to the negotiation table.

Founder Jack Ma wants to take back control of Alibaba. Relations with the U.S. group soured due to an earlier spat over its payment unit Alipay, and Yahoo’s attempt to appoint more directors at the Chinese company. Ma was trying to buy the bulk of Yahoo’s 43 percent stake in a complex transaction worth up to $9 billion.

Disagreement over valuation appears to be the main challenge. Yahoo is holding out for a better offer, saying Alibaba’s value has increased during the discussions, according to people close to the matter. But putting a price on a stake in a private company that has grown some 30-fold over seven years is certainly not easy, especially if trust has broken down between the partners.

The structure of the deal also looks a bit too smart. Under the details of the deal being talked about, Alibaba would inject up to $6 billion of cash and $3 billion of assets into a new subsidiary. The idea is to make the transaction tax-free for Yahoo. One snag is that Yahoo may be eyeing assets that Alibaba doesn’t yet own, such as some businesses in the United States. Another is that the Internal Revenue Service may deem it a sale anyway, which would be taxable, as opposed to a tax-free asset-shuffling.

A tough financing market adds more uncertainty. Alibaba was looking to borrow $4 billion from a group of six to seven banks, but had to cut the size of its debut loan to $3 billion, according to Reuters. The loan market is tight, as many European banks are cutting lending activity in Asia.

Why the league-table bonanza at Glencore-Xstrata?

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How many banks does it take to put together a friendly, all-share merger – and one that’s been on the cards for years anyway? If the companies are Glencore and Xstrata, the punchline is seven – plus a lone banker acting as go-between. And despite the abundance of expensive wisdom informing the negotiations, this mega mining deal clearly needs wider shareholder support.

To be fair to Glencore, the commodity trader is using only using two key banks – Citigroup and Morgan Stanley. That’s pretty much the minimum for multi-billion dollar transactions today. But Xstrata has five – Deutsche Bank, JPMorgan, Goldman Sachs, Nomura and Barclays Capital.

To be sure, any big deal is complicated. And you’d expect Xstrata to need more help: it is selling out to its biggest shareholder and must be seen to be crafting a fair deal. But it still seems a bit much. Barcap’s role as “equity adviser” stands out. There’s no significant financing required, whether in debt or equity, and the two companies are already semi-merged thanks to Glencore holding a 34 percent founding stake in its target. Moreover, Deutsche and JPMorgan are playing the additional role of UK corporate broker – a specialist service focused on relationships with core investors.

Still, ties between corporations and their advisers are long term. It’s not unheard-of for CEOs to appoint banks as a reward for past services or to keep them sweet for future mandates. Even if the actual involvement and cash fees are low, the engagement brings all important league-table credit and bragging rights.

Gamesmanship over rankings is unedifying, but does it matter much? After all, it’s hard to get too worked up about the sanctity of league tables. A huge line-up could hurt shareholders’ interests if independent research was silenced, or a counter-bidder couldn’t find funding and advice. But several big investment banks remain unconnected to the deal, so such worries look surmountable.

Dreamworks’ China deal won’t be access all areas

By Wei Gu The author is a Reuters Breakingviews columnist. The opinions expressed are her own

Dreamworks may soon get an exclusive ticket to China’s closely guarded film industry. The U.S. studio is likely to announce a joint venture with China-based investors during Vice President Xi Jinping’s visit to California on Feb. 17, a person familiar with the situation has told Breakingviews. It should be a good deal for the creators of “Kung Fu Panda”, but does little to lower the Great Wall around film distribution in the People’s Republic.

Movies remain a heavily restricted industry in China. Only 20 foreign films a year can be screened nationally at cinemas, and those must be shown through a designated state-owned intermediary. Beijing said it would comply with World Trade Organisation rules on media by March 2011. But progress on books, newspapers, journals, DVDs and music hasn’t yet followed through to cinema or TV. Only this week China’s broadcast regulator banned foreign shows during prime time.

Joint ventures might get Hollywood closer to China’s giant audiences. By producing in China, Dreamworks can bypass the restrictions on foreign content. The venture will see up to $2 billion investment in the next five years, according to Caijing magazine, more than half likely to come from Chinese partners including China Media Capital and China Development Bank. Dreamworks should get low-cost local talent and wider exposure.

But the deal has political appeal too. Xi Jinping can claim the joint venture as evidence that China is creating a more open market during his closely-watched U.S. trip. And China can pick up animation techniques and merchandise promotion skills from Dreamworks. Meanwhile, more movies in the vein of “Kung Fu Panda” might help Beijing extend its “soft power” around the world.

The deal isn’t perfect by any means. Dreamworks will get only partial control. For movies other than cartoons and China-related family films, the doors may still be shut, and Dreamworks will also have to tolerate Beijing’s restrictions on content and intellectual property regime. Still, even a back-row seat in China’s $2 billion-a-year movie industry should be enough to get Hollywood’s producers feeling animated.

