Where Cash Is Anything But Trash

Why Honeywell prefers debt over equity to finance deals.


Judging from the headlines generated by such stock-financed acquisitions as WorldCom Inc./MCI Communications Corp. and Starwood Lodging Trust/ITT Corp., you'd think every CFO in America would prefer to use equity to do deals. Sky-high stock prices, after all, are making possible all kinds of mergers that would not have been thinkable if done with cash. One reason, of course, is that stock deals can be accounted for as poolings of interest. On the one hand, they allow the buyer to avoid the prolonged drag on earnings from the goodwill that a cash purchase can produce. On the other hand, poolings enable the seller to avoid any capital gains tax liability.

"When the market is doing well, companies rely more on equity financing than on debt," says Ivan Brick, chair of the finance and economics department of the Faculty of Management at Rutgers University, in New Jersey.

In fact, stock transactions accounted for half of the $919 billion in Corporate America's mergers-and-acquisitions activity last year, according to Securities Data Co. And you might think that the rest would have gone that route if only the buyers' stock prices were higher.

Bucking the Trend

But you'd be wrong if you did. Consider Honeywell Inc., an $8 billion (in revenues) Minneapolis-based maker of control products and systems that bucked the trend. In early 1997, it acquired Measurex Corp. for $600 million in cash, even though Honeywell's stock was trading at record levels and its M&A advisers were recommending it use equity.

To finance the deal, which ranked among the largest in 1997 that were paid for in cash, Honeywell issued debt in two tranches: $200 million in five-year notes with a coupon rate of 6.75 percent, and $350 million in 10-year notes with a 7 percent coupon. Both of these were soon swapped into floating-rate debt priced just under 6 percent at the time. And the company used short-term commercial paper to finance the final $50 million in purchase cost.

The deal's strategic rationale won much applause. Although Cupertino, California-based Measurex was a world-class, $416 million (in revenues) manufacturer of computerized controls for the pulp and paper market, the company could no longer afford the research and development required to maintain that position. And Honeywell had been looking to expand its global position in the process control industry for years.

"This is a good acquisition for Honeywell, broadening out its product line," Alexander Paris Sr., an analyst for Chicago-based Barrington Research Associates Inc., said at the time. Donna Takeda, vice president with the global securities research and economics group of Merrill Lynch & Co., praised Honeywell for "breaking into the big time" as a vertically integrated player that could offer a broader suite of automation solutions for the pulp and paper market.

Some analysts scratched their heads over the financing, at least initially. "Most companies today are using stock and completing pooling transactions to do large deals," says Lawrence Stranghoener, Honeywell's CFO. "But when we did our Measurex transaction, we explicitly rejected the notion."

Why? One disadvantage to a pooling transaction is that restructuring charges, severance expenses, and other direct acquisition costs have to be expensed immediately against earnings, and the hit from Measurex would have been considerable. Stranghoener was not entirely convinced that Honeywell could meet the SEC and accounting rules, and he wasn't sure he wanted to commit the time and resources to try to meet them. The pooling approach, he concluded, was cumbersome and risky.

In addition, stock would have required a lengthy registration and issuance process. And Stranghoener, who had been promoted to the position at the start of the year from vice president of business development, wanted his first major deal to sail through without a hitch.

"We wanted to close this transaction as quickly as possible and begin the integration game plan so that employees and customers wouldn't be in the dark about our intentions," he says. "We didn't want employees thinking they needed to find other job opportunities, and we wanted customers to know what the product road map looked like so that they wouldn't look for other suppliers."

Sure enough, Honeywell closed the deal just six weeks after it was announced.

Equity Only Looks Cheap

But there was yet another reason that Stranghoener went with debt, and this involved new thinking about the long-debated question of the relative cost of equity capital. With its stock price moving more or less in line with the market, equity, under the classic theory, would seem to have cost Honeywell a mere 12 percent, based on a traditional premium of 6 percentage points over the interest rate on 30-year Treasury bonds. That premium, of course, reflects the higher return that investors have historically demanded for taking on more risk in equities.

