The month of August has been eventful for shareholders of Hewlett-Packard (HPQ) starting with CEO Mark Hurd’s forced resignation amid charges of financial misconduct and ending with a classic takeover battle for 3Par (PAR), a small and unprofitable data storage company specializing in the hot field of cloud computing. HP and Dell (DELL) are currently slugging it out for 3Par with Dell matching HP’s latest all-cash offer of $1.8 billion, or $27 per share. Both HP and Dell are flush with cash and the bidding war may continue. The current bid of $27 per share for 3Par is nearly three times the price that 3Par’s stock traded at two weeks ago prior to the start of the bidding war.
According to a person familiar with the matter who was quoted in Friday’s Wall Street Journal, HP does not feel “any constraints” due to the company’s $15 billion cash hoard. The company is “in this to win” according to the unnamed source. Dell’s initial agreement with 3Par allows the company to match any rival bid which is what happened Friday morning when Dell matched HP’s $27 high bid. The ball is now again in HP’s court. Under Dell’s agreement with 3Par, Dell will collect a termination fee of more than 4 percent of the total deal value if 3Par eventually chooses to accept HP’s offer.
Rich Price for Promising Technology
According to the Financial Times Lex Column, HP and Dell risk overpaying for 3Par despite the company’s attractive technology in the cloud computing space. Lex notes that 3Par has grown sales from $38 million to $194 million in five years but has failed to generate operating profits over that timeframe. Both Dell and HP hope to sell 3Par products through larger global sales operations but it would take significant growth in sales along with high operating margins to justify the purchase price. At a $1.8 billion price tag, Lex notes that a buyer would have to generate after tax profits of $180 million from 3Par within five years in order to make a “respectable” return on the initial investment. This is highly ambitious given 3Par’s current revenue levels below $200 million.
Dangers of Cash Hoards and Leadership Vacuums
As we have argued on several occasions, excessive cash hoarding can destroy shareholder value in a variety of ways. A few examples:
- Managers with the luxury of vast amounts of excess cash on the balance sheet may be less inclined to optimize the business. If “peace of mind” leads to complacency and lack of motivation to improve the efficiency of a business, shareholder interests will be harmed.
- Cash has a tendency to “burn a hole in the pocket” of executives. Empire building managers with a large cash pile can pursue value destroying acquisitions much too easily. While it is true that many well run companies maintain excess cash for intelligent acquisitions, the risk is always present that the cash will be squandered.
- In today’s environment, the returns on cash are next to nothing so excess cash is not producing reasonable returns on capital employed by the business.
In addition, the manner in which many executives are compensated with stock options rewards cash hoarding by making options more valuable compared to paying out dividends in a timely manner.
HP is facing a “perfect storm” in this bidding war because the company is so flush with cash that it feels “no constraints” and it lacks a permanent CEO at the helm. As a result, the company’s interim management is free to recommend ever escalating offers for 3Par and the next CEO will simply inherit the situation and disclaim responsibility if the financial results prove unsatisfactory. HP’s board has proven its incompetence by allowing former CEO Hurd to walk away with a $12.2 million severance even as they accused him of financial wrongdoing. Clearly, HP’s board cannot be relied upon to check the ambitions of the company’s interim management.
The lesson to investors: When a company hoards cash with the intent to pursue “strategic acquisitions” and shows no apparent recognition of the link between the amount paid for a business and its ultimate financial returns, hang on to your wallet. If the company is making such a move in the midst of a CEO change where the successor CEO will be able to disclaim any role or responsibility in the matter, the situation is even more dangerous.
Disclosure: No Positions.