Complexity caps allure of Yahoo’s Alibaba solution

By Robert Cyran The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Yahoo sounds closer to finding a solution for its long-running Alibaba problem. A mostly cash split-off promises a tax-efficient way for the troubled U.S. Internet firm to slash its stake in its Chinese rival. But the deal is getting so elaborate, it could dilute the benefits for Yahoo shareholders.

The 40 percent stake Yahoo owns in privately held Alibaba is worth about $14 billion, based on an estimate of the whole company produced last October by another shareholder, Softbank. Yahoo’s stake in listed Yahoo Japan is worth about $6 billion. Yet the enterprise value of Yahoo, which is still profitable despite its strategic problems, is under $19 billion, or less than the two Asian stakes alone. The trick to unlocking value has been how to dismember the firm while minimizing the taxman’s cut.

Under the scheme being talked about, Alibaba would inject up to $6 billion of cash and $3 billion of assets into a new subsidiary. Yahoo would take control of it in exchange for reducing its stake in Alibaba to 15 percent. It would be designed for the Internal Revenue Service to deem the transaction asset-shuffling rather than a sale and consider it tax-free.

That’s good news for Yahoo investors, who have been saddled with a non-controlling stake in, and often contentious relationship with, far-flung Alibaba. But even in a best-case scenario, Yahoo will probably still be stuck with a $5 billion stake in the Chinese firm. What’s more, because Alibaba is unlisted, the value at which it can even partially extricate itself fairly is hard to determine.

The deal stands to be further complicated because a slug of the assets Alibaba is to inject into the new vehicle might be ones it doesn’t yet own. Yahoo would have some say over the purchases, but this potentially gives would-be sellers more negotiating leverage, introduces additional parties into the new Yahoo entity, invites more regulatory scrutiny – and therefore reduces clarity for investors. The cleverer Yahoo tries to be untangling itself from China, the less value the whole transaction could create.

Glencore-Xstrata gatecrashers in short supply

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

There’s never been a better time to bid for Xstrata. Glencore’s 34 percent stake has always been a stumbling block but now some Xstrata shareholders oppose an all-share merger proposal from the commodity trader. That backlash could build, and both boards would have to consider any credible counter-bids. An auction may not be probable – but it isn’t impossible.

Size limits the field for a full bid. Topping Glencore’s offer by 20 percent would value all of Xstrata’s equity at about 45 billion pounds ($71 billion), with another $8.1 billion in net debt. So only three global miners are credible gatecrashers – BHP Billiton, Rio Tinto, and Brazil’s Vale.

BHP and Rio are already so big that extra economies of scale wouldn’t be huge. They want only the biggest and best projects, and are thus a bit sniffy about Xstrata’s mines. Mostly they are targeting different resources anyway. Vale initially appears more promising. The Brazilians could reap more synergies, chiefly in Canadian nickel, and tried to buy Xstrata in 2008. But missing out then proved a lucky escape, and Brazil has since reined Vale in.

A breakup is conceivable. The biggest draw would be Xstrata’s operations in copper, a metal both BHP and Rio like. Copper will provide 47 percent of Xstrata’s EBITDA this year, HSBC reckons. Comparable deal valuations imply the business could fetch $50 billion including debt – nearly 70 percent of Xstrata’s enterprise value. Still, a carve-up would be ambitious.

Everything hinges on Glencore. Its board is dutybound to accept any offer for its Xstrata shares that represents compelling value. But Glencore doesn’t need cash. It would doubtless set the bar high on price given the value of existing rights to market Xstrata’s production – contracts which would be in jeopardy in any sale. After all, Glencore wants to produce and trade ever more commodities: abandoning its desired merger with Xstrata would merely halt that progress; selling out could put it into reverse.

Diamond Foods crashes after running before walking

By Jeffrey Goldfarb The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Four months ago, Breakingviews pointed to some oddities in Diamond’s financials, including dubious-sounding “momentum payments” to walnut growers. The company brushed off the inquiries. So did most investors: Diamond shares were trading at over $90 apiece at the time.

As it turns out, Diamond had overstretched. The misstatements now identified by the company’s audit committee suggest the onetime walnut cooperative wasn’t ready for the governance big time. After going public in 2005, Diamond bought popcorn maker Pop Secret in 2008 and then Kettle Chips in 2010. Before long, it set its sights more globally, pursuing a plan to buy Pringles from Procter & Gamble for $2.4 billion. That deal has been on hold and now looks virtually unsalveagable.

Inexperience also showed in the way Diamond initially treated doubters. Short sellers piled into the stock when walnut growers raised concerns about the payments they were receiving. These financial skeptics were dismissed, though word eventually filtered up to the audit committee, which launched its accounting probe last November. A sounder strategy might have been to engage with the shorts – or at least with perplexed growers – sooner. (Though to be fair, there aren’t many public companies that have shown a willingness to do that).

The persistence of skeptics serves as a stark reminder in the post-Enron era that accounting can still catch a company out. It’s all well and good that Diamond Chief Executive Michael Mendes gained the trust of sell-side analysts, many of whom stood behind him even after the irregular payments were brought to their attention. Even on Wednesday, none of the 13 analysts Thomson One records as following the company rated the company’s stock any worse than a “hold”.

