EasyLink Services (ESIC) announced Tuesday that it was being taken over by OpenText, a Canadian company, for $7.25 per share and closed Wednesday at $7.16. I first wrote about ESIC on November 12, 2010, and recommended it when it was trading at $3.95 a share and most recently recommended it on March 26 of this year when it was trading at $4.79 a share. Patient investors in ESIC have been very well rewarded.
ESIC was initially recommended because it seemed ideally situated to exploit the low interest rate environment which has become a feature of the financial world. By borrowing a great deal of money and acquiring a business at least as large as itself, ESIC put itself in a position to throw off more and more cash as long as the after tax cash flow yield on the investment was greater than the after tax interest rate paid on the debt used to acquire the investment. The combination of low interest rates and the tax deductibility of interest expense created a huge gap between the cash flow yield on the investment and the after tax interest expense on the debt and, with the enormous excess cash flow, ESIC was able to pay down the debt at a rapid pace. The cash flow machine that ESIC had become was more and more valuable in "private market" terms - there still was a big question as to whether the stock market would ever wake up to that fact.
I believe that value investing is very largely a search for stocks whose private market values are higher than the market caps suggested by their stock prices. In many cases, we will never really learn the private market value because the company will never be taken over. ESIC gives us a window on private market value. Although it suggests that the market substantially undervalued ESIC, it appears that its private market value was not quite as high as the $8 I suggested. On the other hand, the large gap between the private market value I thought I saw and the price created quite a bit of room for me to "be wrong" and still make a lot of money. This is another important tenet of value investing - the need for a margin of error.
If a company is taken over, the takeover price is, absent extraordinary circumstances, the private market value or a very, very good indicator of the private market value. It should be the highest price any qualified bidder is willing to pay (if it isn't, then the higher offer of another bidder should be accepted). It is a price reached between a willing buyer and a willing seller and represents, in a sense, the market's "verdict" on the value of the company. The fact that it was a price substantially higher than where the stock had been trading suggests that the fundamental thesis about latent value associated with stocks which can benefit due to low interest rates may have merit.
Of course, many companies - for example, Apple (AAPL) - are too big to be taken over. These companies can engage in a low level, slow motion MBO or LBO via share repurchases in which they make the same calculation described about - comparing the after tax interest rate earned or paid on the money used to make the repurchases with the after tax earnings yield on the stock. In many cases, this kind of calculation will still suggest that the stock is a bargain in this interest rate environment.
I am still long ESIC awaiting developments but am lightening up as we close in on $7.25. I will be covering other situations in which companies have an opportunity to benefit from the low interest rate environment.