Bank of America to buy Merrill while Lehman running out of options

Merrill to be bought out by Bank of America? Sure looks like it.

UPDATE (Sunday 3:57PM CST)
NY Times dealbook saying BofA and Merrill in talks.
Having personally started my financial career at Merrill, I am honestly shocked by this headline. Tough to believe that Mother Merrill will no longer be an independent entity.

From the New York Times: Bank of America is in advanced talks to buy Merrill Lynch for at least $38.25 billion in stock, people briefed on the negotiations said on Sunday, as a means to preserve that investment bank while Lehman Brothers looks likely to collapse.

The move suggests a desperate effort at triage on Wall Street, as Bank of America works to shore up the likely next victim of the credit crunch. A deal, valued at between $25 a share to $30 a share, could be announced as soon as Sunday night, these people said. Merrill shares closed at $17.05 on Friday.

Bank of America, the nation’s second largest bank by asset size, had been mulling buying Lehman, perhaps in a consortium with other financial players. But with financial aid from the government looking unlikely, Bank of America has moved on to Merrill, these people said.

As Lehman began to totter in recent weeks, investors feared that Merrill would be the next victim of the credit squeeze. Shares in Merrill, which has already reported tens of billions of dollars in losses, have plunged more than 68 percent over the past year.

Lehman continues to fight for its life after Barclays deal falls apart this afternoon. As I pointed out in my suitors list, Barclays has the capital but the problem was that any deal from Barclays would have required shareholder approval. Needless to say, that won't work.

Wall Street prepares for worst as Lehman deal stalls

Related Articles
Lehman Brothers basically done today
Lehman Brothers: New Plan but Same Problems
Lehman's credit at risk with Moody's

(Friday 2:05PM CST):
Fitch close to cutting Lehman credit rating
Fitch says Lehman rating will be cut without a deal

Lehman firesale looks likely says USNews
Lehman's Long Weekend

NYTimes talks Lehman Family Ties
The Family Ties in the Lehman Drama

There's continues to be lots of speculation today on which firms might be interested in taking on Lehman. And it’s no mystery now that Lehman is looking for a buyer. The firm confirmed that Dick Fuld is actively seeking the white knight scenario.

I am leaning towards a BofA - Lehman deal.

With that said, I decided to put a small list together of firms that could be involved in potentially buying Lehman. In no specific order…

Bank of America – represents the best chance of a US-based bank to take on Lehman. Of course, BAC struck a bad deal earlier this year (Countrywide acquisition) which leads me to believe that they probably still have a “bad taste in the their mouth” at the moment. However, they do have the resources to make it happen and coupling LEH with BAC might even make sense from a “net positive synergy” standpoint.

LEH would provide their strong equity underwriting platform to BAC’s extensive roster of heavyweight banking clients. BAC would also be able to leverage LEH’s oil and gas group to gain more market share in investment banking.

And finally, BAC would be able to step into the prime brokerage business (actually step back into it after they recently sold their platform to BNP Paribas). Although, I am not sure they want to get back into prime brokerage considering how bad the hedge fund market is right now with respect to the industry-wide deleveraging.

Plus BAC still has a few other problems which includes $5 billion settlement for the auction-rate securities debacle.

While I would say “spending” is a bit tight at BAC right now, they do have the balance sheet to put a deal together. They are definitely in the mix - the question is "how much?"

Probability: BAC is the most likely of all US firms to do a deal. But I am not sure any US firms are comfortable enough to take the risk.

Goldman Sachs – the match of Goldman and Lehman hit blogs this morning and, of course, CNBC’s Charlie Gasparino put an end to that rumor with his “sources.”

GS might be somewhat interested in doing this deal but I believe under two conditions: (1) at a price of about $1.5-$2.00 per share (“takeunder” price where its bought cheaper than its current market price) which most certainly Dick Fuld will push away and (2) assurances that the Fed would provide a liquidity backstop of-sorts as they did for the JP Morgan-Bear deal.

