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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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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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Mercury News’ columnist got it wrong. Headline should be: HP Grows Up ( … with corporate real estate playing role) June 2, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Profession of Corporate Real Estate, Silicon Valley.
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Today, Columnist Chris O’Brien lambasts HP for finding success – not from innovating like Apple or Google – but from implementing a “ruthless, brutally effective strategy” that he playfully characterizes as “Buy a company. Cut costs. Trim employees. Repeat.” His column was prompted by HP’s latest layoff announcement.

HP should, however, in fact, be lauded for maturing into a well-run enterprise that can successfully compete in a complex world where success – especially for a large company – requires more than just coming up with the latest and greatest. It requires business acumen, discipline, and management – something that has been missing from the many great product-focused, geekdom companies that are now R.I.P. in the Silicon Valley graveyard. Think (and weep, ’cause it was great in many ways): Sun Microsystems.

HP is showing an alternative way for a tech company to succeed – and to do it long term. It’s a way to build an enduring enterprise – a way away from the self-limiting strategy pursued by most tech companies and which I’ll playfully characterize as: “Design breakthrough product. Develop cult following. Sell before competitor catches up. Repeat first three steps as many times a possible, then (inevitably)…. Blink. Hiccup. Crash.”

HP has become a corporate juggenaut by realizing, under the five-year leadership of CEO Mark Hurd, that success requires the careful management of resources: capital, people, assets, infrastructure. The last of these is partially the domain the HP real estate group which is clearly busy with initiatives like the consolidation of HP’s data centers and which is proving its worth to the enterprise.

According to HP’s latest 10-K, of 77 million square feet of space, fully 10 million square feet had been vacated – probably significantly helping on-going P&L, albeit with some large one-time negative hits for write-offs and reserves. While only three million square feet had been sublet such that this vacated space continues to drain cash, once those unneeded leases burn off, the cash flow savings will become as permanent as are the P&L savings already in place. Having said that, subletting three million square feet is no small feat. (Pun intended.) Moreover, let me tell you, vacating 10 million square feet is an even bigger feat. (Yep, pun intended, again.) You might think, “what’s so hard about moving out of real estate”, but it must have involved thousands of decisions, hundreds of presentations, and dozens of approvals to decide which sites to vacate, when to do it, how to do it, who should should pay for it and who should profit from it.

As companies like HP become mature enterprises – managed by professional managers who leave product design and marketing to others and see their job as managing the enterprise – corporate real estate departments become more important. To manage an enterprise is to manage the company’s infrastructure – both hard (e.g. real estate, IT systems) and soft (e.g. culture) – and corporate real estate plays a central role in this area. Products come and go. People come and go. Infrastructure endures.

Preparing the company for sale: Palm did it right! May 17, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, M & A Integration, Silicon Valley.
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Real estate tends to be one of the last things evaluated during M & A due diligence by the acquiring company, and it’s not surprising that – surprise! – surprises are found there. Lengthy lease commitments, owned property worth less than net book value, contaminated sites, mission critical infrastructure that’s prohibitively expensive to move to the acquiring company’s site: these are just some of the surprises found by acquiring companies when they finally take a look.

Rarely, if ever, do these surprises derail an acquisition, but they do sometimes lead to re-pricing of the deal. And while the price cut might not be much as a percentage of the overall deal price, it can be a significant percentage of the amount had by the acquired company’s equity investors once they’ve paid off creditors and preferred-return equity holders. It’s at that point that the acquired company managers kick themselves for not more carefully managing their real estate portfolio.

You may ask: if they had managed their portfolio carefully, what would have they tried to achieve? What would have been the home run, the hole-in-one, the three-pointer at the buzzer? It would have been this: having real estate commitments (such as leases) and exposures (such as owned properties) that extended into the future no further than the date on which the acquiring company will be able to move the acquired company into its own facilities in an orderly fashion. “Not achievable!” you say? Think again.

Palm, which is being bought by HP for $1.2 billion, may have done it. According to its 10-K’s (see Table 1, below), Palm does not own any property and has done a masterful job over the last few years of decreasing its lease obligations. At the end of FY2007, the value of its minimum future lease obligations was $49.2 million; by end of FY2009, this had been cut in half to only $24.5 million.

Looking at the minimum future lease obligations net of sublease obligations from subtenants shows similar results – $34.7 million at end of FY2007 that were cut in half to $15.3 million at end of FY2009.

Making the story even better: if Palm has been able to avoid committing to any additional leases since the end of FY2009 in May of 2009, then as of the end of FY2010 which ends this month, it’s lease obligations should amount to no more than $13.2 million. After accounting for commitments from subtenants, its net lease commitment would be only $8.0 million. What an incredibly light burden for HP to have to take on! Miniscule in comparison to the value of the deal. It easily sets the stage for HP to be able to move Palm into HP facilities without HP having to bear much of an economic burden to pay rent on the unneeded property.

But wait! There’s more! By time the acquisition is closed and plans can be made and implemented to relocate Palm, it will probably be near the end of Palm’s FY2011 at which time only $2.4 million of lease obligations will remain and, incredibly, only $1.1 million of obligations net of obligations from its subtenants will remain. Can you believe it? Only a $1.1 million overhang of real estate obligation on a $1.2 billion M & A deal. That’s like driving the ball off the tee and coming to within an inch of a cup 700 yards away.

This light burden should make it economically feasible for HP to relocate the Palm operations to HP facilities. There should be plenty of space to accommodate Palm in HP’s 77-million-square-foot real estate portfolio, of which 7 million square feet was vacant and not sublet as of the end of HP’s last fiscal year in October 2009. For comparison, Palm’s Silicon Valley operation occupied only 347,000 square feet.

Yes, Palm did it right. From outside the company, it’s hard to know if it was from careful planning, from restrictions put on Palm by the real estate market or from just dumb luck. I’d like to think it was from the first of these possibilities – that there was an understanding of the need for careful real estate portfolio planning, that the planning was carried out consciously and that it paid off. A clear planning success story if ever there was one.

TAble 1: Palm’s Minimum Lease Obligations as Reported in 10K’s

Year in which rent was projected to be due FY2007 10K FY2008 10K FY2009 10K
2008 11.9 0.0 0.0
2009 11.7 11.5 0.0
2010 11.5 11.3 11.3
2011 11.2 10.7 10.8
2012+ 2.8 2.4 2.4
Total Min Lse Obligation 49.2 35.9 24.5
Less: Subtenant Income 14.5 13.0 9.2
Total “Net” Minimum Lease Obligation 34.7 22.9 15.3