So what causes a business leader to pay a hefty premium to the current market price to complete an acquisition?
Perhaps the shares of the target are extremely under-priced. It’s possible, but unlikely in a fairly priced to moderately over-priced market, given the acquirer and target are widely followed by analysts.
Or perhaps what is more likely, as Buffett pointed out in his 1981 letter to shareholders, three other reasons are at play by these business leaders, either singly or in combination: (1) They’re not in short supply of animal spirits and often relish the increased activity and challenge; (2) They’re measured and compensated by the yardstick of size; or (3) They believe their managerial performance will turnaround a faltering company (using the analogy of the childhood story where the princess kisses a toad and turns it into a prince).
Last week, Texas Instruments (TXN) surprised the investment community with its takeover bid of National Semiconductor (NSM) of $25 per share, representing a 78% premium over the previous trading price (the complete press release is here.) This deal is a $6.5 billion all-cash transaction, which Texas Instruments will pay through available cash and by issuing new debt between $3B-$4 billion. It’s expected to close in six to nine months. Texas Instruments is the market leader in the $42 billion analog semiconductor market with analog revenue of $6 billion and a product portfolio of 30,000 chips. This deal would add National Semiconductor’s 12,000-chip product portfolio, and $1.6 billion in sales, to Texas Instruments’ sales force. The combined analog portfolio would generate 50% of Texas Instruments’ revenue.
Since I’m unable to assess their executives’ animal spirits, let’s examine this deal through the second and third points of Buffett’s prism — the Size Test and the Toad’s Kiss Test.
The Yardstick of Size TestThe latest proxy statement outlines executive compensation, which has cash and non-cash components. The cash components are: base salary, profit sharing and a performance bonus. The non-cash piece is equity compensation in the form of non-qualified stock options and restricted stock units.
In fact, the CEO’s total 2009 compensation package of $9.6 million is broken out as follows:
- Base Salary: 10%
- Profit Sharing:<1%
- Performance Bonus: 18%
- Non-cash Equity: 72%
Base salary is set to be below the market average. Profit sharing is figured using a formula and depends on the level of Texas Instrument's annual operating profit margin. Performance bonuses are set using the compensation committee’s judgment to reflect Texas Instrument’s near-term performance as compared with competitors, its strategic progress, and the performance of the executive’s operations. This bonus compensation considers revenue growth percent, operating margin and total shareholder return.
The company pays total cash compensation appropriately above median if performance is better than competitors, and below median if performance is below that of competitors. Additionally, the compensation committee doesn’t rely on formulas or performance targets or thresholds, using its judgment based on its assessment of the factors above. In fact, the proxy gives us this red flag, “In a cyclical industry such as ours, in which market conditions and therefore growth and profitability can change quickly, we do not use formulas, thresholds or multiples to determine compensation awards. The only exception to this is the broad-based profit sharing program.”
Non-cash equity compensation primarily considers the level of equity compensation granted to similarly situated executives of a peer group of companies. The committee reviews industry, revenue and market capitalization to assist in making its decision.
Going further, sales growth, operating margin and total shareholder return need to be affected for an executive to move the needle on the performance bonus. The common theme amongst all of these is sales. To increase sales growth, they can organically increase sales or perform a bolt-on acquisition. To increase operating margin, they must increase sales and/or decrease costs. To affect shareholder return, an increase in profitability that flows straight down from the top line with increased revenue would also affect it. Acquiring National Semiconductor would give them more sales.
It’s quite clear Texas Instruments executives have the incentive to be measured against their peers and compensated based on size — the size of sales.
The Toad’s Kiss TestThe semiconductor industry is notoriously cyclical, and unless a company can carve a niche, differentiate the inventory, or create a consumer monopoly, its products are a commodity. With that come pricing competition and normally an inability to have pricing power.
Although they’ve been improving gross margins, National Semiconductor’s performance has been lackluster. Sales, pre-tax profit, and earnings have gone sideways for the last decade. Their ROE and ROIC are anything but consistent. Five-year FCF growth is -8.3% and book value growth is -17%. Additionally, they carry over $1B in long-term debt compared to their $1.5B in sales—not the definition of a wonderful company. It is by all accounts right now a “toad” in Buffett’s analogy.
In the press release, Rich Templeton, Texas Instruments chairman, president, and CEO since 2004, said “This acquisition is about strength and growth. National has an excellent development team, and its products combined with our own can offer customers an analog portfolio of unmatched depth and breadth. In recent years, National’s management team has done an outstanding job of improving margins and streamlining expenses, which upon close will increase TI’s profitability and earnings per share, excluding transaction costs.”
Templeton then continues with the “Toad’s Kiss” statement, “Our ability to accelerate National’s growth with our much larger sales force is the foundation of our belief that we can produce strong returns on our investment. The combined sales team will be 10 times larger than National’s is today, and the portfolio will be exposed to more customers in more markets.”
Apparently, Texas Instruments believes that with its managerial prowess it will be able to turn around the growth story at National Semiconductor by acquiring (kissing) it.
ConclusionIt appears Texas Instruments isn’t aiming to increase economic value to its shareholders but rather increasing managerial domain and/or reported numbers for accounting purposes. They meet the first test — Texas Instruments business leaders clearly have the incentive to be measured against their peers and compensated based on the size of sales. Additionally, they meet the second test — firmly believing in their ability to help and manage National Semiconductor's growth in product sales.
Perhaps Texas Instruments will pull a rabbit out of a hat — given enough time we shall see. However, we know most M&As don’t end well. What is certain is that current National Semiconductor shareholders got the better end of the deal. They’d be well-advised to take the money and run.
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