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3Par’s lease cancellation option and the HP vs Dell bidding war August 24, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, M & A Integration, Silicon Valley.
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3 comments

Update 9/3/2010:  It appears that the bidding war for 3Par did happen.  After a number of volleys, it looks like HP is the winner.  Yesterday, 3Par accepted its latest offer, and Dell said it is withdrawing from the bidding.

According to the San Jose Mercury News, here’s how the bidding went:

Aug 16:  Dell and 3Par announce they have an agreement for Dell to acquire 3Par at $18 a share.

Aug 23:  Before the stock market opens, HP announces competing offer to acquire 3Par at $24 a share.

Aug 26:  3Par announces in the morning that Dell has countered at $24.30; HP raises to $27 after the market closes in the afternoon.

Aug 27:  3Par announces before the market opens that Dell has raised its bid to $27 and HP goes to $30 two hours later.

Sept 2:  3Par announces before the market opens that Dell has raised to $32 and that HP has countered at $33. Dell announces it’s withdrawing from the bidding an hour later.

Update 8/26/2010:  Yesterday, Dell matched HP’s offer for 3Par and 3Par has accepted it.  This does not preclude HP from making another bid, but reportedly there is a $72-million termination penalty that 3Par would have to pay if it didn’t close with Dell.  

It’s good entertainment watching the bidding for 3Par.  Dell offered $1.1 billion .. a full 87% premium over 3Par’s pre-offer market cap … and it looked like a “go” … until HP, yesterday, offered $1.6 billion.  Dell, reportedly, is preparing another offer.  It has quite a deficit to overcome … $400 million … but if it matches or betters HP’s offer, we might see an exciting bidding war. 

How the two companies perceive the overall value of 3Par is, of course, based on how 3Par’s product lines, technology, and talent could add value to their respective companies. When, however,  it comes down to the short strokes… when the increments between the bids are in the neighborhood of $100 million, $50 million, or even $10 million or less … that’s when those leading the acquisition teams will be looking for the not-so-obvious elements of value hidden in 3Par.  

When they look at the real estate … and they need look no further than 3Par’s 10-k … they’ll find a nugget.  3Par’s annual operating lease expense is about $2.5 milliion, but mostly from its 263,000-square-foot headquarters in Fremont CA (in Silicon Valley) for which it has the right to cancel the lease as of May 2011, albeit with a $1 million cancellation fee.  If the acquirer can move the 3Par operation to property they already have (and which is difficult to dispose given the depressed real estate markets), there’s hidden value in that right to cancel.

It looks like 3Par … when it amended the lease to include the cancellation provision … may have already been thinking about how it might look to a potential purchaser.  And it had good reason to think that a suitor might be from nearby …  with the acquisition-minded likes of  HP, Intel, Oracle, and Cisco all headquartered in Silicon Valley.

So, could the presence of this cancellation provision determine who wins the bidding war?  Maybe.  It depends on how short are the short strokes.

While it is difficult to estimate the extra value that could be garnered from eliminating some of 3Par’s real estate overhead, it is clear that the cancellation option most likely has more value to HP, which has lots of real estate in Silicon Valley where it is headquartered, than to Dell which is headquartered in Texas. 

As to how much value could be gained.. here’s my stab at quantifying it:  The annual expense that could be saved by eliminating the lease looks to  be on the order of $2 million.  There would be other savings to be had, though, from consolidating 3Par operations into the acquirer’s operations. Using a (very imperfect) rule-of-thumb for the  cost of housing an employee of around $10,000 per year … and assuming that most of 3Par’s 668 employees are at headquarters, the potential savings could be close to $6 million per year.  That savings would be eroded away by the costs of retrofitting space to accommodate 3Par and by the migration of some expenses (such as utillities) with the people, but a reasonable estimate of the annual savings possible from integrating 3Par into the acquirer’s facilities might be about $3 million, on a pre-tax basis.. That’s about $2 million, after-tax, virtually all of which would flow to the bottom line.  At a p/e ratio of, say, 10, that savings would be worth $20 million to shareholders.  Not a big number relative to the overall offer price of $1.5 billion, but maybe enough on-the-margin to help win the bid.  Depends on how short are the short strokes.

