Shareholder Cash Distributions:

Transcription

1 Shareholder Cash Distributions: An Emotional But Healthy Decision Financial Strategy Group March 21, 2006 Marc Zenner Managing Director and Global Head Shams Butt Director Gavriel Kimyagarov Associate Tomer Berkovitz Vicky Polyakov Analyst

2 Table of Contents 1. Distributions Landscape 2. Cash Is Not King 3. Distribution Benchmarking 4. Economic Drivers of the Distribution Decisions 5. Activist Hedge Funds 1

3 The Value Creation Process Cash Flow from Operations Primary Value Creation Asset Sales Capital Market Sources Internal Positive NPV Investments Value Creation Through Investments Value Creating Acquisitions Secondary Value Creation Excess Cash Dividends Debt Buyback Overlevered Value Creation Through Capital Structure & Distribution Appropriate Leverage Special Dividends Share Buybacks 2 On-Balance Sheet Cash

4 Distributions Landscape

5 Dramatic Rise in Distributions: S&P1500 Rising S&P 1500 Distributions ($bn) 700% 600% Share Buybacks Common Dividends Special Dividends Tax Reform % 400% % % % Share Buybacks Common Dividends Special Dividends Total Source: Bloomberg and FactSet +48% +33%

6 US Drivers of Distribution Increases Push From The Business Side Strong balance sheet Strong cash flow Conservative M&A and CapEx Repatriated cash Pull From The Investors Dividend valuation premium Post-Enron preference for earnings over cash Low interest rates Lower tax rates since 05/2003 Aging baby boomers demand yield Activist hedge funds 4

7 Dramatic Rise in Distributions: TA100 Tel Aviv 100 Dividends ($mm) Tel Aviv 100 Dividend Paying Firms 300% % 200% Tax Reform % % % Common Dividends $78 $40 $112 $218 $ % +94% +24% 5 Source: Bloomberg and FactSet

8 Drivers of Distribution Increases Tax reforms Strong cash flow Impact from US markets Low interest rates Large owners cashing out Proceeds often used to pay back acquisition debt 6

9 More Dividend Increases S&P 500 Dividend Increases by Quarter Before Tax Cut After Tax Cut Number of Dividend Increasers Q 02 3Q 02 4Q 02 1Q 03 2Q 03 3Q 03 4Q 03 1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05 Since the dividend tax cut in May 2003, there has been an upward trend in the pattern of dividend increases for S&P 500 (1) companies Quarter 7 (1) Excluding financial companies and utilities Source: Factset

10 Shareholder Distribution Options Common Dividends Share Repurchases Special Dividends Main Economic Drivers Predictable free cash flow in excess of operating needs Use of on balance sheet excess liquidity Distribution of unpredictable free cash flow Capital structure optimization (i.e. leveraged recap) Signals Cash flow strength and management confidence about future cash flows Disciplined approach to capital management Undervaluation Disciplined approach to capital management Other Effects Capitalizes on current favorable dividend environment and dividend premium Shareholders are not forced to sell to receive cash May establish valuation floor Increases shareholder concentration and removes short-term investors Generates EPS growth through share count reduction Shareholders can choose to cash in or not Moderate tax advantage Preserves free float Monetization of large owners who cannot sell in buyback All shareholders receive same amount: no seller / keeper disadvantage 8

11 Three Major Philosophies on Buybacks Valuation Agnostic Valuation Driven Capital Structure Driven 9

12 Cash Is Not King

13 Cash Balances Do Not Lower the Cost of Equity Asset Beta % of Value Weighted Beta Cash % 0.00 Physical Asset % 1.20 Entire Company 100% 1.20 Adjusted Beta Theory: Cash Balances Lower Risk & Returns Practice: Cash Balances Do Not Lower Equity Betas Cash/Assets (%) Cash has a beta of zero and finance theory suggests that: High Cash Balance Low Beta Low Cash Balance High Beta In practice, we observe a slightly positive relation between cash balances and betas (1) This evidence suggests that the markets do not fully adjust betas to reflect the low risks of holding cash (1) Results shown for members of the S&P 500. Source: FactSet 10

14 Cash Balances Do Not Lower the Cost of Debt Industry R-squared Gross Leverage Net Leverage Aerospace & Defense 64% 72% Specialty Chemicals Apparel Retail Food/Alcohol/HPC Energy Integrated & E&P Energy - MLPs Energy - Oil Services Life Insurance 22 2 Medical Products Pharma & Biotech Broad Media Metals & Mining Diversified Industrials Paper Power Technology Telecommunications Shipping Median Sources: FactSet & Citigroup.