The end of that cozy relationship with Wall Street may even bring a silver lining. It’s a numbers game, and the analysts who went nuts for Diamond’s story hopefully won’t be so easily persuaded again by other too-good-to-be-true tales.

(A previous version incorrectly stated the share price in the first paragraph).

Xstrata holders right to fret over Mick’s rewards

By Quentin Webb

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Xstrata shareholders are right to fret over Mick Davis’s potential rewards from selling the company to Glencore. The chief executive drives a hard bargain, is a shareholder too, and won’t be the one recommending any merger to outsiders. But there is a potential conflict of interest in that Davis could receive two extra benefits merely for clinching a deal.

First, the Xstrata boss will see three years of “long-term incentive plan” shares vest immediately and in full upon any takeover. If the latest LTIP award is in line with previous years, this element of Davis’s deal will be worth about 8 million pounds. Options worth another 1.8 million pounds net will also vest.

Second, Davis will be entitled to receive a cash payment equal to a year’s pay, bonus and benefits following any “change of control”. The Sunday Telegraph reckons this would be worth another 5.7 million pounds. But it seems unlikely that Davis will actually take this cash. He certainly shouldn’t if he is the new CEO of the merged group. It would be farcical to pull the cord of his golden parachute if he is staying in the cockpit.

Shareholders should draw some comfort from Davis’s significant existing interest. His holdings exceed 55 million pounds once ordinary shares, and vested but unexercised options (less their strike price) are tallied. That helps align his economic interests with other investors’.

Still, the general principle is right. When companies are as entwined as Glencore and Xstrata, merger proposals merit close attention anyway. And parachutes can certainly cloud CEOs’ thinking. In U.S. companies, where independent chairmen are admittedly less common, researchers at Philadelphia’s Drexel and London’s City university have found that the more glittering a CEO’s parachute, the lower the premium offered to shareholders.

Don’t bet against Glenstrata antitrust roadblock

By John Foley

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Glencore’s tie-up with Xstrata may not harm competition. But that won’t stop regulators from trying to wrap it up in red tape for several months. As the two miners head into a $90 billion all-share merger, competition watchdogs from China to South Africa, Australia and Europe will get a chance to probe into the two companies’ business, and impose conditions on an eventual union.

Many customers already see Glencore and Xstrata as one. Glencore basically controls Xstrata, and sells much of its sister company’s production. Take thermal coal. Glencore accounts for 28 percent of global traded volumes, and Xstrata is the largest producer. But since mining and marketing are largely separate businesses, putting the two together shouldn’t change the market. The European Commission took that view when it passed Xstrata’s takeover of Falconbridge in 2006.

That’s not true across the board. Glencore may have room to sell more of Xstrata’s copper and zinc, where it already has 50 percent and 60 percent of the traded market. That may warrant some behavioural remedies – although these needn’t be a dealbreaker. China’s competition arbiter allowed the merger of Russian miners Uralkali and Silvinit in July with a promise to keep supply flowing.

Two things, though, argue for closer scrutiny. First is the combined group’s size, which would be just behind Rio Tinto based on Feb. 6 market capitalisations. Big miners can make life uncomfortable for governments as well as buyers. Look at Australia’s planned mining tax in 2010, which was watered down after miners – including Xstrata – threatened to pull investment.

Glencore is also an irresistible target, thanks to decades of operational secrecy. Digging in controversial places like the Democratic Republic of Congo, and environmental spats that generated $780,000 of fines in 2010, mean many non-government organizations will lobby watchdogs to let in some daylight.

April Fool’s comes early to comical M&A market

By Robert Cyran

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It’s hard not to smirk at the latest transaction to shoot out of the M&A pipeline. America’s largest title insurer, the $4 billion Fidelity National Financial, is buying O’Charley’s, an owner of U.S. steak joints. Not only is it a deal ripe for bad jokes about a combination plate of mortgage deeds and French fries. It also defies all convention.

Fidelity specializes in the humdrum world of processing real estate documents to ensure sellers actually own the properties they’ve put on the block. O’Charley’s is a struggling casual dining chain serving up delectables like “New York Pizza Pasta.” Not even the most hubristic investment banker would pitch huge synergies.

But there’s a still funnier twist. Fidelity National’s chairman, William Foley, knows both mortgages and meat. The company is essentially his brainchild. He rolled up a bunch of smaller title insurers over a quarter century. During some of that span, Foley also ran CKE, parent company of the Hardee’s burger joints.

That may explain the direction Fidelity National has been moving. It already owns stakes in restaurants with revenue of $400 million a year – and recently sold its flood insurance business. Of course, insurers often seek ways to invest proceeds from premiums. It’s just they typically use an intermediary, like a private equity firm, instead of direct ownership of uncorrelated companies.

Investors aren’t so sure about Foley’s ambitions. Fidelity National shares fell over 1 percent on the O’Charley’s news. The 42 percent premium it is paying may impede any hopes of a reasonable return. What’s more, shareholders could be worried Foley will replicate the trouble he ran into at CKE when it expanded too rapidly.