And let’s suppose hypothetically those conditions were to be met, it might still be asking a lot. GS, who steps up to earnings plate next week, might be facing their own host of debt-related problems at the moment. One of the largest holders of Level 3 assets on Wall Street, GS would be reluctant to take on the responsibility of trading more toxic debt into this beleaguered market environment.

Probability: Unlikely that it would happen with Goldman. They are probably too busy putting out their own fires and need to make sure that they don’t compromise the strength of their balance sheet. They probably figure they can win in the situation by simply eating up investment banking market share once Lehman gets swallowed up by another firm.

JP Morgan – after digesting Bear it would be a lot to ask from Dimon and his army of executives. No way they could do this kind of deal. The firm is stretched right now. Just wouldn’t make sense.

Citigroup – one word: impossible! The firm is too busy shedding non-core assets and dumping bad business units. Not only did they lose huge on Pandit’s hedge funds but are also suffering from writedowns in Fannie and Freddie Mac.

Probability: JPM and C are nowhere in the game - too many battles to fight on various other fronts. You have better odds on a Vegas table then betting that one of these two firms plays White Knight.

Korea Development Bank – might be the dark horse in all of the speculation. Up until about late last week, LEH and KDB were in close negotiations. KDB was said to have offered six trillion won (4.3-5.2 billion dollars) for a 25% stake. Think about what that sum of money could buy them now – the whole thing? Maybe so.

South Korean regulators would be the enemy to this deal. The chairman of the South Korean Financial Services Commission explicitly told KDB that such a transaction would be highly scrutinized.

Probability: At this new “discounted” price, I wouldn’t be surprised to see KDB roll the dice. In KDB's eyes, the "cheap just got cheaper."

Other firms to watch: HSBC and Barclays. Barclays intrigues me slightly to the extent that they enjoy about a $40 billion market cap and have plentiful resources to do a deal.

UBS to split Investment Bankers and Brokers

Firm tries to restore client confidence

Bloomberg is reporting that UBS, Switzerland's biggest bank, plans to separate its investment banking and wealth management units after the recent subprime meltdowns. All being done to stop the bleeding - an attempt to stop their rich clients from taking their money out of the firm and running for the exits.

More precisely, the firm will separate the firm into three different pieces: wealth management, asset management, and investment banking. This move has prompted critics to speculate that the firm is preparing to facilitate a sale.

The firm saw over $15 billion withdrawn from its wealth management unit during the second quarter.

I wouldn't be surprised to see Merrill Lynch do the same thing.

After $43 billion in write-downs, UBS to split main businesses [NY Times]

UBS to split investment bank from wealth management [Bloomberg]

Meredith Whitney: More Weakness Ahead?

When Meredith speaks people listen. She is a sharp analyst that has made some bold calls the past couple of years. Her biggest call: Citi's failures. This interview took place earlier this week on the CNBC set. Among her points in this interview:

1. Expect to see further weakness in housing prices



2. Banks are recapitalizing but very little of that is being used for loans



3. Systemic risk still pretty high for most investment banks



4. In this kind of market, money goes from "weaker" hands to "stronger" hands



5. Credit card industry will have repricing problems with their loan portfolios due to higher regulation

Her calls have been pretty spot-on recently. This interview is probably a bit extreme to the extent that she might be "overselling" the current market conditions. But at any rate, I would recommend that you keep her word in mind. And if you have a problem with her then maybe you should take it up with her husband.

Current Fortune article on Meredith Whitney [Fortune.com]

Blackrock and Neuberger for sale?

Institutional money management firms have always been a good business. Maybe not as sexy as prinicpal trading or investment banking but always a dependable revenue stream. They offer highly predictable cash flows without the cost of extensive capital requirements that might go into other business models that sit at these same revenue levels.

