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Madness of Hostile Bids

Adam Hamilton
December 27, 2004

For gold-stock investors and speculators, 2004 proved fascinating on multiple fronts. While gold stocks didn't perform as well as they did in 2003 in general, they still offered returns far in excess of the mainstream stock markets for contrarians willing to buy during the wicked spring correction. And with the underlying gold bull still in Stage One, the best is almost certainly yet to come.

As I reflect on this past year, one thing that really sticks out in my mind is the frenzy of gold-stock mergers and acquisitions. Of the 15 companies that make up the flagship HUI gold-stock index, an amazing 7 tried to acquire other gold or silver miners during the course of 2004! The fabled gold-stock bull is finally stirring up some excitement four years after it stealthily launched in November 2000.

For gold miners, the urge to merge is totally understandable. Unlike your average information company that can spin up to full operations from nothing in under a year, it usually takes 3 to 5 years to develop a gold mine, sometimes much longer if all the fruitless exploration before the big mineralization discovery is considered. As such, it is very difficult for gold miners to grow organically at any reasonably rapid pace.

And investors and speculators, as you and I well know, demand rapid growth. We are monumentally fickle with our capital and will chase the best growth stories in our sectors of choice, gold and silver stocks at the moment. Thus, in order to attract our capital and praise managements at the gold companies are under immense pressure to add to their reserves and mine production through acquisitions.

From an investor's perspective though, there is an expensive dark side to all of this frenzied acquisition activity. Depending on how potential deals are executed, acquisitions can cost the shareholders of the acquiring company dearly. And since the numero uno mission of management is to enhance value for existing shareholders, they have to be ever cognizant of the great damage they can wreak on shareholders from ill-structured deals.

The worst type of acquisition possible for the acquiring shareholders is the hostile bid. In general a hostile bid occurs when the acquiring company launches a takeover campaign without the consent of the target company. In order to finance these hostile bids, the acquirer usually dilutes its existing shareholder base, reducing their ownership, by issuing new shares to finance the potential deal. Fears of excessive dilution virtually always spawn sharp selloffs when hostile bids are announced.

With at least 4 of the 7 major HUI component acquisition attempts in 2004 outright hostile, without the consent of the target, I would like to discuss their ugly impact on investors this year. This is not purely academic for me either, as I, my partners, and our clients were blasted out of positions in acquirers when our stops were nearly immediately hit in 3 of these 4 hostile HUI deals.

For the purposes of this essay, I am not interested in whether a deal actually went through or was voted down. Instead I am focusing solely on the brutal immediate impact on the shareholders of the acquiring company when a hostile bid is announced. Free markets exact swift and merciless judgment on hostile bidders.

There is no quicker way for managements to kick their existing shareholders in the teeth than to announce a hostile bid. Actually, I am surprised bloodthirsty lawyers aren't all over this as strong cases can be made that managements brazenly violate their fiduciary duties to shareholders by going hostile. The ugly results are so predictable that no manager on earth could convince a judge that he had no idea that his hostile bid would crush his shareholders.

Our lone graphic this week is kind of a flowchart that shows who was bidding for whom in the HUI in 2004, and whether their bid was hostile or a more amiable mutually consented merger. In order to determine if a particular bid was hostile, we went back to the original press releases and accompanying financial news stories released the day the announcements were originally made. If you disagree with the classification of any of these deals, your argument is with the press releases and day-zero news stories released, not me.

Each HUI acquirer is colored in red or blue, for hostile or amiable buyout attempts respectively. The only stock on this chart that is not a member of the HUI is WHT, but WHT was just the most sought-after merger target in 2004, it didn't do any major HUI acquisition attempts itself. As you look at the arrows, marvel at our incestuous little gold-stock world!

Under each acquisition attempt, hostile or amiable, a small chart is rendered. These charts show the acquiring company's stock performance 10 days before through 60 days after bid announcements. In addition, under the hostile bid attempts there is a number that shows the potential acquirer's stock performance in the single trading day of the announcement (if announced during market hours) or after the announcement (if announced after market close).

The inescapable conclusion, which managers at acquiring gold companies should consider very carefully, is that hostile bids have very high costs for existing shareholders in terms of the tremendous loss of market capitalization suffered when dilution is feared from an expensive potential deal. As far as I can tell there is generally no other way for a gold company to hurt its shareholders faster than by going hostile.

These tiny charts really drive home why shareholders get so irate with their managers when they go hostile. It is no wonder that investors often feel their managers are telling them to "go to hell" when they embark on such a reckless course with a nearly guaranteed unpleasant outcome. The table in the lower right of this graphic shows the average losses by acquiring HUI shareholders in the trading days after a hostile bid is announced.

Within only one trading day after the acquiring company announces it is trying to buy the target without the target's consent, the acquiring shareholders take a vicious 7.4% hit on average. 7.4% in a single trading day is staggering, it annualizes out to something like an 1850% loss! I believe this brutal first day hit is due to the fact that managers often choose to dilute existing shareholders with new stock, the corporate equivalent of governments printing fiat currency for nothing, rather than prudently saving up and paying 100% cash for their acquisitions.

