Breakingviews

P&G didn’t crunch its Pringles partner adequately

By Jeffrey Goldfarb The author is a Reuters Breakingviews columnist. The opinions expressed are his own. Procter & Gamble didn’t crunch the details on its Pringles partner adequately. Troubles escalated for Diamond Foods, the agreed buyer of the chips brand, on Thursday as the Securities and Exchange Commission initiated a probe into its accounting on the heels of the snack food company’s own internal inquiry. The scale of the issues being investigated suggests the consumer giant missed some warning signs.

Everything looked crisp back in April when the $2.4 billion transaction was announced. Diamond shares soared as it appeared to fulfill ambitions to grow from a walnut co-operative to a global player in salty treats. For P&G, a craftily-structured deal allowed it to finally exit the food business.

Things began crumbling in September amid growing questions, from Breakingviews and others, not only about the accounting treatment of payments to growers now under the microscope but other oddities involving the company’s finances and disclosures. Investors bet against Diamond shares. In November, the deal was put on hold.

It’s hard to blame P&G and its advisers – Morgan Stanley and Blackstone – for not seeing six months in advance that Diamond would make suspicious payments to walnut suppliers. And Diamond also may ultimately be vindicated of any wrongdoing. But accounting sloppiness is often a symptom of larger governance and control problems. In any event, P&G’s responsibility to its shareholders, who will own stock in the newly merged Diamond-Pringles, didn’t end in April.

The $180 billion consumer products group had less incentive than, say, short sellers, to invest extra time and money into a forensic scrubbing of Diamond after the deal was signed. Moreover, gathering non-public information about Diamond could have created a messy conflict with any related confidentially agreements it signed.

This leaves an impression that P&G’s concern with tax efficiency outweighed a desire to more thoroughly understand Diamond. The complex reverse Morris Trust structure being used to unload Pringles erases P&G’s obligation to Uncle Sam, which is nice for shareholders. And P&G is a master of the format, having used it twice before. Ultimately, the Diamond deal offers a simple M&A lesson for corporations everywhere: better know thy partner.

Fed shows outsized concern for too-small-to-fail

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

The Federal Reserve reckons there may be a too-small-to-fail problem of sorts. The U.S. central bank spent nearly two years scrutinizing the tiny takeover of Utah-based Bonneville Bank by prepaid debit card firm Green Dot. The soundness of even niche banks matters. But in the too-big-to-fail era, the watchdog’s slow process is an unneeded deterrent to the sector’s small fry.

Green Dot, a $1.3 billion market-value company whose cards are sold by Wal-Mart and other retailers, bought the Beehive State minnow partly to secure bank holding company status. The Fed’s regulatory imprimatur should give Green Dot investors more comfort. Owning a bank will also enhance operating efficiency and innovation. Green Dot can now collect interchange and other fees directly and introduce new products without waiting for a third-party bank’s say-so.

Shareholders liked the development, pushing up Green Dot shares by almost 10 percent following the Fed’s approval. The news should also be good for unbanked or under-banked Americans. Green Dot can now afford to cut fees and still remain profitable. Yet despite Bonneville’s paltry $36 million of assets, the Fed deliberated over the transaction for 21 months. One of the bank’s five governors, Elizabeth Duke, even voted against it.

Duke expressed concern that Green Dot’s business model isn’t diversified enough – so, in a sense, maybe too small to survive. Along with concerns about economic shocks and competition from big banks, future regulation could endanger the company’s profits.

The safety of small lenders is a legitimate concern. But there’s a new agency to help alleviate some of the Fed’s burden with regards to consumer protection. What’s more, with big banks having grown bigger since leaning on taxpayers to survive the crisis, systemic concerns should be where the central bank is focused.

Rumble in rock garden presages more hostile M&A

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

A rumble in the rock garden may presage more hostile M&A. That’s one way to read the unsolicited $4.6 billion offer that Martin Marietta Materials made for larger rival Vulcan Materials. The all-stock deal won’t succeed without some more fill. But the lesson is clear: if profits can’t be mined from the ground, they can still be found by cutting costs.

Aggregating the two makes financial sense – the companies had been circling each other for nearly a decade. The question of who gets to run the ship appears, unsurprisingly, to have kept a deal from taking place. Not anymore. Martin is making the most of its more efficient operation to put the deal to Vulcan’s shareholders.

Though it’s almost a third smaller by market value than its quarry, Martin sports higher profit margins and more revenue per employee, and its stock has outperformed its rival’s. So promises to cut up to $250 million in costs annually are credible. Those savings are worth around $1.5 billion to shareholders today. The premium on offer comes to just a third of that – leaving ample space to pay more without crushing its investors.