15 Cash Can Increase Required Return on Non-cash Assets Example: Low Cash Balances Asset Amount ($mm) Rate of Return Return ($mm) Cash % 7 Non-Cash 9, % 1,000 Total 10, % 1,007 With low cash balances, a return of 10.2% on non-cash assets yields a firm-wide ROIC of 10.1% Example: High Cash Balances Asset Amount ($mm) Return (%) Return ($mm) Cash 2, % 70 Non-Cash 8, % 937 Total 10, % 1,007 With higher cash balances, the firm must increase its return on non-cash assets from 10.0% to 11.7% to achieve its target ROIC of 10.1% 12

16 Benchmarking

17 Payout Benchmarking Cash Flow Basis Total LTM Payout: Dow Jones Industrial Index 160% 140% 120% 100% 80% 376% 197% 148% 147% 121% 117% 107% 106% 99% 98% 91% 81% 81% 80% Share Repurchases Dividends 74% 73% 73% 71% 70% Median = 74% 63% 62% 60% 60% 48% 40% 35% 40% 20% 0% 8% NM NM NM WMT DD PG HD DIS INTC IBM MMM MO HON C VZ T PFE HPQ MCD BA MRK KO XOM JNJ UTX GE JPM AXP AIG CAT MSFT AA 13 (1) Total payout is defined as indicative annual dividends plus LTM share repurchases divided by LTM Cash Flow From Operations less Capex

18 Total Payout Benchmarking Oil Services Sector Total Yield (1) 4.0% 3.0% 3.6% Dividends Median: 0.8% Share Repurchases 2.0% 1.0% 0.0% 1.7% 1.4% 1.0% 1.0% 1.0% 0.8% 0.8% 0.7% 0.7% 0.4% 0.3% 0.2% S&P 1500 Dividend Yield Median = 0.7% 0.0% 0.0% 0.0% 0.0% 0.0% GSF CKH SII SLB BHI CAM BJS DO PDE HAL VTS NE ESV WFT PKD GW NOI RIG Total Earnings Payout (2) 140% 120% 100% 80% 60% 131% Dividends Median: 24.8% Share Repurchases 40% 20% 0% 14 39% 32% 30% 28% 27% 25% 22% 14% 13% 10% 6% 4% S&P 1500 Dividend Payout Median = 10.3% 0% 0% 0% 0% 0% GSF DO PDE CKH BHI SII SLB CAM BJS HAL VTS ESV NE WFT PKD GW NOI RIG (1) Total yield is defined as indicative annual dividends plus average share repurchases over the past 3 years divided by current market capitalization (2) Total payout is defined as indicative annual dividends plus average share repurchases over the past 3 years divided by next twelve months net income Note: Median calculations only for the sample of firms that pay dividends and have executed share buybacks in the past 3 years

19 Total Payout Benchmarking Branded Consumer Total Yield (1) 14.0% 12.0% 12.6% Share Repurchases Dividends 10.0% 8.0% 7.6% 7.1% 6.9% 6.7% Peer Median = 4.4% 6.0% 4.0% 4.9% 4.8% 4.5% 4.4% 4.4% 4.4% 3.9% 3.6% 3.4% S&P 500 Median = 3.3% 3.4% 3.1% 2.0% 2.1% 0.0% CLX BUD KMB PFE MAT BMY AVP CL PEP KFT KO EL MCD UNA PG JNJ HAS Total Payout (2) 140% 120% 100% 80% 60% 241% 133% 108% 98% 95% 94% 91% 90% 86% Share Repurchases Dividends 79% 76% 73% 69% 57% Peer Median = 86% S&P 500 Median = 55% 51% 48% 40% 38% 20% 15 0% CLX BUD KMB AVP MAT BMY PFE PEP CL KO EL PG KFT MCD UNA JNJ HAS (1) Total yield is defined as indicative annual dividends plus average share repurchases over the past 3 years divided by current market capitalization. (2) Total payout is defined as indicative annual dividends plus average share repurchases over the past 3 years divided by next twelve months net income.

