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Activists at the Gate, part 2



Readers, welcome back. Last time, I mentioned Boris Johnson, a somewhat prophetic statement as he nearly became Prime Minister of the UK a mere few days later. Haunted by the ghost of Prime Ministers past in the leadup to Halloween? How fitting. This time I’ll be careful with what I say in my introduction. On a totally unrelated note, I can see myself being a billionaire sometime next week.


In my previous post, I wrote about running campaigns, the only thing that actually matters, and why not to destroy your reputation. This week I’ll look at the three types of activist strategies and answer some questions from readers. If you’ve got any questions, different perspectives or think I’m flat out wrong, please send them over to crombie@crombiegi.com, I’m always keen to chat investing.


I’ll say this at the outset: the best thing that can possibly happen in an activist campaign is: you show up on day one, make your suggestion and management respond “You know what James, you’re right we should do that.” It’s all over by lunch on the first day. Minimum time, maximum alpha, on to the next opportunity. If this approach fails, and you decide to go public, you could be in for a long fight.


So how do you "do" activism? To my mind there are three broad categories:

1. Operating improvements

2. Financing improvements

3. Special situations


1. Operating Improvements

The first, operating improvements, revolves around the classic drivers of free cash flow: revenue growth, margin changes and investment (in capital expenditure and net working capital). These are usually the most difficult and most rewarding campaigns. They’re difficult because if you’re suggesting operational improvements, you’re essentially saying management should have made different decisions or they have performed poorly. If this escalates, the fights can get ugly. Even if they agree with you, implementing the suggestions can be a lengthy challenge involving tens of thousands of employees... and it may not work.


However, the rewards can be sizeable. If the operational turnaround is successful (or markets think it might be) cash flows and the share price should increase. This is activism at its best: helping companies get better at what they do.


The reality is that most management teams are exceptionally talented at operations. Indeed, they’ve been trained in, promoted for, and remunerated based on operational excellence for their entire careers. They are usually highly intelligent and capable individuals and they are almost certainly better at operations than fund managers. However, an activist’s outside perspective can be useful.


This is not to say management are infallible or that certain forces within companies and markets can’t result in sub-optimal decisions. Although there are some exceptions. I once heard a management team described as “when they’re talking, they’re lying. When they’re not, they’re stealing” thankfully, these teams tend to be the exception. The reality is whatever the activist is asking management to do has probably been considered and discarded for one reason or another. Often that reason even makes sense. If management backtrack, they must explain publicly why they’ve changed course, and someone will probably need to be replaced / fired or take a hit to their professional reputation. With that context and knowledge of the stakes, it’s little wonder management can fight hard against an activist’s suggestions.


2. Financing Changes

The second case: financing changes, are slightly easier but lower reward. You’re essentially saying the company has too much or too little debt, it’s paying too much or too little for it, or you’ve got a tonne of cash on your balance sheet, why don’t you give it to us? I was in a meeting once where the latter question was posed by a particularly, even by hedge funds’ lofty standards, obnoxious fund manager. The CFO responded without blinking “given how you guys performed last year, I’m glad we didn’t.”


Financing changes tend to be one of the easier campaigns for a variety of reasons. They’re more opportunities as management tends to be a bit behind the curve in optimising debt and equity financing. Such optimisation is relatively expensive, time consuming and management often have better things to do. Essentially, financing changes are an exercise in paper-pushing, not wide-ranging operating changes affecting tens of thousands of people.


That said, financing changes don’t tend to make huge differences to the value of a company. One of the basic laws of corporate finance is that you cannot create more pie (i.e. company value) by cutting it differently (i.e. altering the percentages of debt and equity used to finance the operations). Put more simply, companies buy assets with debt and equity. Those assets generate cash flows. How those assets were purchased (debt / equity) doesn’t alter the cash flows they produce. For the finance theory sticklers, yes, the tax shield provided by debt can have a small impact on company value, but it’s not enough to form an investment strategy.


Caveats aside, are times where companies have kept an inordinate amount of cash on their balance sheets for a long time. Indeed, some CFOs make Smaug the dragon’s views on the hoarding of riches seem relatively moderate. What can happen is an excessive cash balance is hoarded for so long the market no longer believes it can be liberated (i.e. paid out to shareholders) and so discounts its value accordingly. For example, a company may have $200 million cash on hand, but only $150 million of it is included in the share price. If an activist liberates it, returns can be pretty solid.


So, financing campaigns: easier but lower generally lower yield.


3. Special Situations

Finally, we have special situations. This includes things like encouraging or blocking mergers, encouraging the breakup of the company or the sale of certain divisions and just about everything else.


Let’s look at mergers. They are strange beasts and nearly always full of promise. They are often motivated more by management’s desire to grow EPS (without regard for the return on investment) than by genuine value creation.


In a merger, an acquiring company seeks to make the merged entity worth more than the sum of the parts by extracting “synergies” from the deal. Synergies are cost savings or revenue gains generated by putting the two companies together. For example, you only need one head office and can cross-sell products to customer bases.