That gives Vulcan ammo to fight off this initial offer. Investors have already bounced the stock above the bid’s value. Initial proposals in hostile deals rarely win acceptance, and this one isn’t a knockout. But the logic of the deal, and its potential savings, should enable some melding between the two boards – with a bit of nudge from arbitrageurs.

When executives’ optimism about the economy is highest and businesses pull in cash faster than they can deploy it, empires are built. Those conditions certainly don’t describe the slumbering market for construction materials. But the prolonged downturn – and the cheaper market valuations that result – has inspired Martin to try and force a cost cutting exercise on its rival. Chances are that message won’t be lost across other industries.

JPMorgan faces tangle in cable M&A

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

JPMorgan may soon rank among Germany’s top cable-TV broadcasters. The U.S. investment bank committed to be a back-up buyer if regulators stop Liberty Global acquiring number three cable firm, Kabel Baden-Wuerttemberg. But if JPMorgan finds itself on the hook, that won’t automatically be the death knell for these unusual agreements.

The firm made the commitment in March before the euro zone crisis intensified. Its position now appears awkward. The Federal Cartel Office must decide by Dec. 15 whether Liberty, run by media tycoon John Malone, can combine KabelBW with the number two in German cable, Unitymedia. The watchdog worries the deal could disadvantage television stations, which pay to transmit programmes, and housing associations, which buy cable for whole apartment blocks.

Liberty has offered some remedies. But if these don’t suffice, JPMorgan has to shell out 910 million euros to buy KabelBW from EQT, the Swedish buyout firm it advised originally. Then it would have to re-auction the company. Taking on illiquid, leveraged buyout equity is the last thing a bank should want to do right now. But it’s not hard to see why JPMorgan agreed to help its client in this way. Its balance sheet wasn’t shot to pieces in the crisis, and it has obtained some safeguards. Liberty would help fund the purchase and has indemnified JPM against loss on any re-sale. What’s more, JPMorgan wouldn’t actually own KabelBW until early 2012 and would then class it as an asset held for sale. Effectively, JPM’s role is purely as a legal owner.

Moreover, a new KabelBW auction shouldn’t be hard. Private equity loves cable’s cashflows, and KabelBW is on a tear: EBITDA leapt 15 percent in the year to end-September. Former suitors like CVC would probably re-bid. A buyer could keep in place KabelBW’s capital structure, with its keenly priced junk bonds issued in March – financing impossible to obtain in today’s crisis-ravaged markets.

Liberty has done similar things before, getting banks to “warehouse” a Czech M&A target before regulatory approval. Such devices resolve a common M&A dilemma: the best fit between buyer and seller can lead to both the highest offer price, and the biggest risk regulators say no. Assuming JPM escapes a prolonged tangle, the “backstop” may not stop here.

Spanish banking sector to pay for its sins

By Fiona Maharg-Bravo The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Spain wants its banking sector to pay for its sins – literally. Banco Sabadell is taking troubled lender CAM off Madrid’s hands, and Spain’s bank-backed deposit guarantee fund is helping by making a big capital injection. Such deals minimise the cost to the taxpayer, but aren’t a free lunch for the state and won’t solve the sector’s problems.

The CAM rescue does not come cheap. Sabadell will adopt CAM after it receives a 5.25 billion euro capital injection from the deposit guarantee fund (FGD). This pot has 6.6 billion euros in resources, and has also agreed to guarantee 80 percent of losses on 24.6 billion euros worth of CAM’s assets over 10 years. An auditor has estimated the potential losses at 5.5 billion euros, of which 3.9 billion euros have already been set aside by CAM. If this forecast is right, the total cost of the CAM rescue – the capital boost plus the insurance on the unprovisioned losses – will be 6.5 billion euros.

The advantage of this scheme is that the CAM rescue will have zero impact on this year’s budget deficit, at a time when the government is already likely to miss the 6 percent of GDP target. But the country’s bailout fund, the FROB, will still have to guarantee CAM’s funding. What’s more, the CAM rescue will drain the FGD’s resources, which are also earmarked to guarantee deposits as well as pay for potential losses of past and future bank rescues.

Small wonder that the government recently ordered lenders to beef up their contributions to the FGD. These could total up to 2.5 billion a year, based on 2010 numbers, according to Cheuvreux estimates. But this is nowhere near enough to cover future losses in the system, particularly if the new government opts for creating a bad bank for all 176 billion euros worth of impaired and foreclosed property assets.