Now managers could argue with us investors that a one-day 7.4% hit is manageable. But the losses just get worse on average. By trading day 5, the average HUI hostile acquirer was down 10.4%. They kept falling to 12.3% by day 10. Six weeks after the announcement, 30 trading days later, the average loss grinded lower to 13.6%. By twelve weeks after their hostile bids, trading day 60, the HUI hostile acquirers were down 21.9% on average. Ouch!

In 2004, on average, the shareholders of HUI companies that went hostile lost a horrific one-fifth of their entire capital in the twelve weeks following the announcements. Arguments about potential long-term value of acquisitions aside, this is a big problem for any investors that actively manage their risk as all prudent investors should. If investors run 20% trailing stops on positions to protect themselves from the inevitable periodic HUI corrections, then they can easily be stopped out by hostile bids alone.

If selling to avoid excessive future dilution is so intense during an average hostile bid that it drives the acquiring company low enough to run stops, the damage done can intensify significantly. The mechanical sell orders after a certain percentage retreat add more cascading downside pressure to the already wounded acquirer and magnify its losses. Even more investors are induced to sell as its price is driven lower and lower in a vicious circle. And the hostile bid is the catalyst that ignites it.

This ugly phenomenon is certainly not a hostile-only thing. When IAG attempted to merge amiably with WHT, it plummeted 9.4% on day 1, 19.6% by day 10, and a staggering 32.6% by trading day 30 only six weeks later! Provocatively, the only time a HUI stock actually rose after a merger announcement was when IAG solicited GFI to do a reverse merger to fend off GSS's hostile bid. It was only in this white-knight scenario in 2004 when the acquirer didn't initiate that its stock price didn't take a serious hit.

In every other case though, usually moreso on hostile bids, the acquiring shareholders were kicked in the teeth. It is interesting to note that these 7 HUI acquiring companies in 2004, collectively, command 44.8% of the total market capitalization of the entire HUI index! Thus, odds are high that the steep acquirer selloffs are a material factor in the surreal decline of the HUI leverage to gold that we are now witnessing. The hostile bids may be not only hurting their shareholders, but the progress of the HUI bull in general.

And sometimes the fallout from these hostile bids goes far beyond the steep initial losses. A key case in point is GSS, the single biggest gold-stock disappointment in 2004 in my opinion.

Just over a year ago, in the December 2003 issue of our Zeal Intelligence newsletter still available on our website for our subscribers, we did a comprehensive technical screen of all the blue-chip gold and silver stocks of the HUI and XAU. The goal of the screen was to find the best potential performers for the next upleg due to start in 2004 after the anticipated correction. Out of every company in the HUI and XAU, GSS emerged the shiny winner at the very top of the heap.

As of December 2003, GSS had dwarfed the gains of the HUI on average in each of its four preceding major uplegs. Its bull-to-date leverage to the HUI itself at the time was a magnificent 2.5x, meaning that it tended to go up on average two-and-half times whatever gain the HUI managed to achieve in a particular upleg. GSS's leverage to gold was even more mind-boggling, 15.7x bull to date at the time. The company was a gold superstar.

Like virtually all other major gold stocks, GSS corrected in early 2004 in line with the HUI as it should have. It even started rallying sharply with the HUI at its bottom in early May, again right as expected. But on May 27th when GSS management suddenly went hostile at IAG, the whole winning aura of GSS fell apart. Since that fateful day of infamy, GSS has struggled and generally grinded lower while most other HUI stocks went on to decent 2004 rallies.

GSS not only fell 6.4% the day its hostile takeover attempt was announced, it plummeted again when the financial carnage of this ill-fated gambit became public in its SEC-filed financials. On August 16th IAG announced it was refusing GSS's hostile offer and instead had created an agreement with GFI, calling in GFI as a white knight to save it from a predatory GSS. Then on November 3rd after market close GSS released its Q3 financial results, including the IAG hostile bid expenses it was forced to write off.

The next day alone, over five months after GSS's hostile bid, its stock plummeted by another 12.1% on the Q3 losses. This stopped us out too, no big surprise, for a modest realized profit. Incredibly 91% of the $4.3m loss was a direct writeoff of costs incurred by GSS in going hostile on IAG! Thus, negative fallout from hostile bids can hammer shareholders hard many months after the bids and even after they fall through. Hostile bids are the curse that keeps on cursing!

I have talked with several consulting clients of mine, savvy gold-stock players with 7-figure gold-stock portfolios, who have just flat out lost confidence in GSS's management due to this hostile bid nonsense. They were as excited as I was last year about GSS, but after seeing its management squander most of its reputation with investors by going hostile, it is going to be hard for GSS to earn back their trust.