Addendum 8/26/2010:  Maybe the short stroke is the $72-million cancellation penalty.

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Ten Things You Need to Know about the New Lease Accounting Standard August 23, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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4 comments

The “Exposure Draft on Leases” issued by FASB and IASB on August 17, 2010 is 66 pages of sometimes dense reading. I thought people might like a succinct  summary of what’s in it and what are its implications. At the risk of over-simplifying something that is pretty complex, here it is in ten little bites, starting with the main driver of the change … namely, the desire to make lease obligations more visible to investors by putting virtually all ….

Leases on Balance Sheets. (#1)   The present value of virtually all lease obligations will go on balance sheets in two places: as a “right-to-use” asset on the “left side” of the balance sheet and as an offsetting “lease liability” on the “right side”. This will not, though, be a simple calculator exercise; judgement will be required because the amount to be capitalized will be based on ….

Likely” Obligations, not “Minimum” Obligations. (#2)  The amount that goes onto the balance sheet is based on the “likely” lease obligation, taking into account factors such as the likelihood of exercising options to renew and the likely payments to be made as contingent rents. The need to make assumptions about options, contingent rents, foreign exchange rates, future market rental rates and the like, is going to lead to a lot of ….

Auditor Scrutiny. (#3)   Auditors will feel compelled to closely watch the assumptions used in calculating the amounts that go onto balance sheets. Where there are assumptions in accounting, there is room for manipulation. Most companies will want to make assumptions that minimize the amounts that go on balance sheets, and auditors will be watching for things like unsubstantiated claims that options to renew are unlikely to be exercised. They’ll also be scrutinizing the accuracy of P&L accounting for leases as that accounting becomes more complex as a result of the change to ….

Amortization and Interest Expenses Instead of Rent Expense on P&L. (#4)  Instead of a rent expense, companies will experience an amortization expense related to the right-to-use asset and also an interest expense related to the lease liability. The latter will be higher in the earlier years of the lease than in the later years, and therefore, so too, the total expense associated with a lease will be higher in the earlier years than in the later years.  Moreover and importantly, this total expense will be higher in the early years than what it would have been under existing accounting … and this will, when the new standard is first used, lead to ….

Busted Budgets. (#5)   Transition rules require that existing leases on the day that the new standard is applied will be accounted for as if they were new leases.  Therefore, in the early years of the application of the new accounting, virutally all leases will have a higher P&L expense associated with them than they would have had under existing accounting.  Most companies will experience an increase in lease expense of from 5% to 10% just due to the accounting.  This ratcheting up of lease expenses is going to reverberate throughout companies and have numerous ….

Downstream Effects. (#6)  The new accounting for leases will have many consequences, affecting everything from corporate and business unit budgets (and people’s bonuses!) … to real estate charge-back methodologies … to financial statement performance metrics … to compliance with bond and debt covenants … to cost-plus contract pricing.  In addition, the new lease accounting has important ….

Strategic Implications. (#7)  Three areas of strategy will be greatly affected. First, own-vs-lease decisions take on a new complexion as leases, particularly long leases, become undesirable. Second, lease duration becomes a more important decision putting the financial statement benefits of “going short” at odds with the desire to control space and lock-in current rental rates that can be had by “going long”. Third, longer-term consolidation planning takes on new value if it can substantiate assumptions that exercising of options to renew are unlikely. It is going to be crucial for companies to address these strategic implications, but it may be difficult for them because so many resources are going to be tied up dealing with ….

Compliance Complexity. (#8)  Most companies do not now have the processes, systems, personnel, and databases to comply with the new standard. A huge amount of work will be involved in establishing all of this infrastructure, and doing so will be challenging and complex because the infrastructure will need to transcend intra-company boundaries. This is why there is still uncertainty about when will be the standard’s ….