So the FGD will have to ask for yet more support from the sector, or borrow money externally using a state guarantee. The added burden on the banking sector won’t help the credit crunch in Spain. In the past, half of the FGD was financed by the state. Spain’s next government priority must be to come up with a definitive bank restructuring.

Latin America gets closer even as Europe cracks

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

Almost two centuries ago, Simon Bolivar briefly united parts of what became more than a half-dozen Latin American nations. With the euro zone in turmoil, the notion of a single Latin American currency that partly reunites pieces of Bolivar’s Gran Colombia seems far-fetched. Yet with private companies from the Texas border to the tip of Patagonia cuddling up in mergers like never before, it can’t be ruled out for ever.

So far this year, 143 cross-border mergers and acquisitions between South American companies have been announced, according to Thomson Reuters. That’s the most ever and a 25 percent increase on the number of deals last year – though the dollar value of transactions was higher in 2010. To give a sense of how regional consolidation has accelerated, more cross-frontier deal-making happened in the last two years than in all of the six years before that.

The region’s nearly 600 million people have, with a few exceptions, become significantly more prosperous in recent years. And many companies are no longer content to view themselves simply as national players. As they expand their horizons, so too must the providers that serve them, from airlines – Brazil’s TAM and Chile’s LAN announced a $3.3 billion merger in August – to banks, hotel chains and telephone companies.

Even ructions in Europe are creating opportunities. This week’s announcement of CorpBanca of Chile’s $1.2 billion purchase of Banco Santander’s Colombian banking business is a case in point. The sale gives Santander, an early consolidator of Latin American financial assets, a double boost. The Madrid-based bank will record a capital gain of $820 million and strengthen its balance sheet.

The Chilean bank, meanwhile, gets its first major foothold outside its home country and a business serving Colombian companies, whose attractive growth rates have caught the attention of other regional financial institutions. Last week, Banco de Credito del Peru nabbed control of Colombian broker Correval, which had earlier been in talks with Brazil’s BTG Pactual.

New England power merger deserves final nixing

By Rob Cox The author is a Reuters Breakingviews columnist and Northeast Utilities customer. The opinions expresssed are his own.

It is now official: Northeast Utilities, New England’s biggest electric utility, failed in the duties that accompany its monopoly. With the release of a new report, regulators have all the evidence they need to power down Northeast Utilities’ $4.7 billion takeover of Massachusetts rival NSTAR.

The report, commissioned by the state of Connecticut and conducted by a consultancy run by James Lee Witt, a former Federal Emergency Management Agency director, faulted the $6.1 billion utility’s Connecticut Light & Power subsidiary for myriad inadequacies in preparation, response and communications before and after snowstorm Alfred swept over the Northeast on Oct. 29.

For the 800,000-plus homes and businesses that lost power for more than a week twice in just about two months – the earlier trigger being Hurricane Irene in August – the conclusions won’t come as much of a surprise. But some of the report’s findings point to a broader problem of competency and accountability that should concern regulators in Massachusetts and elsewhere who are now vetting the merger with NSTAR.

Take, for instance, CL&P’s preparations for the October storm. Its worst-case scenario planning foresaw a maximum outage of just 100,000 customers, or 8 percent of its base of 1.2 million. In the end, 70 percent lost power.

Though it was unseasonal, others had managed to foresee such a storm. Witt’s firm points out in its report that United Illuminating – the other non-municipal utility operating in Connecticut – had a severe-event level contingency in which 71 percent of its customers were assumed to go dark. Better preparation helped United Illuminating to avoid a systemic loss of power – just 15 percent of its customers were cut off. And it was able to restore essential service more quickly.

The report lists 27 recommendations for Northeast Utilities to improve its planning, procedures, training, and performance. Following these non-binding recommendations would require investment. That’s almost impossible to reconcile with the company’s pledge to squeeze $784 million of savings from its combination with NSTAR.

Loan hangover will cast pall over European buyouts

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

Once again, banks in Europe have been left standing when the music stopped. In an echo of 2008, lenders backing private equity deals have found themselves with a big backlog of unsold loans. That bodes ill for future buyouts.

Private equity deals are usually financed by a handful of banks, which tide the borrower over until it can arrange permanent financing in the form of “senior” loans and riskier instruments such as high-yield bonds. But numerous banks, including Goldman Sachs and Morgan Stanley, were wrong-footed by the rapid escalation of the euro crisis. Lenders suddenly found there were few takers for the loans they wanted to syndicate, while the market for new junk bonds effectively closed.

Eleven European buyouts remain “hung” in this way, with total debt of nearly 5.2 billion euros, Thomson Reuters LPC data shows. That’s a fraction of the 80-billion-euro mountain that banks were left with four years ago. And it’s halved since August, as banks have pulled out the stops to shift deals.

