In late 2014, I wrote an article titled “Peter Lynch – The Perfect Stock” (link). One of the thirteen attributes listed for the perfect stock was material insider purchases (There’s no better tip-off to the probable success of a stock than that people in the company are putting their own money into it). In that article, I wrote about a company where that was happening in a big way:
I’ll point you to a company that I’m interested in that has had significant insider buying as of late: WPX Energy (WPX). The company named a new CEO in May; since that time, he has purchased 44,000 shares on the open market. Due to the fact that energy companies have been routed in recent market trading, his cost on those purchases has totaled ~$836,000, or an average of ~$19 per share; that is nearly 100% higher than where shares recently traded. His most recent purchase was last week.
In the past two weeks, three directors have also purchased more than $100,000 of shares on the open market (each), in addition to purchases back in May; of those directors, none had purchased shares in any size over the prior two and a half years. Directors and managers (namely the CEO and CFO) have purchased 50,000 shares, at a cost of more than $550,000, in the past 10 days. When the people who know the company most intimately are willing to directly invest in the stock in a big way, that’s a good sign that the company warrants closer inspection.
I took a small stake in WPX around that time and haven’t done anything since then. I’ll admit that my understanding of the company at that time was, and still is, limited; my investment –Â or what could more aptly be called speculation –Â was based on some research I saw put together by the gentlemen at the GoodHaven Fund, as well the repurchase activity outlined above.
Something interesting happened at WPX a few weeks back that led me to write this article.
On July 14, the company announced that they had reached an agreement to acquire RKI Exploration & Production, LLC for $2.35 billion; note that this is a sizable deal relative to WPX Energy’s market cap. What grabbed my attention was the proposed financing for the deal:
“RKI unit holders will receive 40 million shares of WPX stock, valued at approximately $470 million based on the terms of the agreement. WPX intends to fund the balance of the acquisition through a combination of long-term debt, additional equity and cash on hand.”
As of the most recent quarterly filing, WPX had 206 million weighted average shares outstanding; issuing 40 million shares would increase the number of shares out by nearly 20%, diluting current shareholders interest in the legacy WPX assets pretty significantly.
Consider that in the context of what I said above: CEO Rick Muncrief had bought more than $800,000 worth of shares in the open market in his first six months at the company at an average cost of $19 per share – presumably because he thought the stock was cheap; that average cost is significantly higher than where the shares were trading the day the deal was announced (~$11.50 per share). Other executives and members of the board have also purchased shares in the open market, presumably because they felt WPX was undervalued as well. Turning around and “selling” a portion of the business after a significant decline in the valuation doesn’t seem to make much sense here.
Normally I would take this as an indication management is more focused on empire building than they are on increasing per share intrinsic value; I would start looking for the nearest exit.
But this is where the story gets interesting: two days after the deal was announced, executives and members of the board of directors collectively purchased more than 180,000 shares of WPX on the open market; they bought more than $1.8 million worth of stock in a single day.
President and CEO Rick Muncrief bought another 30,000 shares – the first time he has bought more shares on the open market since the transactions I discussed back in December. Six other individuals bought more than $100,000 worth of stock on that day. It’s clear that they’ve become even more confident in the company’s future as a result of the proposed deal.
Now I’m really scratching my head.
As an investor, this is an interesting combination to consider: management and the board continue to buy shares in the open market with their own money, and in size; they’ve done so at a cost basis materially higher than where the stock currently trades. As a minority shareholder, I like it when I can buy shares at a sizable discount to where insiders have chosen to do so.
At the same time, those same insiders just willingly “sold” a good chunk of the legacy business at a price that they presumably believe is attractive. It doesn’t mesh with their prior actions.
In 1982, Warren discussed the use of equity to fund M&A in his letter to shareholders:
The first choice of these managers in making acquisitions may be to use cash or debt. But frequently the CEO’s cravings outpace cash and credit resources (certainly mine always have). Frequently, also, these cravings occur when his own stock is selling far below intrinsic business value. This state of affairs produces a moment of truth. At that point, as Yogi Berra has said, “You can observe a lot just by watching.” For shareholders then will find which objective the management truly prefers –Â expansion of domain or maintenance of owners’ wealth.
As Warren goes on to explain, the decision to issue equity could still be justified: WPX may be cheap (as purchases by management and board members would lead you to believe), but the assets purchased from RKI could be just as attractive or even cheaper. If this is a true business-value-for-business-value merger, as Warren calls it, equity issuance could be justified.
Personally, I’m not sure if that’s the case: as I noted above, I simply don’t have enough insight into the industry to draw a knowledgeable conclusion one way or the other. Based on what I’ve read from others who are more knowledgeable than myself on this subject, the markers outlined by management in justifying the purchase price suggest a fair, or even optimistic, valuation; that conclusion was reached without any consideration for the “currency” used to fund the deal.
My bet would be that in the majority of cases, shareholders end up worse off as a result of deals like this. Warren explained in that same shareholder letter (1982) why that’s the case:
Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely, in a negotiated transaction, it inevitably wants to - and usually can - receive full business value in whatever kind of currency the value is to be delivered. If cash is to be used in payment, the seller’s calculation of value received couldn’t be easier. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.
Meanwhile, the buyer wishing to use his own stock as currency for the purchase has no problems if the stock is selling in the market at full intrinsic value.
But suppose it is selling at only half intrinsic value. In that case, the buyer is faced with the unhappy prospect of using a substantially undervalued currency to make its purchase.
Ironically, were the buyer to instead be a seller of its entire business, it too could negotiate for, and probably get, full intrinsic business value. But when the buyer makes a partial sale of itself - and that is what the issuance of shares to make an acquisition amounts to - it can customarily get no higher value set on its shares than the market chooses to grant it.
The acquirer who nevertheless barges ahead ends up using an undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvelous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilization of gold - or even silver - valued as lead.
Based on management’s own actions, I presume that they’d argue their stock is undervalued; even if the purchase price for RKI is appropriate in dollars, this could still prove to be a questionable buy (admittedly, the amount of equity used would require the gap between WPX’s stock price and intrinsic value to be pretty large for this impact to be meaningful). With the stock down more than 50% from where the CEO and other insiders first started buying in size with their own money, one could make the argument that has happened here. Hopefully management will be asked about this directly on their upcoming quarterly conference call (August 6).
This isn’t the first time I’ve written about this topic. I wrote a similar article about Johnson & Johnson (JNJ) back in 2011 (here), which deserves a quick update: four years later, I’d argue the use of equity in the Synthes deal looks as questionable – or worse – than it did at that time. As is often the case, Warren Buffett (Trades, Portfolio) looks spot on with hindsight (link).