Both, Blackrock and Neuberger, are very attractive assets held by Merrill and Lehman, respectively. But in the wake of the recent writedowns, it is thought that both firms are being pondered to be sold. Will they be sold? I would say no, but if they are, then we will know that Merrill and Lehman are seriously desperate for cash. Let's look at both money management firms:

Blackrock Inc. (NYSE: BLK) is an investment management firm that has almost $1.4 trillion in assets under management. Blackrock was founded as the Financial Management Group in 1988 within the private equity firm Blackstone Group. After a number of acquisitions, the firm was spunoff from the Blackstone Group under the name Blackrock and was aggressively branded as an independent money management firm. Then in 1995, PNC Financial purchased BLK where assets under management would grow to $165 billion over the next few years. Shortly thereafter, the firm decided to go public.

Since then, Blackrock acquired State Street Research, a mutual fund previously owned by MetLife, and also merged with Merrill Lynch Investment Managers (MLIM). The MLIM deal, which was completed in 2006, halved PNC's ownership and gave Merrill Lynch a 49% stake in the company.

Neugerger Berman Inc. is an investment advisory firm founded in 1939 by Roy Neuberger to mange funds for high net worth individuals. In 1950, Neuberger became one of the first firms to offer a no-load mutual fund to individual investors and, in 1971, launched a portfolio for institutions which pushed the firm into the foray of institutional based money management.

In 2003, Lehman Brothers bought NB for $2.6 billion in cash and stock which at the time represented about 4% of NB's assets under management. Analysts at the time commented that price was "reasonable" considering the stature of the NB brand. Talk among analysts is that Lehman could possibly fetch $8 billion if it were to sell off NB on the basis of their firm's $130 billion in assets under management.

With respect to a sale of either of these firm, I really don't think that Merrill or Lehman wants to engage into such a transaction. Both money managers are cash flow machines and provide a nice anchor in earnings to an otherwise volatile earnings environment. But it appears that they might need to do so as to increase their firms' liquidity after their massive writedowns. In fact, any asset sales of either of these two firms would probably be followed by a downgrade by the credit agencies which, in turn, could lead to a host of other potential problems.

If in fact they were to sell the assets, my expectation is that Merrill would sell a 10% stake in Blackrock while Lehman would sell off the entire firm. Merrill and Lehman, at a minimum, must demand a sale price of more than 5% of the assets under management and possibly even more. Therefore, $8 billion for Neuberger would be good and $8.5 billion (assuming they sell a 10% stake in BLK) should suit Merrill. Anything less could spell trouble.

Lehman no more....

CFO and COO fired today, firm goes on selling block

(I really did not think I would be writing this post....I actually had faith in Callan but I guess I was wrong)

Another iBank bit the dust....this time it was the once-mighty Lehman Brothers. But before that news broke the CFO, Erin Callan, [must-read bio of her in the WSJ] that everyone spoke so highly of got the axe first thing this morning. For the record, I was a fan of her no-frills style. But just one quarter ago she proclaimed LEH's capital structure fit for the environment and their balance sheet flush with cash. Unfortunately she was wrong on both fronts. Evidently, she hardly knew what was going on with the firm. Is that bad? Maybe but it's not really her fault.

With the advent of complex derivatives and hybrid structures on the CDO desks, not even a room full of Harvard PhDs could unpeel the potential losses that the firm had (and probably has) on it's books.

I don't blame her, I don't blame derivatives, I don't blame corruption nor do I blame overzealous investment bankers. I simply blame one simple metric: EPS (more precisely increasing the EPS on a quarter-by-quarter basis to push share prices higher). The past few years we have seen iBanks making money hand over fist and everyone wanted a piece of the action. Both CEOs and shareholders, alike, wanted equity growth through higher revenues and stronger EPS figures. Everything was about increasing the firm's bottom line. Increase prop trading, a deal here, another deal there and then BAM - money for everyone. The trading desk was the "big bet" for higher revenue and EPS growth. In man cases, a complete disregard for VAR. Well they got what they wanted, however, at the cost of unintended consequences.