Not only did GSS lose market capitalization and profits, but it forfeited the far more valuable and harder-to-win-back trust and respect of many investors. It has also modestly dragged down the HUI with its poor 2004 performance, but thankfully it makes up less than 5% of the flagship gold-stock index.

As a speculation masochist, I still like GSS and may buy and recommend it again in the next upleg so I am not trying to unduly single it out in this essay, but for me personally it is the shining 2004 example of why hostile bids can be so catastrophic for shareholders in acquiring companies. Believe me, similar dark tales of woe can be weaved for CDE and HMY too, and maybe GLG a few months from now.

Since these initial hostile bid announcements are totally beyond the control of us shareholders, the onus of finding a better way to do things really falls on our managers. Gold-company managements must balance their need to grow with ensuring that existing shareholders are not brutally beaten to a bloody pulp when managements decide to launch acquisition campaigns. I have a few ideas for managers to consider.

First and foremost, resist the big temptation to go hostile. Yes it is an adrenaline rush to be a wheeler and dealer and yes it is the simplest way to undertake a business combination since no real groundwork needs to be laid with the target. But, even if the bid is successful odds are the staggering costs to your existing shareholders, not to mention your reputation, may ultimately prove to be too high to justify the acquisition.

If you truly feel that your company and another company may be far more valuable to both sets of shareholders as a combination, then try to pull off an amiable merger. Your managers can talk with the other company's managers quietly, behind the scenes, with absolutely nothing going public. If both Boards of Directors then agree that the combination would be favorable and mutually beneficial, then you can jointly announce the amiable merger via a press conference. If one company is perceived as the de facto acquirer it may still take a stock hit, but probably not as much as it would via a hostile bid.

If the other company doesn't want to merge amiably, then so be it. No sense in going hostile. Managers change and perhaps the potential target will change its mind down the road a little ways. Remember that hostile bids have a way of escalating out of control as egos get involved, and it is not prudent nor sound from a fiduciary perspective to pay too high of price for another company's mines and assets. An excessively high purchasing price can destroy return on investment for years to come.

There are also some structural strategies that you can follow to ease the impact of a merger on your shareholders. If you want to buy another company, don't start merger talks until you can offer an all-cash deal. Gold-stock investors in general hate fiat currencies and the practice of companies issuing stock out of nowhere to dilute them is painfully like governments printing fiat. Dilution is like inflation, in a sense unfairly taxing existing shareholders. If you can pull off a deal without dilution, paying 100% cash, the markets will smile on it much more favorably.

Another key thing to consider is to not to bite off more than you can chew. Some of the acquisition proposals in 2004 were asinine, smaller companies trying to eat far bigger companies which necessarily means massive dilution and probably big debt. Just as most fish in nature generally feed on fish smaller than themselves, it is much easier to do all-cash deals if you only look at targets significantly smaller than your company. Rather than stalking majors or intermediates that you have to dilute to buy, buy up small juniors for cash instead. Many juniors have great promise and they are very cheaply valued compared to expensive HUI gold stocks.

Finally, don't forgo or give up on truly organic internal mine growth. Exploring and growing your own properties is usually far more cost effective over the long run then paying someone else a huge premium for their exploration and development work. Internal organic growth is far slower than acquisitions most of the time, but it ends up building stronger and more financially sound companies. A tightly run carefully grown company is far more valuable to investors than a loosely stitched together Frankenstein's Monster of expensive acquisitions.

Hostile bids may seem attractive up front, but there is an indisputable madness about them when the typical fallout on acquiring shareholders is systematically studied. Hostile bids should almost never be used, as the costs are so high in market-cap, profits, reputation, and trust terms that the benefits of a business combination may not be able to overcome the negative stigma for years. Hostile bids are usually bad all the way around.

The frenzied HUI merger mania of 2004 really shuffled the elite gold stocks around in terms of their relative attractiveness for investing in the next major HUI upleg. At Zeal right now we are hard at work researching some big internal gold-stock studies to try and find the best candidates for investment and speculation going forward in this gold bull.

We hope to publish this exclusive gold-stock research for our monthly Zeal Intelligence newsletter subscribers sometime in the coming months as we finish various stages of it. Don't miss it if you are getting ready to reinvest in the next major gold and silver uplegs!

The bottom line is the madness of hostile bids is difficult to argue against. Hostile bids in general do more serious damage to stock prices and acquiring company shareholders than almost any other events, including bad negative earnings surprises. Mergers are fine if executed properly via mutually amiable acceptance and little or no dilution, but hostile bids tend to muck up an acquirer for a long time to come.

Managers need to refrain from going hostile and shareholders have to strive to hold managers accountable if they destroy shareholder wealth by going hostile. Shareholders should vote no on any hostile deal, period, that has hurt their wealth by seriously eroding the market capitalization of a company they own. They should also fire managers who brazenly violate their fiduciary duty to shareholders by going hostile.

There are certainly better ways to grow gold-stock companies than unleashing the madness of hostile bids!

December 24, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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