When Bad Stocks Make Good Buyouts


The First Data deal illustrates why private equity investors see value where public shareholders don't

Payment processor First Data (FDC) has had a tough time pleasing public shareholders, yet private equity giant Kohlberg Kravis Roberts is likely to earn a good return from the $29 billion buyout it proposed on Apr. 2 (see BusinessWeek.com, 4/2/07, "A Big Transaction for First Data").

The deal is a good illustration of the paradox of private equity. Companies that fail to please public stockholders often make the best deals for private investors. That's particularly true in service sectors, where slow-growth financial, health-care, and information-technology services companies are among the current favorites for private equity investors.

First Data, the largest credit- and debit-card processor, was once considered a promising growth company. But it has had trouble meeting Wall Street's demand for quarterly earnings growth. Its revenues from continuing operations increased a modest 8% in 2006, to $7.1 billion. Net income for the year dropped 12%, to $1.5 billion. On the last trading day before the acquisition was announced, Mar. 30, shares of the company closed at $26.90, well below the 52-week high of $48.88. The stock closed at $32.45 on Apr. 2, up 21%.

The earnings issue has been compounded by change at the strategic and managerial level. Longtime Chairman and Chief Executive Henry Duques was replaced by Charles Fote in 2003. But Fote failed to win over investors, and Duques returned two years ago. And First Data spun off its Western Union (WU) business last year, in a major shift that reduced revenue by $3 billion a year.

Steady Cash Flow Is Key

Poor earnings and trouble in the executive suite can be attractive to private equity investors, though. Such issues allow them to buy a company at an attractive price. The key issue in a leveraged buyout is whether the target has strong, steady cash flow that can support debt used to boost returns.

By that measure, First Data is plenty attractive. The company had solid cash flow of $1.1 billion in 2006. The company also has the ability to enter new markets, which can reward private equity investors who have a longer time horizon than many public shareholders. "This is a textbook private equity deal," says Phillip Phan, professor of management at the Lally School of Management & Technology at Rensselaer Polytechnic Institute in Troy, N.Y.

The combination of steady cash flows, relatively low technology investment needs, and "poor management" make First Data attractive, Phan said. He believes the company has been losing business to banks that increasingly prefer to handle their own payments. But he says the loss of that business isn't inevitable. Not only can that problem be fixed, but First Data also can be moved into new markets such as micro payments, extending the use of cards into tiny purchases such as soda from a vending machine. "This is a technical issue, not a conceptual issue, that will be solved with new management talent, probably somebody from the online retail sector," Phan said.

First Data wasn't immediately available for comment. KKR declined to discuss the deal. Duques issued a statement saying, "We believe that current market conditions present an exceptional opportunity to fulfill our commitment to maximize the value of First Data by delivering an immediate cash premium to our shareholders." KKR member Scott Nuttall said in a statement, "We believe with continued investments … First Data will build on its history of innovation and industry leadership." He also called the company's management "world class."

Ripe for an LBO

A report issued last month by credit strategists at Goldman Sachs (GS) said that First Data's financial profile could be strong enough to attract private equity investors. The Goldman report, which examined nearly 1,000 companies, studied the internal rate of return (IRR) in an LBO after asset sales and other forms of restructuring. An IRR takes the present value of future earnings into account. Companies with an IRR of 20% or higher are often considered good buyout targets. The Goldman report estimated that First Data's IRR would be as much as 21.3%.

The report highlights how bad stocks can make good buyouts. Many of the companies Goldman sees as the most promising acquisition candidates are rated neutral or even sell by the investment bank's research analysts. That's especially true of those in services businesses, including tech, health care, and finance services, largely because those have been growth businesses in the past but are now becoming more mature (see BusinessWeek.com, 3/28/07, "The Most Promising Buyout Prospects").

Consider the case of Unisys (UIS), the IT services giant based in Blue Bell, Pa. Goldman analysts have a sell rating on the stock, but the firm's report says that a buyout of the company could yield an internal rate of return of more than 66% over five years. That's assuming a private equity firm paid a premium to the current stock price of about 20%.

Rival Suitor a Possibility

Health-care services companies Amerisource Bergen (ABC) and Owens & Minor (OMI) also have sell ratings from Goldman. But the firm estimates that the potential returns for an acquirer would be 64% and 49%, respectively. Hewitt Associates (HEW), a tech services company, carries a sell rating and potential rate of return of 46%.

In the First Data deal, the biggest risk for KKR may be the prospect of a rival suitor. The deal includes a "go-shop" provision that allows First Data several weeks to consider a better offer, should one come along. That's an increasingly common technique that allows boards to argue that they are accepting the highest possible price (see BusinessWeek.com, 2/12/07, "Private Equity Slugfest"). Should that happen, a bidding war could raise the price of a deal and make a First Data buyout less attractive.


Steve Ballmer, Power Forward
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