But Stranghoener, like others, contends that classic theory understates equity's cost by a considerable margin today, because investors expect much higher returns. Honeywell's current return on equity is 20 percent, which is a much higher hurdle than 12 percent for new investments, and those that fall short could hurt its standing.

"If I can't invest in projects that earn at least 20 percent return on equity, then I will dilute the current ROE for the company," says Stranghoener. "I am not interested in doing that, and my investors aren't interested in taking on such projects. So the cost of equity is really closer to the ROE, and if that, indeed, is the cost, then there is a tremendous advantage to using debt." Despite the virtues of the Measurex deal, it was not projected to generate a return north of 20 percent anytime soon.

In other words, Stranghoener contends that issuing new stock to buy Measurex could have sent the wrong message to investors. "We would, in effect, have been saying that we think the stock is pretty fully valued; we're going to take advantage of that and sell some at these levels," he says. "The track record of companies doing acquisitions is not very good. Investors automatically take a skeptical view of almost any transaction. Particularly at a time when we were doing a large deal, we wanted to avoid sending the message that we don't have such a strong belief in the outlook for the company."

The declining cost of debt, meanwhile, may have been obscured by the run up in stocks, he notes. "Stock prices have increased significantly, but interest rates have also come down substantially, and the cost of borrowing, even for very long periods of time, is very attractive."

There were, of course, disadvantages to using debt. The goodwill amounts to $400 million to $450 million to be amortized over 20 to 25 years, and the borrowing immediately boosted Honeywell's debt-to-capital ratio to 42 percent from 31 percent, putting it outside its policy range of 30 percent to 40 percent.

To pay down enough debt to get the ratio back within that range, the new CFO decided to suspend the company's share repurchase program. That wasn't an easy decision, since Honeywell had long used free cash flow to repurchase shares. But it had used up the $250 million that had been authorized for buy-backs in July 1995.

Living With Leverage

As for the goodwill Honeywell took on with Measurex, Stranghoener discounts its importance. "It's purely an accounting charge anyway, not a cash outlay," he says.

As it turned out, it didn't take that much to get Wall Street to understand Honeywell's choice of financing. Analysts accepted its assurances that it would resume repurchasing shares in the second half of 1997 (which it did in October), and the ratings agencies chose not to downgrade Honeywell's credit despite the increase in its debt load. Stranghoener has also been able to keep the company's debt free of any financial covenants.

"I think we told a very good story about the strategic fit and a very good story about the valuation," says the CFO, and in the end, "everybody strongly endorsed the financing structure we chose."

The Measurex deal wasn't the first that Honeywell had done with debt. In the past four years, the company has bought almost 50 companies, most in the $5 million to $50 million range. All have been financed through cash. "You have to go back 10 years to find a deal we financed with stock," says Stranghoener.

He won't rule out the use of stock if, for example, a seller's assets are compelling but it demands equity for tax reasons, or the deal is so large--worth, say, $1 billion or more--that the new borrowing required would boost Honeywell's total debt load to an unacceptable level.

More Than a Coin Toss

"What I am suggesting," says Stranghoener, "is that for the types of deals we do, as long as we have ample debt capacity, our preference is to use debt, because it's the lowest-cost source of financing and enables us to close deals fairly quickly." Ed Rimland, an M&A adviser at Bear, Stearns & Co., in New York, says he understands why Stranghoener opted for debt. But he notes that software and other high-tech companies often use stock because they're growing so fast, and banks, more often than not, have to use stock because of regulators' capital requirements. Otherwise, he says, "it's a toss-up if you have the debt capacity."

But Honeywell investors have reason to be pleased that Stranghoener didn't just flip a coin. Granted, so far the results of the Measurex deal have not lived up to the advance billing, despite an aggressive integration program that has yielded greater-than-expected cost savings. "We are not seeing as much revenue as we expected," comments Stranghoener. And while he insists that the acquisition "makes powerful strategic sense and will be a big winner for us," he also says, "I'll be the first to acknowledge that the numbers don't yet show that."

So Honeywell's stock, after rising on expectations for the acquisition, has fallen back to where it was at the time the deal was announced. But by doing it with debt, Stranghoener has helped prevent the stock from falling even further.

Stephen Barr is a contributing editor of CFO.


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