Paulson's Checklist Casts Doubt on Verizon-Yahoo Deal

GuruFocus.com

- By James Li

Early this week, Verizon Communications Inc. (VZ) made a definitive agreement to acquire Yahoo! Inc. (YHOO) for about $4.83 billion. While the merger has high potential synergies, it is subject to a high variety of risks. Using Paulson's Merger Arbitrage Checklist, the Verizon-Yahoo merger is likely to face challenges during the process.


A brief history on Paulson and his checklist

John Paulson (Trades, Portfolio), president and portfolio manager of Paulson & Co. Inc., specializes in "risk arbitrage," a strategy that buys stock in the target company and shorts the stock in the parent company upon a merger announcement. Assuming that the merger succeeds, the arbitrageur can capture the spread between the per share target price of the deal and the current stock price of the target. However, this strategy carries high risk: if the deal fails, the stock prices usually revert to pre-announcement levels, and the arbitrageur can potentially suffer a substantial loss as a result.

As the name implies, the "risk" in "risk arbitrage" refers to any factor that reduces the likelihood of a successful merger. In his book, "Managing Hedge Fund Risk," Paulson devotes a single chapter to discussing this "risk." While the risks can be divided into macro risks and micro risks, the Harvard scholar's checklist focuses on the micro risks, those pertaining to the transaction itself. Paulson has discussed the following criteria for a successful merger:

  • Definitive agreements.

  • Strategic rationale.

  • No financing and due diligence conditions.

  • Solidly performing target.

  • Reasonable valuations.

  • Limited regulatory risk.



The above criteria can be classified into three risk categories, as described in Paulson's risk management book: earnings risk, financing risk and legal risk. Among these risk categories, earnings and legal risks most likely predict the success of a merger. Even though financing risks can substantially threaten a merger deal's success, financing issues usually occur concurrently with earnings risk.

Merger deals face several potential risks

Poor earnings can potentially destroy a merger deal between two companies. Should a target's earnings performance weaken between the announcement date to the expected closing date, the parent company can try to negotiate a lower price target or simply cancel the merger. This situation can be worse if both companies have experienced declining earnings performance in recent years. For example, although Tesla Motors Inc. (TSLA) and SolarCity Corp. (SCTY) have announced a merger agreement, both companies have poor financial strength and profitability ratings. An earlier article suggested that, while potential synergies do exist, the Tesla-SolarCity merger is not likely to succeed.

Merger deals that have financing conditions usually have higher risk due to the earnings risk described above. Although financing issues seldom occur in stock transactions, decreases in the stock market can worsen the parent company's ability to finance the merger. Cash transactions likely have higher financing risks since any decrease in earnings or operating income can significantly decrease the amount of cash available to finance the transaction.

Some mergers, although they have little earnings and financing risk, fail due to legal issues. Such issues can occur on the announcement date, between the announcement date and the expected closing date, or right before the deal is expected to close. Unless the companies provide a definitive agreement that they plan to merge, one company can effectively terminate the deal with few or no repercussions.

Additionally, certain due diligence clauses can weaken the merger's success: performance tests, "drop-dead dates" and other provisions such as walkaways and regulatory outs. Mergers that do not have any financing or due diligence clauses usually have a higher success rate than mergers that have such clauses.

Antitrust issues provide another branch of potential legal risks. Statements like "this deal is subject to customary closing conditions, including regulatory approvals" often appear in merger announcement press releases. Before merger deals can take place, they usually must be approved by antitrust committees like the Federal Trade Commission or the Department of Justice. During its process to acquire US Airways Group (NYSE:LCC), American Airlines Group Inc. (AAL) faced antitrust threats from the Department of Justice, who sought to block the merger due to potential decreases in competition and increases in airfare prices. Even though the airline is required to surrender gates at seven major U.S. airports, American still received federal approval for the merger.

Evaluation of the Verizon-Yahoo! merger raises some doubts

Based on Paulson's discussion of the risks, GuruFocus introduced the Merger Arbitrage Checklist to determine the likelihood of a merger's success. For each criteria on the checklist, users can rate it on a scale of 1-5, with 5 representing the best score.

Based on their press release, the two companies entered a definitive agreement for Verizon to acquire Yahoo!. Thus, we can rate the Definitive Agreement a 5. We can also rate the Strategic Rationale a 5: by acquiring Yahoo!'s core business, Verizon CEO Lowell McAdam can fortify his telecom company's competitive power and take advantage of the growing digital media industry. McAdam further discussed his rationale in his June 26 conference call: Since Yahoo!'s operating business complements AOL's business, the management at Verizon can create a portfolio of the top assets from the three firms. A previous article further discussed the merger's potential synergies and benefits.

While the merger has a strategic rationale to it, there are some complications about the merger. Even though there is no reference to financing conditions in the merger announcement, Verizon's CEO claims his company's assets match up with AOL's assets, suggesting a strong asset base. Additionally, based on the company's 15-year financials, Verizon's cash and total current assets have increased during the past five quarters. Thus, for the "no financing condition" criterion, we can rate it a "neutral" 3.

Since the two firms entered into a definitive agreement, we could assume Verizon and Yahoo! completed due diligence. However, the agreement is subject to customary closing adjustments including the approval of Yahoo's shareholders. This suggests that Yahoo!'s shareholders could potentially vote against the merger and thus implies a due diligence clause. We will rate the "no diligence clause" a 2 due to the voluntary voting of Yahoo!'s shareholders.

Yahoo!'s financial outlook is relatively weak. Despite having a financial strength rating of 6, Yahoo! currently has an Altman Z-score of 1.48, suggesting mild to moderate distress. During the past 10 years, Yahoo!'s Z-scores have decreased, implying a weakening business operation. Since the company's return on invested capital is negative, Yahoo! likely destroys value as it grows. Furthermore, the Internet company's margins and returns are deeply negative despite a profitability rank of 6. Based on these financial metrics, we rate the "solidly performing target" condition a 1, the worst score possible.

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Last, an analysis of the merger's potential legal issues results in a rating of 1 for the "limited regulatory risk" condition. As implied in Yahoo!'s forward-looking statements listed in the press release, the merger has high potential risks, including inability to get stockholder and regulatory approval, potential adverse affects on Yahoo!'s partners and potential litigation risks regarding Yahoo!'s business relevant to the merger.

The merger's overall rating using the Paulson's checklist is 2.9, which raises doubts that the Verizon-Yahoo! merger will be successful. In her conference call, Yahoo! CEO Marissa Mayer addressed the "complexities" of the merger: shareholder approval, a requisite proxy and an approval from the Securities and Exchange Commission since Yahoo! needs to "be renamed and reregistered as a 40s act company."

Conclusions and see also

Since this merger has recently been announced, there may not be enough information about whether the merger has any financing and due diligence clauses. Despite potential legal issues, the deal overall has good strategic rationale and is likely sustainable. However, based on initial evaluations, the merger will face many obstacles before its expected closing date in early 2017.

Disclosure: The author currently does not own any stocks discussed in this article.

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This article first appeared on GuruFocus.