But managing the backlog hasn’t been easy. Banks have increased interest rates to make the loans more attractive to buyers, and sold them on for as little as 91 percent of face value. Debt packages have been rejigged to reduce cash interest payments, or to replace junk bonds with costlier mezzanine finance.

In financial terms, the absolute hit looks modest for banks. So-called “flex” clauses allow them to pass on perhaps 1.5 percentage points of extra interest costs to the borrower. And underwriting fees, equivalent to maybe 3-4 percent of the financing package, effectively provide a cushion that can be absorbed before banks have to recognise a loss.

Still, banks are forced to set aside large chunks of scarce capital against the loans on their balance sheets. And writing off fees still hurts, particularly when the investment banking industry is suffering.

Exclusive: Ditching CEO won’t save US utility deal

By Rob Cox The author is  a Reuters Breakingviews columnist and a Northeast Utilities customer. The opinions expressed are his own.

Northeast Utilities made an offering at the altar of the regulatory gods. The New England utility parted ways with the executive who headed its biggest division, Connecticut Light & Power, over its poor handling of two storms that left millions of customers without power for weeks. Investors seemed to think that will help it gain approval for a $4.7 billion takeover of rival NSTAR. Their optimism looks misplaced.

In an interview with Reuters Breakingviews, Connecticut’s Commissioner of the Department of Energy and Environmental Protection, Dan Esty said Governor Dan Malloy’s administration is determined to insert itself into the merger approval process, even if that means introducing and fast-tracking special legislation.

“There are important questions that need to be vetted for the people of Connecticut” before this deal is approved, Esty told Reuters Breakingviews. “The state needs to know how the merger will impact ratepayers and what lines of accountability will be drawn.”

That’s a stark change from the state’s earlier line. Connecticut’s Public Utilities Regulatory Authority had previously decided it had no jurisdiction over the deal, which was announced a little over a year ago, leaving final approval to utilities regulators in Massachusetts. That was before Hurricane Irene and a snowstorm on Halloween weekend left millions of customers of Connecticut Light & Power, NU’s primary subsidiary, without power for more than a week.

CL&P’s planning, response and communications are now the subject of numerous investigations by the state and local authorities. The company failed to meet a handful of deadlines for restoring power. On Thursday NU accepted the resignation of CL&P’s Butler, who had become the public face of the company’s failings during the outages.

It’s easy to see why that news warmed investors’ hearts and gave NU shares a 1.8 percent lift Friday. By removing the man in charge of the bungled performance of CL&P, the monopoly can argue that it is accountable to its customers and local regulators.

Music gods again divert EMI’s destiny

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

The music gods have meddled again with EMI’s destiny. In the minds of financiers and industry wags, the union of the British music group – home to the Beatles and the Beastie Boys – with U.S. rival Warner Music was just a matter of time. But the star-crossed match has been knocked off course again by the sale of EMI’s two divisions to Sony and Vivendi’s Universal Music.

EMI’s path to this point has been torturous. An overleveraged buyout in 2007 led to seizure of the music company by lender Citigroup earlier this year. The bank, a reluctant owner, appeared to have a quick way out when billionaire Len Blavatnik acquired Warner soon after. The logic for a deal is nearly as compelling as it was when the two companies first tried to merge in 2000. EMI and Warner remain the runts among the four majors, complement each other geographically and present cost-cutting opportunities.

Yet Universal, the world’s largest music company, and number-two Sony have bold plans of their own. With twice as much revenue as Warner but about the same operating margin, Universal needs cost reductions to capitalize on its scale. Though it’s paying a rich seven times EBITDA through March for EMI’s recorded music business, it expects about $160 million of annual savings. Taxed and capitalized, those should cover over half the $1.9 billion purchase price.

For Sony’s part, taking control of EMI’s music publishing business for $2.2 billion would vault it to the top spot in the sector. It would also leave the rival BMG partnership established by private equity firm KKR and German media group Bertelsmann still lacking the anchor asset it had been seeking to give it serious clout.

Still, EMI’s fate is not quite sealed. Citi made sure Universal assumed all the regulatory risk on the deal. Though Universal plans to sell 500 million euros of assets, U.S. and European trustbusters will still have plenty of questions. In some countries, the enlarged Universal would control over 40 percent of the market; in the United States, it would have about a 38 percent share. The competition review may take a year or more. This isn’t necessarily the day the music died for Warner and EMI.

Previous version incorrectly stated revenue comparison in third paragraph