Effective Date. (#9)   The IASB and FASB plan on issuing the final standard by June 2011, but compliance will probably not be required immediately. It will be difficult for companies to put in place the infrastructure to comply and comments to that effect are likely to be made to the accounting boards during the Exposure Draft comment period which goes until December 15, 2010. Most observers think the boards will set the Effective Date for sometime in 2012 or 2013. That does not mean, though, that companies have the luxury of waiting before they address the new standard. There is much for them to do to get ready to comply. More importantly, though … from a strategic-point-of-view … the standard is already “in play” because there will be ….

No Grandfathering. (#10)  On the date that a company begins using the new standard, all existing leases will go onto the balance sheet as if they were brand new leases on that date. That means that leases being signed “today” will be subjected to the new accounting and that lease decisions being made “today” need to be viewed through the lens of the new accounting … which leads to my ….

Closing thought.  If you’ve not yet formulated your company’s response to the new lease accounting … by reviewing your real estate strategy and modifying it, as necessary … by revamping your decision-making framework and tools to incorporate the new accounting … and by laying out how you’ll go about planning and implementing the infrastructure needed to comply … then, you’re already behind.

A good way to learn more about the new accounting is to read my other blog posts on the new lease accounting where I’ve dealt with the strategic and practical implications of the new standard. You can easily follow my future posts by subscribing to the blog via email (which you can do on the right side bar).  You can also check out the webinar series on “The New Lease Accounting Standard and You” that I held for TRIRIGA and which is still available on-demand, or alternatively, read my companion white paper published by TRIRIGA.

Exposure Draft on Lease Accounting Is Out August 17, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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3 comments

Today,  IASB and FASB issued the long-anticipated Exposure Draft on lease accounting.   While the ED is a few weeks later than originally anticipated, the target date for the issuance of the new standard remains June 2011.

Comments from interested parties will be received up to December 15, 2010.

You can view the ED here.

And you can view my previous posts on the new lease accounting here.

My White Paper on the New Lease Accounting Is Available August 9, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.
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If you register on the TRIRIGA website, you can get access to my white paper “The New Lease Accounting Standard and You” here. Like the TRIRIGA webinars that I’ve held, the paper will inform you about … not just what the new standard will be, but … what the strategic and process implications are for those involved in corporate real estate.

If you’d like to hear the webinars, they are also still available, on-demand, on TRIRIGA’s website here. If you have time to listen to just one of the three, I’d recommend the second webinar entitled: “Strategic and Practical Implications”. I’ve had many people tell me that they found the webinars very illuminating.

BTW, FASB and IASB are expected to issue the Exposure Draft on Lease Accounting this week.   There probably won’t be too much new in the document for those who have read the previously-issued Discussion Draft and who have followed the accounting boards deliberations over the last few months … but the issuance of the Exposure Draft should spur companies to get serious about addressing how the new accounting standard is going to affect their real estate strategies and processes.   See my previous posts on the New Lease Accounting, here.

It’s Time to Buy that HQ August 3, 2010

Posted by Bob Cook in Corporate HQ, Financial Planning & Analysis, Lease Accounting.
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8 comments

The ducks are all lined up: low prices … low borrowing costs … cash hoards … lease accounting.

I’ve previously posted an article on Northrop Grumman’s decision to buy its new headquarters. Reportedly, the new lease accounting influenced the decision, but other factors were undoubtedly also at play … probably the ones I just listed, above.

Perhaps never before has the time been more opportune for companies to buy real estate assets… and because purchasing makes most sense where long-term occupancy is relatively assured, HQ’s are obvious acquisition targets for companies. We may see a reversal of the trend towards leasing HQ’s that began in the 1980’s … when many companies became enamored with the cash they could raise through sale-leasebacks or leasing space offered by speculative developers.

If a company does not already own its HQ, now is the time to buy.

Low Prices

Office building prices are significantly depressed. According to the Moody’s/REAL Commercial Property Price Index (CPPI), prices have fallen to the levels of 2003/2004, which were themselves low relative to the prices around the turn-of-the-millennium. And the decline in prices might not be over. 