20 Total Payout Benchmarking Technology (2003 vs. Current) Total Yield (1) 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 21.8% 8.9% 8.8% 7.3% 7.3% 7.2% 5.8% 5.7% 4.1% 2.7% 2.5% 2.2% 1.9% 0.8% 0.7% 0.0% 2003 Current 3.2% 3.1% 2.5% 1.6% 0.9% 1.1% 0.4% 0.2% Median Current = 5.7% Median 2003 = 1.0% 1.9% 0.9% A INTC TXN IBM MSFT CSCO HPQ AMAT EMC TSM KLAC MOT ORCL ASML Total Earnings Payout (2) 160% 140% 468% 187% 151% 139% 142% 129% 125% 2003 Current 120% 100% 90% 102% 97% Median Current = 99.3% 80% 60% 40% 20% 0% 65% Median 2003 = 35.2% 55% 59% 54% 53% 45% 40% 40% 30% 31% 29% 28% 15% 12% 14% 0% A TXN INTC MSFT CSCO AMAT IBM HPQ EMC KLAC TSM MOT ORCL ASML 16 (1) Total yield is defined as indicative annual dividends plus LTM share repurchases divided by current market capitalization. (2) Total payout is defined as indicative annual dividends plus LTM share repurchases divided by next twelve months net income.

21 Dividends Payout US vs. Israel Dividend Yield (1) S&P1500 Tel Aviv % 3.2% 1.8% 1.3% 1.4% 1.3% 1.5% 2.3% 1.7% 2.1% Dividend Payout (2) S&P1500 Tel Aviv % 53% 57% 54% 55% 44% 34% 34% 31% 32% (1) Dividend yield is defined as annual total dividend paid by S&P1500 / TA 100 divided by sum of market value of the firms. (2) Dividend payout is defined as annual total dividend paid by S&P1500 / TA 100 divided by year end total earnings. Source: Bloomberg and FactSet

22 Economic Drivers of the Distribution Decisions

23 Positive Investor Reaction to Dividend Initiations Cumulative Excess Returns Around Announcement of Selected Dividend Initiations Excess Returns for Dividend Initiations of Various Sizes Cumulative Excess Returns 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% Cumulative Excess Returns Announcement Date (End of Day) Days Relative to Announcement (Day 0) Mean Excess Return (%) 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 4.1% 0.6% 0.6% 0.3% 0% to 1% 1% to 2% 2% to 3% 3% and up * Total of 274 companies initiating dividends from November 1994 through December 2004 Announced Dividend Yield (%) Cumulative Excess Returns (Two Days Before Announcement to One Day After) Dividend Increases Dividend Initiations Median 0.33% 0.35% Mean 0.49% 1.18% 18 *4392 Company announcements between 1990 and 2005

24 Positive Investor Reaction to Dividends Increases Cumulative Excess Returns Around Announcement of Selected Dividend Increases Excess Returns for Dividend Increases of Various Sizes Cumulative Excess Returns 0.8% 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% Announcement Date (End of Day) -0.1% Days Relative to Announcement (Day 0) Cumulative Excess Returns * Total of 4825 companies increasing dividends from January 1990 through December 2004 Mean Excess Return (%) 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% 0.3% 0.7% 1.4% 1.2% 0% to 20% 20% to 40% 40% to 60% 60% and up Increase in Existing Dividend (%) Cumulative Excess Returns (Two Days Before Announcement to One Day After) Dividend Increases Dividend Initiations Median 0.33% 0.35% Mean 0.49% 1.18% 19

25 Dividend Initiations in Israel Total of 36 companies initiated dividends from January 2002 through December 2005 Cumulative Excess Returns 2.5% 2.0% 1.5% 1.0% 0.5% Cumulative Excess Returns 0.0% Announcement Date (End of Day) -0.5% Days Relative to Announcement (Day 0) 20 American Israeli Paper Mills (2002) El-Rov (Israel) Ltd (2002) Blue Square Chain Investments and Properties Ltd (2002) Bayside Land Corp (2002) Discount Investment Corp (2002) Elco Holdings Ltd (2002) Excellence Investments Ltd (2002) Frutarom (2002) Lipman Electronic Engineering Ltd (2002) Mivtach Shamir (2002) Property & Building Corp (2002) Bezeq Israeli Telecommunication Corp Ltd (2003) Clal Industries and Investments (2003) FMS Enterprises Migun Ltd (2003) IDB Development Corp Ltd (2003) IDB Holding Corp Ltd (2003) Israel Corp Ltd/The (2003) Suny Electronic Inc Ltd (2003) Tadiran Communications Ltd (2003) Alrov Properties and Lodgings Ltd (2004) Arazim Investments Ltd (2004) Avner Oil & Gas Ltd (2004) Delek Drilling - LP (2004) Direct-IDI Insurance Co Ltd (2004) Ituran Location and Control Ltd (2004) Knafaim Arkia Holdings Ltd (2004) Mizrahi Tefahot Bank Ltd (2004) Ormat Industries (2004) Osem Investment Ltd (2004) Africa Israel Properties Ltd (2005) Azorim-Investment Development & Construction Co Ltd (2005) Elbit Medical Imaging Ltd (2005) Formula Systems 1985 Ltd (2005) Matrix LT Ltd (2005) Perrigo Co (2005) Partner Communications (2005)