News for 28 Mar 2008

- Lehman traded lower yesterday by 8.9% to $38.71 on rumors that the firm is "short on cash".  Keep in mind this same type of rumor and corresponding sell-off happened with Bear three weeks ago.  I'm not saying the same is going to happen with Lehman but I am saying taking caution in trading this name. The shares have fallen 41% percent this year amid the $200 billion in industry-wide losses.  I wouldn't be surprised to see more weakness in this stock over the next week or so. 

- The number of bearish put options traded on Lehman's stock exceeded call options by 3-to-1 and put volume in the first three hours of the day topped the daily average of the past 20 sessions. This is a very bearish sign with respect to investor sentiment as it applies to LEH.  Puts are generally bought by people who believe that the stock will go down in value while calls are usually a bet on the upside.  In this case, people were buying puts "hand over fist."

- Lehman's response to the trading action: "There are a lot of rumors in the marketplace that are totally unfounded,'' Cohen said in a telephone interview with Bloomberg yesterday. "We are suspicious that the rumors are being promulgated by short sellers of our stock that have an economic self interest.'' 

- And here's an interesting note reported by Bloomberg that dissects a huge put trade today:

A so-called bear spread of almost 20,000 Lehman options contracts traded at 9:51 a.m., according to traders and Bloomberg data. An investor using the strategy buys puts while simultaneously selling them at a lower strike price. The position reduces the overall cost of the trade and also caps the total potential profit if the stock falls.

When the Lehman spread traded, the stock was at $42.05, down 1 percent from the previous close. Thirty-five minutes later, the shares had plunged 8.3 percent to $38.55.

- Hmmm!  Sounds like some traders are going to get burned.  Its been my experiences that more times than not, when people take a huge "speculative, rumor-based, negative" position like this...they usually lose.  This is action that great to watch but I wouldn't dare engage into.  This one will be fun to see unfold.

JPM looks to raise BSC bid from $2 to $10.

Late tonight it has been revealed through anonymous sources that JPM and Bear are in negotiations to raise the bid price from $2 to $10 per share.  The renegotiation came about with JPM approaching BSC about upping the price on the sentiment that the deal will be rejected.  Apparently, he felt bad about the price - cognitive dissonance.

According to the New York Times...

"The Fed, which must approve any new deal, was balking at the new offer price on Sunday night after several days of frantic, secret negotiations, these people said. As a result, it was still possible the renegotiated deal might be postponed or collapse entirely, said these people, who were granted anonymity because of their confidentiality agreements.

If the Fed were to reject the new proposal, it could set off a furor among shareholders of both firms that the government was preventing them from making a fair deal."

In another strange twist, JPM is working the deal to ensure they can snare approx 39.5% of the outstanding shares from BSC that would give it nearly the 40% required by Delaware law to be considered the "majority".  This would give them the power to override challenges made by the largest shareholder, British billionaire financier Joe Lewis.

This comes on the heels of Mr Dimon apparently calling other Wall Street CEOs pleading with them not to hire away the BSC employees.

The drama continues....Personally, I think the deal prices goes up even more.  As I stated previously, I didn't think the deal would get done at $2.  And, honestly, I still don't think this is over yet.  In fact, if it doesn't get passed at $10 per share then is it possible that the deal falls apart completely. 

Bear mauled by JPM & Co.

The more I think about it the angrier I get (if I were a Bear Stearns shareholder).  Forced into a firesale, Bear executives sold the firm for a reported $2 per share last weekend.  And that came on the heals of Bear estimating that firm’s book value being worth at least $80 per share.  Now that’s a serious disconnect.  My first question: Mr. Dimon (JPM CEO), could you do us all a favor and reconcile the $72 difference?