Synergies are also rarely realised in full, if at all. Furthermore, if an operationally weaker company acquires a stronger one, the weaker can dilute the stronger, destroying value. For activists, blocking these mergers can generate sound returns. Conversely, if a company is truly broken, sometimes your best bet is to sell it and make it someone else’s problem – again, activists can encourage this.


Company breakups can generate value too. If two unrelated divisions are held in one company, they can be worth more apart than they are together. A good example was Eagle Materials (EXP US) during the pandemic. It was a concrete and plasterboard company in the US. There are just about no synergies between concrete and plasterboard, so an activist recommended the company be split and sold to competitors. Each division was worth more in a sale than it was as one company. There are a variety of reasons this happened which are beyond the scope of this article.


Another underappreciated aspect of special situations: management fundamentally don’t understand what the market is thinking. For instance, perhaps management are concerned about delivering operational improvements when all the market really cares about is pending litigation that might cause the company to breach a debt covenant. Again this is not to say management inept, simply that they have spent their careers getting extremely good at operations. The first time they’re asked to engage with the market or make capital allocation decisions is often when they step into the C-Suite. It is here that market natives like fund managers can provide useful insights.


It would be remiss of me not to mention short-side activism. I’ve never engaged in this as I think the returns on brain damage are simply too low – a reflection of the brain damage, rather than the returns. If you publish a letter saying that the company is fraudulent or that management are being dishonest you are probably going to get sued. The tough part about this is that management spend the company’s resources suing you and you spend investor resources defending yourself. Company resources usually dwarf yours by orders of magnitude. Once the legal battle starts, it will probably take months, be extremely time consuming and seriously inhibit your ability to find new ideas. In a previous post, I wrote that sometimes, when shorting frauds, it’s best to show up after the battle and stab the wounded.


I don’t want to suggest that short-side activists don’t do an important service, they absolutely do… Nor am I suggesting that there aren’t people who make a lot of money from it because there absolutely are. All I’m saying is I prefer to keep my shorting out of the headlines.


Questions from readers:

A few readers wrote to me after the last article with questions. If you’ve got any questions, thoughts or comments, send them to crombie@crombiegi.com.


Are smaller companies easier targets?

In some ways they are. It’s easier to get a meaningful stake, perhaps even one large enough to propose directors yourself. However, the same rules apply. You need other shareholders on side to ensure your proposed directors get elected and it’s better to do it behind closed doors.


What if management hold a controlling stake?

Move on. There are far better uses of your time. The reason activism works (when it does) is because you ask politely, and if the response is unsatisfactory, you have avenues to apply more pressure. If management hold a controlling stake, they can tell you to take a long walk off a short pier.


A recent example is Lord Zuc (who I’m convinced isn’t human). Meta Platforms (the Facebook parent) has a dual share class. It means Zuckerberg holds 13% of the shares and 54.5% of the voting rights. This allows him to do as he pleases. Presently, the company is investing essentially all of its operating cash flow into the Metaverse. This generates no revenue now, meaning cash flow to investors is much lower than if Meta stopped doing this. The reason Zuc is doing this is because Meta is a mature company. There are no further users to join the platform meaning less eyeballs to advertise to, meaning revenue growth will slow. The Metaverse is a way of generating additional revenue growth. How? We don’t know. Then again, when Meta first listed, it was unclear how it would make money and that worked out pretty well.


Will that work out well this time? We don’t know. The market doesn’t seem to think so which has seen the shares lose 70% of their value this year. Investors have asked Zuc to change course. He has told them to find a pier. There is literally nothing they can do. There are plenty of good activist ideas out there, go find them and their alpha opportunities. Don’t waste time if you can’t apply pressure. You owe that to your investors and your own sanity.


What do I think of this letter to Lastminute.com?

This example demonstrates the last two points pretty well. I’ve had a brief look into this case. Essentially, Lastminute.com (LM) appears to have learned their management practices from a combination of Monty Python sketches and the Fyre Festival documentary. The board of directors don’t appear to be behaving in the interests of shareholders and there’s evidence of some level of corruption amongst management, if not outright fraud. RC appear to be correct. But as I talked about last week, being right is far less important for success than you might imagine.


Raper Capital (RC) hold 0.5% of the outstanding shares and want the board of directors to put the company up for sale. This approach makes sense. Sometimes, when the rot is as bad as it seems, the best option is to sell the company. The challenge RC will face is this: LM is ~45% owned by Freesailors Coöperatief U.A., a holding vehicle owned by Sterling Strategic Value (an activist investor) and some of LM’s top management team. LM will probably end up doing whatever Freesailors wants them to do. I’ve had a quick look at the publicly available information, and it doesn’t seem like Freesailors is all that keen on a sale. While it is possible that RC can get another 49.6% of investors on board, it’s highly unlikely.


Thanks for reading, I’ll see you next time.



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