26 Pfizer Inc.: 12/12/2005 Announcement of a 26% increase in annual dividend (roughly $1.5bn) from $0.76 per share to $0.96 per share 12.0% 10.0% 8.0% Cumulative Excess Returns 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Cumulative Excess Returns Announcement Date (End of Day) -10.0% Days Relative to Announcement (Day 0) (1) This is the return in excess of the company s expected return, as indicated by the company s beta relative to the S&P 500 and the performance of the S&P 500 over the time period described. 21

27 Whole Foods Market: 11/12/2003 Dividend initiation at an annual rate of $0.60 per share, payable quarterly The stock traded up $5.95 from $58.73 to $64.68 (+10.1%) on the day of the announcement DAILY DATA: MAY 12, 2003 THROUGH NOVEMBER 12, (a) (b) Price Jun Jul Aug Sep Oct Nov Dec Jan 2004 Feb Mar Apr May Jun Jul Aug Sep Oct Nov 22 WFMI (a) 11/12/2003: WFMI Initiates Cash Dividend (b) 01/02/2004: First Ex-Dividend Date

28 Positive Reaction to Share Buybacks Cumulative Excess Returns for Share Repurchase Announcements of Various Sizes One Time Repurchasers Multiple Repurchasers 8.0% 8.0% 7.5% Mean Excess Return (%) 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 2.5% 2.9% 4.4% 4.2% Mean Excess Return (%) 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.7% 2.5% 3.2% 0.0% 0% to 5% 5% to 10% 10% to 15% 15% and up Percentage of Shares Repurchased 0.0% 0% to 5% 5% to 10% 10% to 15% 15% and up Mean 2.2 Buybacks Mean 2.4 Buybacks Mean 2.7 Buybacks Percentage of Shares Repurchased Mean 3.3 Buybacks 23 Note: We exclude companies buying back more than 75% of their outstanding market capital. Returns examined using (-2, 2) day window around announcement date. Repurchases from 1995 to 2004.

29 TXU Corp.: 11/23/2004 Announcement of an Accelerated Share Repurchase (ASR) agreement with Citigroup to purchase 52.5mm shares at $64.57 per share (notional of $3.4bn) 25.0% 20.0% Cumulative Excess Returns 15.0% 10.0% 5.0% Announcement Date (End of Day) Cumulative Excess Returns 0.0% Days Relative to Announcement (Day 0) (1) This is the return in excess of the company s expected return, as indicated by the company s beta relative to the S&P 500 and the performance of the S&P 500 over the time period described. 24

30 Brown-Forman Corp.: 02/03/2003 Announcement to repurchase 8.3mm shares in a Dutch auction for ~$600mm Transaction increased Brown-Forman s debt level from $200mm to over $800mm Moody s and S&P downgraded the Company by one notch to A/A2 20.0% Cumulative Excess Returns 15.0% 10.0% 5.0% 0.0% Cumulative Excess Returns Offer Expiration Date (March 5, 2003) Announcement Date (February 3, 2003) -5.0% Days Relative to Announcem ent (Day 0) (1) This is the return in excess of the company s expected return, as indicated by the company s beta relative to the S&P 500 and the performance of the S&P 500 over the time period described. 25

31 DuPont: 10/25/2005 Announcement of an ASR program of $3bn to be completed immediately, and an additional $2bn intended for completion in mid 2006 The ratings agencies downgraded DuPont by two notches to A/A2 14.0% 12.0% Cumulative Excess Returns 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% Cumulative Excess Returns Announcement Date (End of Day) -4.0% Days Relative to Announcement (Day 0) (1) This is the return in excess of the company s expected return, as indicated by the company s beta relative to the S&P 500 and the performance of the S&P 500 over the time period described. 26

32 Open Market vs. Tender Offers Cumulative Excess Returns Around Announcement of Open Market, Dutch Auction Tender, and Fixed-Price Tender Offers 16.0% Cumulative Outperformance vs. S&P % 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% Announcement Date (End of Day) -4.0% Trading Days Relative to Announcement (Day 0) Open Market Dutch Auction Tender Offers Fixed-Price Tender Offers 27

