Shorter battle?, page-16

My view on the acquisition, in short, is that Mr. Kane selected a so so time to do a full-priced acquisition for Boral which earns mediocre return for its shareholders for years and whether this acquisition works depends on continuous industry recovery and his skill in the post-merger integration.

(1) Is Headwaters a good business?
After a series of acquisitions Headwaters takes plenty of debts to purchase earning power. That's why the Net Debt to Shareholders Equity ratio is 238% in FY 16 but ROE is generally looking good at about 17% for the last 3 years. Its pre-tax earnings growth rates in FY14, FY15 and FY16 are 64%, 88% and 92% respectively. It even looks more exciting when one sees housing starts in US jumped 25% in Oct. But don't forget where Headwaters comes from: a serial business buyer.

(2) How about Boral? Several points I'd like to share here.

(2.1) Boral's business economics in general: mediocre
Boral's average ROE in a decade is about 5.8%. During the recent 3 years, Boral's ROE increased quite a bit from the industry downturn 3% to the current 8.5%. But revenue has not yet recovered to pre-GFC level(10 years ago) and in fact, the top line keeps shrinking.

(2.2) Boral's share performance since Kane assumes the role: good
Mr Kane assumes the top job in Oct 2012 when the share price was basically at a very low level if we look back. He didn't expand the business. He simply made the business more efficient. He cut cost successfully and paid out all profits through dividends and share buyback. As a result, despite of revenue shrinking, net profits recover to pre-GFC level, cash flow is strong and share price soars. Market cap $2.8 billion in Oct 2012 grows to $4.6 billion before the deal announced in Nov 2016, implying a PE 18×. If considered dividends paid, 4 years CAGR is higher than 13.5%.

(2.3) Mr. Kane's interest
FY16 Mr Kane's fixed salary plus Short Term Incentives is $3.5m. He also sold half of the newly vested Long Term Incentives crystalising $1.77m in Sep 2015 and keeps the other half which is 353,566 shares worth about $2.1m. Now he also awarded 2.13m LTI which if all vested today, is worth about $10m to $12m.

LTI's hurdle is basically the Total Shareholders Return in the next 3-5 years. The total LTI is something that you need to work very hard and brilliantly to achieve. But that $10m to $12m is not something that you can achieve all at one time. Even you achieve every hurdle, you get $3m to $4m every year. So compared to fixed remuneration and STI, LTI is kind of hard. STI in Boral has a sole hurdle which is EBIT. In the boom time, a cyclical company can simply expand its business by using more debts. Interest costs doesn't concern EBIT but EBIT can benefit from more debts.

I have to say, I like this remuneration plan including family relocation support for 5 years (consulted from EY, designed by the Board) very much if I were Mr. Kane: no downside risk while the upside potential looks just no complaints. Once the merger finishes, EBIT in 2017 is set to get a greater boost!

(3) Pros and cons of the deal
Pros: Mr. Kane is an American and develops his career mostly in US. To select the right local managers to manage Headwaters shouldn't be a problem. His record in Boral's last 4 years demonstrates his specialty in cost cutting, in anther word: synergy. So the chance to achieve that proclaimed $100m synergy is bigger with Mr. Kane's hands on the wheel. Moreover, with the strong growth momentum in both the industry and Headwaters, Mr. Kane should be able to achieve good results in this deal.

Cons: to pay almost USD $1.8 billion to buy Headwaters currently producing USD $50 mllion implying a 2.8% return on investment could be less clever than me paying $2.6 billion (assuming share price $152) to buy Blackmors which produces $100m. Only Blackmores has dropped significantly since my purchase so I am looking so stupid but Headwaters is still looking so hot at PE 36×.

Paying hefty price to buy assets at boom time seems to be an irresistible move for executives in cyclical industries. Boral's current ROE is 8.7%. To make this investment worthwhile or at least not a drag on the 8.7%, Headwaters has to quickly grow and grow and grow in a short time, (better well before the industry downturn starts) say in 3-4 years to achieve net profit after tax above USD $160m and maintain it a few more years before it enters the downturn again and starts impairing assets again!! So the cons is the timing and the price it pays. Though $160m level seems comfy for Mr Kane as I estimate (his specialty+industry momentum), the cons makes Boral simply bigger but not better.

(4) A few comments about Boral's intrinsic value

When Mr. Kane announced a 5% mild share buybacks in 18 Mar 2015, Boral's market cap was 782.7×$5.7=$4.46 billion. Assume Mr. Kane knows the rule of share buyback: only buys back when it is undervalued. So probably Boral's Intrinsic Value back in 18 Mar 2015 should be bigger than $4.46 billion.


We know Mr. Kane basically paid out all profits (FY15+FY16=$513m) either through dividends and share buybacks. So if assuming IV didn't grow for the last 2 years (of course, bullish shareholders won't agree but let's use this as a worst case), IV in FY16 should be still larger than $4.46-$0.513=$3.9 billion.

Now what is the market cap? 743.6×$5.02=$3.7 billion which is more than 5% lower than its worst case IV in FY16. So logically Mr Kane should start buyback again with the cash at bank $452m. But he couldn't. He just announced the deal which if canceled by Boral will cost Boral $75m breakup fee and, raised $450m from instos and he also needs cash to pay down the reclassified to current liabilities matured debts $352m. In general, he lacks the flexibility/liquidity/initiatives to do an opportunistic/ tax efficient/ very low business and forex risk boost for shareholders value which I doubt concerns him a lot.

Mr. Kane is a professional manager, not an owner.

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Do your own research. My opinion could be very subjective and bias.