My next question: why didn’t the Fed allow other firms to potentially bid for the firm.  I’m sure with all the firepower and deep pockets that Goldman has, they would have submitted an offer.  Instead they allowed JPM to do a deal with virtually no downside risk (to the extent that the Fed would allow for emergency funding) plus the option to purchase the $1.2 billion Bear building if shareholders are to vote down the deal.      

And with such a terrible offer comes a new set of problems.  The New York Times reported in Wednesday’s business edition a new showdown commencing:  a battle between bondholders and shareholders.  One side wanting the deal to go through as to secure the assets from bankruptcy proceeding (bondholders) while the other side wants to breathe life into the equity side of the balance sheet (equity holders).  All while each side trying to buy up as many shares as possible in order to increase their voting power for the upcoming shareholders meeting. 

If you can't tell, count me as one "against" the deal.  In fact, I may buy shares in the open market in the next couple of weeks to get in on the vote.

Stay tuned.

Microsoft goes "HOSTILE" on Yahoo! A Q&A Perspective...Part I

A successful hostile takeover from the perspective of the bidder is a rare occurrence.  Generally speaking, hostile deals are frowned upon by not only some shareholders on both sides of a deal but also by the bankers that sometimes provide the financing.  The synergies are also highly scrutinized as history has not been kind to these types of deals.  But this case may be different...

As we all know, Microsoft placed a $44.6 billion bet that buying Yahoo can give it the Internet presence that it has longed for in recent years.  After years of testing and research, Microsoft's foray into online search and advertising can be summarized in one word:  FAILED!  With Balmer at the helm, he is determined to change that here and now.  The software giant's surprising, unsolicited offer for Yahoo represents a 60% premium over the Internet company's recent share price.  If the deal goes on to close, this would be the biggest tech transaction ever recorded.

With so many details and questions surrounding this deal and the use of a "hostile" strategy, I have decided to tackle this deal from a Q&A standpoint.... 

What is a hostile takeover and why is Microsoft forcing a hostile takeover on Yahoo?

Normally, when a bidder makes an offer for another company, it usually informs the board of the target beforehand. If the target board feels that the offer is such that the shareholders will be best served by accepting, it will then recommend the offer be accepted by the shareholders.  This is commonly referred to as a "friendly" takeover.  A hostile situation is complete different.  In the case of hostile takeover normally one of the two (if not both) following conditions will exist between the respective parties:  (1) the board rejects the offer, but the bidder continues to aggressively pursue it, and/or (2) a bidder goes public to make an offer without informing the board prior to such offer.

In the case of Microsoft and Yahoo, I would say both conditions, to some extent, exist.  In 2006, Microsoft began showing interest in a Yahoo deal.  But after some initial discussions, Yahoo pushed Microsoft away.  Yahoo figured that they could go "Lone Ranger" by way of strategic partnerships and internal growth initiatives.  Well that failed miserably.  In recent years, Yahoo has suffered from disappointing online-ad sales, declining web-search market share and high management turnover. 

With Yahoo turning its back to Microsoft, that basically meant that the desktop giant had no choice but to take the deal public and make a hostile bid for it.  And, in all fairness, to Microsoft, its a smart move knowing that they themselves are in a "must win" situation.

Is it possible that other potential buyers could enter the fray at this point? 

Possible but very unlikely.  I am not sure that there is anyone, at least among those who might be interested in making a play on Yahoo, that has the kind of financial firepower and war chest of cash that Microsoft has on hand.  And in this world of high powered private equity firms, the turmoil of the credit markets make it unlikely that any consortium of dealmakers could ban together to pick up Yahoo.

So at this point I don't see any white knights entering into a bidding war with the Goliath of desktop software. 

I heard of a tactic that Yahoo may use which involves enacting a "poison pill"...what is it and how does it apply in this case?

The "poison pill" is a takeover defense used by target firms and can take many forms as it applies to defense.  The most common poison pill is known as a shareholder rights plan.   