33 Positive Reaction to Special Dividends Recent Large Special Dividends for S&P 1500 Companies Declaration Dividend Dividend Excess Ticker Company Name Date per Share Yield Return (1) LANC Lancaster Colony Corp 11/21/2005 $ PD Phelps Dodge Corp 10/20/ PKE Park Electrochemical Corp 10/19/ MSM MSC Industrial Direct Co 6/30/ CTCO Commonwealth Telephone Enterprises Inc 5/3/ FNF Fidelity National Financial Inc 3/9/ QSII Quality Systems Inc 1/31/ LTD Ltd Brands 11/23/ (4.6) PCH Potlatch Corp 10/25/ PKE Park Electrochemical Corp 10/25/ (4.5) DSCP Datascope Corp 9/20/ MLI Mueller Industries Inc 9/2/ CDI CDI Corp 7/22/ (13.6) MSFT Microsoft Corp 7/20/ CZN Citizens Communications Co 7/11/ ETH Ethan Allen Interiors Inc 4/27/ RUS Russ Berrie & Co Inc 4/12/ (17.8) AXE Anixter International Inc 2/12/ (0.4) GGG Graco Inc 12/12/ MSA Mine Safety Appliances Co 11/5/ CDI CDI Corp 7/23/ Common Themes The median abnormal return for large special dividends in (defined as dividend yield greater than or equal to 4%) is + 1.7% The median abnormal return from 1 day prior to 1 day after the declaration date is + 0.9% 28 (1) Cumulative abnormal return in excess of S&P 500 index from 1 day before to 1 day after declaration date. Note: Large special dividends included here have been defined as having a dividend yield greater than 4%

34 Sustainable Dividends? Cash Distributed to Shareholder Cash Flow Dividends (Years) Excess Cash for Share Buybacks, Special Dividends, and Acquisitions Sustainable Common Dividends Bullish about liquidity Bullish about future cash flows Predictable free cash flow for sustainable common dividends Less predictable free cash flow or excess on-balance sheet liquidity for buybacks or special dividends 29

35 Minimum Liquidity Needs PROBABILITY OF MEETING CASH USES Uses of Free Cash Flow 2006E 2006E E 2006E E Capital Expenditures $140 $315 $510 Debt Maturities Share Repurchases (Issuances) Dividend Payment Total Uses of Cash Flow $852 $1,289 $1,821 Expected Operating Cash Flow 999 2,106 3,321 Probability of Meeting Cash Uses 62.4% 83.5% 89.6% Existing Cash: $1,037mm Available Liquidity $1,037 $1,037 $1,037 + Expected Operating Cash Flow 999 2,106 3,321 - Total Uses of Cash Flow 852 1,289 1,821 Expected Scenario Surplus / (Shortfall) $1,184 $1,854 $2,538 Probability of Meeting Cash Uses 96.6% 96.9% 97.1% Minimum Cash Balance Needed to Protect Against 95% Scenario: $731 99% Scenario: $1,492 Note: We exclude any planned share repurchases as these are discretionary cash outflows and will likely not feature in a liquidity downturn. 30

36 Valuation Paradigm Shifts in 2000 and 2003 The focus on cash instead of earnings post tech bubble (2000) and the tax reduction on qualifying dividends (spring 2003) have contributed to a dividend premium Traditional Valuation Analysis Dividend Premium Analysis Forecasted EPS Dividends Forecasted Retained EPS x x x Sector Multiple Dividend Multiple Retained Earnings Multiple VALUATION Value of Dividends Value of Retained Earnings + = VALUATION 31

37 Activist Hedge Funds

38 Growing Activism by Hedge Funds DROPPING RETURNS Annual Average Return Assets ($ in Billions) 30% 25% 20% 15% 10% 5.9% 5% 1,200 1, Average : 1999: 17% 28.3% 27.3% 27.9% Average : 2005: 7% 19.5% 4.1% 19.7% 19.4% 15.9% 3.2% 5.4% 4.7% SURGING ASSETS % 9.2% 8.7% 0% -1.3% M05 Pressure to Find Alpha Cumulative Excess Returns 10% 8% 6% 4% 2% 0% -2% -4% -6% ACTIVISM HAS WORKED All Activism Non-M&A Activism Announcement Date (End of Day) Cumulative Excess Returns Note: Sample includes 31 companies who have faced hedge fund activism. The non-m&a activism group excludes nine companies targeted for M&A activity. Expect More Activism 32 Sources: Hedge Fund Research Inc. and FactSet.