Many industry observers think prices are likely to fall even more as we near, over the next couple years, the maturity dates of a huge number of commercial real estate loans … many of which are underwater. National Real Estate Investor quotes Trepp LLC, a servicer of collateralized mortgage-backed securities: “The average loan-to-value ratio among 1,125 CMBS loans in a survey sample was a whopping 160%, up from 72.7% when the loans were securitized.”

Earlier this year, Standard and Poor’s issued a report titled “The Worst May Still Be Yet to Come for U.S. Commercial Real Estate Loans”, stating that “the decline in collateral values poses a difficulty for loans that need to be refinanced” and that “refinancing needs will be somewhat elevated in 2011 and 2012, although the bulk of them will not come until 2015.” 

And with the vacancy rate of U.S. office buildings at 7.4% … a 17-year high, there is little hope that these buildings with underwater loans will be generating enough NOI anytime soon to be able to cover debt service on new loans of the same amounts, even at today’s historically low interest rates. Without the ability to attract debt financing, office building prices are likely to remain depressed.

Low Borrowing Costs

And while the low borrowing costs are not going to be of much value to property owners facing the prospect of buildings being partially or wholly vacated, those low borrowing costs are very valuable to companies that become owner-occupants.

According to the Wall Street Journal, today’s rates on corporate bonds are “some of the lowest borrowing costs in history.” Corporations are already flooding the market with bonds, raising cash … sometimes probably without a clear understanding of how the funds will be used. The borrowing frenzy is not just among investment-grade companies. According to that same WSJ article, referring to last month’s bond activity, “This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings.” 

Access to cheap funds available to corporates is going to make ownership very attractive … and the discrepancy between their ability to borrow cheaply and real-estate-investors’ inability to borrow much is momentous.

Cash Hoards

Even without borrowing, many companies have large cash hoards. Many have purred through the Great Recession largely unscathed, sometimes generating even more cash than usual because their capital investment opportunities have declined. And companies continue to be reluctant to give this cash back to shareholders. Issuing dividends has been out-of-favor for awhile, due to the double-taxation affecting shareholders, and buying back stock has been a risky proposition given the volatility of the markets. So the cash has accumulated.

The tech companies are an egregious example of cash hoarding … Cisco has $40 billion, Microsoft has $36 billion and Google has $30 billion. Shareholders generally don’t like it, preferring to get the money back into their pockets so they can choose how to reinvest it. This has prompted Cisco, Microsoft and others to announce major stock buyback programs. Those programs could take years to execute, though … and in the meantime, more and more cash is accumulated.

The hoarding trend is not limited to tech companies. According to Fortune, “Non-financial companies in the S&P 500 index reported $837 billion in cash at the end of March … (and) are holding cash reflecting 10% of their value today, (while) since 1999, companies on average held cash equal to (only) 6.6% of their value.”

As companies decide what to do with all this cash, given low prices and the new lease accounting (see next), buying real estate has got to be among the considerations. 

The New Lease Accounting

I’ve written extensively here about the New Lease Accounting and how it will make leasing less desirable than it was. All leases will be going onto the balance sheet, taking away one of the benefits of leasing (at least for those companies who have been sensitive to how much assets are on their balance sheet). Also, from a P&L perspective, owning will often be more attractive, particularly where there are low borrowing costs and a low building value relative to land value.

While other considerations, e.g. NPV of cash, might be the main driver for own-vs-lease decisions, the New Lease Accounting removes the objections to owning that have been based on financial statement concerns and that have stopped many companies from owning in the past.

Can we expect to see a trend to ownership?

While there were prognostications that sale-leasebacks, including those for HQ’s, would become more common as a result of the financial-crisis-induced credit crunch of 2008/2009, we seem to be past that. The future trend is likely to be the opposite … more towards more companies buying HQ’s. The Northrop Grumman deal is one. Also announced in 2010 have been Andarko Petroleum’s purchase of its HQ in Woodlands TX and Horizon Blue Cross’s purchase in Newark NJ. I imagine there have been more … and that more are yet to come.