In a shareholder rights plan, the target company issues rights to existing shareholders to acquire a large number of new securities, usually common stock or preferred stock, at a discount to the current market price. The new rights typically allow holders (other than a bidder) to convert their right into a large number of common shares if anyone acquires more than a set amount of the target's stock (typically 10-20%). This dilutes the percentage of the target owned by the bidder, and makes it more expensive to acquire control of the target.  Many times the dilution can kill pending deals. 

In the case of Yahoo, the firm does have a shareholder rights plan in place which could make the deal expensive.  However, the timing of the deal suggests the Microsoft (aka "Softie) might be looking to take its case to shareholders via a proxy fight for Yahoo board seats.  If Softie wins seats on the board then they could in effect have the new board members drop the provisions of the poison pill and let Softie close the deal without a shot fired.

What are the odds that this deal is consummated? 

Tough to put numbers on it but if I were forced to do so, I would say about 75% chance it gets done.  Microsoft can make a great case and has the war chest to put together a hefty deal.  And Yahoo, on the other hand, has very little leverage in light of the poor financial results and forecasts that they have provided shareholders in recent quarters.  So, with that, I say that a deal is definitely "more likely than not."

Should I buy Yahoo stock on the premise that Microsoft will probably up the target price at some point?

Absolutely not!  This is a risky transaction that has many hurdles and potential pitfalls (proxy vote, antitrust problems, white knight scenario, etc.) that could kill the deal and send Yahoo's stock tumbling into a complete free fall.  It could easily lose 30-40% in minutes if news broke that the deal is off while the upside at this point is pretty much capped.

If anything, you might be able to look at the weakness in Softie's share price as an opportunity to initiate a position.   

How important is this deal to Microsoft?

This deal is real important to Microsoft.  While I hate to cast a superlative on Microsoft, I will say that Microsoft's long term survival is very dependent on their Internet success or lack thereof.  And up to this point, Microsoft has struggled mightily to establish a foothold in the search and online ad market.  With that said, it's a must do deal for Balmer and Co.

This Q&A is to be continued, please stay tuned...

 

Subprime Storm Brewing! Traders Run to Take Cover!

Word broke today that the "smart money" at Bear Stearns (ticker symbol: BSC) sent a letter to its clients [Wall Street Journal] advising them of the NAVs for their subprime-heavy hedge funds. 

Turns out that the Bear's High-Grade Structured Credit Strategies Enhanced Leverage Fund was virtually wiped out of its entire asset base while another Bear subprime fund is worth less than a 10th of its value from a few months ago. 

And, amazingly, this comes after Bear put up $1.6 billion in rescue finanacing.  Talk about throwing good money after bad!

For readers unfamiliar with "subprime" allow me to provide a quick primer:  "subprime" is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history.  While these "subprime" loans provide investors with an above-average yield it doesn't come cheap!  The risk premium attributed to these instruments is usually classified of the "highest risk" and, commonly referred to as junk.  And, unfortunately these instruments seem to be holding up on their moniker.  An alarming number of these loans are in default and the meltdown is showing no sign of slowing down.

What's next and what is the net result?  I would suppose that we see at least half a dozen hedge funds take huge hits while attempting to "unwind" trades and the net result as I see it:  the "smart money" gets burned chasing the hot dot!  Now that's a surprise!

>> Subprime Uncertainty Fans Out [Wall Street Journal] <<

Disclosure:  I do not hold any position in BSC nor does my firm have any exposure to BSC.

Starwood Hotels...a HOT takeover target? Bidding starts at $90 per share!

Today, shares of Hilton Hotel (ticker symbol: HLT) soared 26% after word broke that the company agreed to be bought by the Blackstone Group for $20.1 billion in cash.  The deal is valued at $26 billion including debt.  This proposed acquisition represents a 32% premium over Tuesday's closing price.  With this transaction setting a form of precedent, I am a believer that the next target in this space is Starwood Hotels (ticker symbol: HOT).  Starwood is the corporate holding firm for the St. Regis Hotels, the luxurious W Hotels, Westin and Sheraton Hotels.