39 Forcing Investors to Undertake Activist Strategies INFLUENCE DECISION MAKING PROCESS INCREASE CAPITAL DISTRIBUTION (LEVERAGE) MONETIZE OTHER ASSETS (REAL ESTATE) FRUSTRATE / COMPLICATE M & A TAKE OVER / SELL COMPANY Time Warner & Carl Icahn Blockbuster & Carl Icahn Phelps-Dodge & Atticus Kerr-McGee & Carl Icahn Temple-Inland & Carl Icahn Wendy s International & Pershing Bally Total Fitness Holding Corp. & Liberation Investment Group Ashland &Atticus Capital Mylan/ King & Icahn/ Perry Deutsche Boerse & TCA/Atticus Acxiom & ValueAct Circuit City & Highfields Kmart/Sears & ESL Beverly Enterprises & Appaloosa Management Common Tactics Gain small foothold Publicize it Attract other funds; team-up Seek to embarrass management Threaten proxy fight Highlight financial performance shortfalls 33

40 Who Is at Risk? Common Attributes of Targeted Companies Lower market capitalizations relative to peers Substantial cash balances Too low or too high financial leverage Stock price or earnings underperformance Targets S&P 1500 Median Market Value (in $bn) $782 $2,078 Cash / Assets 9% 7% Cash / Market Value 12% 7% Market Value/ Book Equity 1.7x 2.4x Price / FY1 EPS 16.6x 18.4x Book Value Leverage 40.0% 30.4% Market Value Leverage 25.7% 15.3% Avg. Annual Return (3-Yr) 11.7% 14.8% % of Insider Ownership 7.6% 2.6% Targets are 31 corporations who have faced hedge fund activism in All numbers are median values. Depressed valuation multiples Low market value relative to apparent asset value 34

41 Identifying Likely Targets Market Value (5%) Cash / Assets (30%) Debt/ Total Cap (10%) Note: Lower scores equate to higher probability of hedge fund activism. Forward P/E (10%) 3-Year Total Return (30%) Insider Ownership (15%) Ticker Rank Value Rank Value Rank Value Rank Value Rank Value Rank Value Activism Target Rank APC 14 $22, % % 4 7.8x 1 98% 9 0.5% 1 MUR 5 9, OXY 20 33, BR 19 28, PCZ 12 20, NBL 3 6, DVN 18 27, NFX 2 6, EOG 10 18, KMG 6 10, APA 15 22, TLM 11 18, PXD 4 6, SU 17 27, NXY 8 12, ECA 21 41, HSE 13 20, XTO 9 16, CHK 7 10, SWN 1 6, , CNQ 16 26,

42 Long Equity Short Debt: KerrMcGee Credit markets react negatively to event risk when the events involve asset sales, cash distributions, and added leverage Long Equity Short Credit $ Price $85 $80 $75 $70 $65 $60 $ Volume (000 s) Spreads ($) $50 Jan Feb Mar Apr May Jun Jul Aug /03/05 01/27/05 02/20/05 03/16/05 04/09/05 05/03/05 05/27/05 BBB Long-Term Industrial Index KMG 6.95% 7/1/2024 BB Industrial Index 36

43 Leverage Through Options: Wendy s Investment through Stock Buy shares at $41 / share Sell shares at $49 / share Investment through Options Buy call options at $2.4 / option Sell options at $5.7 / option ROI: 19% ROI: 136% Investment Return (%) 200% Option Returns Stock Returns 150% 100% 136% 50% 0% 19% Apr May Jun Jun Jul Aug Aug Note: Based on buying 11.38mm shares of Wendy s over a 10-day period starting 4/15/05, and liquidating the position on 8/23/05. Option strike assumed at $44 with maturity of 6 months at the time of purchase. This hypothetical example is loosely based on the Pershing / Wendy s case. Ignores transaction costs and option market liquidity 37

44 Biggest Issues Long term vs. short term Not all hedge funds are equal What is the value of financial flexibility? Different incentives for options holders vs. shareholders Proactive vs. reactive 38

45 Concluding Thoughts The biggest pushback Growth vs. value Yes. High growers pay less dividends No. Market knows already Other big pushbacks Cyclical overvaluation Keep precious cash on balance sheet Why Is It Such a Hard Decision? 39

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