Salesforce To Buy Slack – A Case Study In Value Destruction? (Part 1)
Salesforce’s bid to acquire Slack combines many points of interest.
It would be the 2nd largest software deal in history.
It has also destroyed more shareholder value in a week than any merger announcement in the last 20 years.
It creates a classic merger arbitrage scenario. And it is a case study in the making for thinking about the merits of growth by acquisition.
The day before Thanksgiving, The Wall Street Journal broke the story that Salesforce CRM – the CRM giant – was preparing an offer to buy Slack, a fast-growing, unprofitable software company that sells what they call “a channel-based messaging platform” (though some of us might mistake it for an email utility, albeit a “new and improved” email utility).
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Slack’s shares jumped almost 40%. Salesforce fell about 4%.
A few days later, Salesforce confirmed that it would offer a combined cash and stock package worth about $27 Bn to acquire Slack, which would make it the 2nd largest software company acquisition on record, after IBM’s IBM $34 Bn deal for Red Hat RHT in 2018 and ahead of Microsoft’s MSFT $26 Bn acquisition of Linked In in 2016.
The announcement carved another 10% off Salesforce’s market capitalization, and boosted the Slack’s value proportionally.
A Classic Merger Arbitrage Scenario
The first thing to say about all this is that it constitutes a nice illustration of a stereotypical market pattern, triggered by an acquisition event – which sets up an investment strategy known as merger arbitrage.
- “Merger arbitrage is an investment strategy that involves buying shares of a company that is being acquired. It may also involve shorting the shares of the acquiring company. The objective of the strategy is to capture the arbitrage spread—the difference between the acquisition price and the price at which the target’s stock trades before the consummation of the merger.”
A bid by one company to acquire another company always has two effects. First of all, the shares of the target rise promptly to somewhere near the offering price. This is easy to understand. The offer price entails a significant premium over the current market price. Even though it is only a bid (and not a done deal), the market price will rise in anticipation of its consummation. The premiums are often large. IBM bid 60% above Red Hat’s previous share price. Microsoft’s offered a 50% premium for Linked In. Both deals were all-cash. Salesforce’s premium for Slack is in the same range (50-55%), though because it includes both cash and stock, the value of the offer fluctuates in sync with the value of Salesforce’s own shares.
Typically, however, the target company’s shares do not immediately reach the level of the offer, but hover somewhat below it. This is the merger arbitrage spread. It exists because the deal will take several months (on average) to close, and there is some possibility that it may fall apart, for any number of reasons. But if all goes well, the spread closes as the deal approaches its conclusion. As it did in the IBM/Red Hat deal.
The Red Hat merger arb spread was 12% on the day after the deal was announced. Investors relying only on public information could have entered the position at that level. The bet was simple: if you thought the deal would close at $190 a share, you bought all you could at $169 a share. Easy money — except that you had to be right in assuming the deal would close. In fact, there was considerable uncertainty surrounding the Red Hat acquisition. It took 253 days to close – unusually long, due to an extended Dept of Justice review for possible antirust concerns. The 12% spread translated to a 17.8% annualized gain for investors who stayed the course. The size of the spread can also be interpreted as an implied probability that the deal will close – in this case, it was said to be 72% on the day after the announcement.
The assets-under-management of merger arbitrage investment funds increased by a factor of more than 100 between 1990 and 2007. Which of course also drove down the average spreads. The deals vary widely and selectivity can improve the prospects for a savvy investor. It is a research-intensive business. Lots of room for active investing to make a difference (although there are a few exchange traded funds – ETFs – that purport to package merger arbitrage strategies in a more passive vehicle.) This is the logical side of the merger arbitrage, and most merger arb investors play this angle. Between 2011 and 2019, 94% of announced deals did in fact close.
The merger arbitrage spread for the Salesforce/Slack deal follows the same pattern, so far.
The most straightforward investment thesis is to bet that this offer, too, will succeed. Buy at the spread and wait for it to come home.
It takes an average of about 4 months for these deals to close, so the simple buy-on-the-announcement strategy returns about 9-10%. Most merger arb funds don’t do that well, because they come in late, or leave early, and some deals fall apart. In the last ten years, the merger arb strategy has averaged a modest 5%-ish return at best. It’s a living.
In any case, Slack’s existing shareholders are happy enough. And the merger arbs will likely make money even with just a 3% spread.
The other side of the deal is more mysterious. It is mysterious in general, and very mysterious in this case.
The price of the acquiring company falls about 80% of the time. Salesforce’s loss of value was massive – $32 Bn, larger that the bid itself, larger in fact than the entire market value of Slack.
The scope of this value destruction is far larger than in similar deals.
This deal is ugly. Even with the boost in Slack’s share price, over $25 Bn in stock market value has evaporated.
What this signifies, first of all, is that Mr. & Mrs. Market, in their collective wisdom, at least the wisdom of the moment, really – but really – dislike this transaction.
There are several reasons for this.
Some of the negative sentiment is of a general nature. Investors in recent years have come to distrust and punish most corporate acquisitions. This is clear from the general pattern of value destruction across all of the deals discussed here. It creates what is called the Conglomerate Discount. The market has come to prefer “pure plays” — companies that are focused on one coherent line of business – rather than “conglomerates” – companies with diversified portfolios that include a variety of often semi-related or unrelated business units. Investors would rather assemble their own portfolios from simple elements, instead of entrusting corporate management teams with the unaccustomed responsibilities of “asset management.”
This phenomenon is now well established, much written about, and widely understood as a fact-of-market-life. It constitutes a headwind against which every new corporate deal must attempt to justify itself. A study of 2500 mergers (between 1993-2010) found that the average acquiring company lost 10% of its value in the 24 months following the transaction.
But the Salesforce/Slack situation raises additional concerns which pertain particularly to this deal. Analysts disagree about the business logic driving the transaction. Some see it as a “turning point” for the company and the sector, or indeed “a defining moment for cloud software,” or a “game-changer.” Others see it as an overpriced, misguided transaction that is likely to fail. Underneath the classic merger arb pattern, there is a substantive business case, which Salesforce spokesmen have tried to articulate. It gives rise to two competing investment theses, Pro and Con, depending on whether you accept Salesforce’s rationale for the Slack acquisition. The market at the moment seems to have succumbed to negative sentiment for now. But we know that sentiment should often be taken as a contrarian signal. In the next column, we’ll try to pick apart the fundamental merits, and demerits, of the deal.