Now lets review the numbers of today's announced deal and what an "implied" buyout price might be for HOT based on Blackstone's offer for HLT:

Blackstone Offer for Hilton

Given the Blackstone Offer Price for HLT of $47.50 per share the stock closed today at $45.50.  Based on today's closing price, the price-to-earnings multiple (2008 EPS) stands at 29.6x.

Keep in mind the following:  Starwood's capital structure is less reliant on debt as is Hilton.  Hilton sits on about $7 billion in debt (debt-to equity ratio of 1.9) whereas Starwood has approximately $2.61 billion in debt giving it debt-to-equity ratio of 0.83.  This would, potentially, make it a a very good target for LBO firms.  An LBO firm could step in and immediately refinance HOT's current debt (as is done in most cases) and issue senior debt based on HOT's assets.

With that said and based on my "behind the envelope" calculations, I would predict any offer for Starwood to look something like this...

Buyout Offer for Starwood

Based on the multiples listed above and a 2008 EPS of $3.01 the implied price of a 100% buyout of HOT's equity => $90.00 per share

This price would value the deal at approximately $21.6 billion including debt.  Effectively a 20% premium on today's share price to get a deal done....

Everyone in private equity is running for the exit doors! (KKR is going public)

KKR, one of the world's largest and most successful private equity firms, has decided to take itself public and "cash out".  This will ulitmately push the firm to compete against the world's top investment banks such as Goldman Sachs, CSFB, and Merrill Lynch.  KKR's planned IPO seeks $1.25 billion which would represent between 5% and 10% of the firm's value.  With those number, we would potentially extrapolate the value of the firm at roughly $25 billion. 

Since the Blackstone IPO, we are seeing a rush to the IPO market with recent filing by Och Ziff (hedge fund) and I also expect potential filing by the Carlyle Group and also Texas Pacific Group. 

What does this all mean?  The idea of selling their equity simply represents a "cashing out" of the "smart money" private equity executives.  When these guys are selling, it means something!  They see the top of the private equity market coming to a halt soon.  Eventually, the debt market (which is used to help finance these monster deals) will dry up with higher yields and and higher transaction costs.

[Wall Street Journal Article] http://online.wsj.com/article/SB118349434385057002.html?mod=home_whats_news_us

Edward Lampert's ESL Raising More Money

I am always fascinated by Edward Lampert's successes and he is back on the road raising more money for his funds.  Here is a short video that David Faber did on Lampert.

Why P/E Multiples Are Flawed according to McKinsey...

Most investors like to quote the P/E multiple of stocks to determine intrinsic valuation.  Although widely used, P/E multiples have two major flaws according to a study recently done by the McKinsey Consulting firm:

(1) P/Es are systematically affected by capital structure. For companies whose unlevered P/E (the ratio they would have if entirely financed by equity) is greater than one over the cost of debt, P/E ratios rise with leverage.  Thus, a company with a relatively high all-equity P/E ratio can artifically increase its P/E ratio by swapping debt for equity.

(2) The P/E ratio is based on earnings, which includes many nonoperating items, such as restructuring charges and writeoffs.  Since these are often one-time events, multiples based on these earnings can be misleading to investors.  In 2002, for instance, AOL wrote off nearly $100 billion in goodwill and other tangibles.  Even though the EBITA (earnings before interest, taxes, and amortization) of the company equaled $6.4 billion, it ultimately recorded a $98 billion loss.  The result: earnings were negative due to this charge and its P/E ratio was meaningless.

According McKinsey, an alternative to the P/E ratio is the Enterprise Value-to-EBITA metric.  In general, this metric is less susceptible to manipulation by changes in capital structure.  Since enterprise value includes both debt and equity, and EBITA is the profit available to investors, a change in capital structure will have no systematic effect.  Only when such a change lowers the cost of capital will changes lead to a higher multiple.