If you owned a business that you thought was worth at most $2 billion and someone offered you $4 billion – you’d likely take the offer. Economists might also see the difference in the offer price and your reservation price as the efficiency gain of having your assets being combined with the assets of the acquisition firm. Following-up on my earlier discussion of the proposed Indiana Toll Road deal, I took a close look at the analysis from Crowe Chizek, which had been prepared for the State of Indiana. Crowe Chizek’s assertion that these rights are worth only half what Cintra and Macquarie offered is why Governor Daniels is able to push this deal through – even as Daniel Gross argues that these private firms are ripping off the taxpayers:
What’s in it for the foreign companies? Huge potential profits. Gigantic, steady profits. Toll roads are an incredible asset class. They’re often monopolies. They can support debt, since they provide a recurring guaranteed revenue stream that is likely to rise over time, as more people take to the roads and tolls increase. According to Cintra, the Indiana Toll Road generated $96 million in revenues in 2005, and Cintra expects a 12.5 percent internal rate of return on its investment. The heavy lifting has already been done: The state or federal governments have acquired the land and rights of way, built the roads and maintained them for years, and enacted toll increases. All the private companies have to do is deliver cash upfront, maintain the roads, and collect the windfall. The buyers can also increase their profits by making toll roads run more efficiently with technology.
Of course, the state could also run the toll roads more efficiently with technology. But isn’t it evident that there has been a huge efficiency gain when the private firms can offer double the state’s reservation price as established by the Crowe Chisek discounted cash flow model? After all, Cintra and Macquarie are still expecting an internal rate of return that is twice the 6% discount rate that Crowe Chisek is sensibly using. The alleged efficiency gain would have to come from Cintra and Macquarie being able to run the toll roads not only more cheaply than the government but also more cheaply than the other bidders if this were a truly competitive auction. Interestingly, Gross is suggesting that private entities expect a fairly high risk premium, which seems to go along with Brad DeLong’s risk arbitrage thinking in regards Social Security reform ideas – to which he might have a good laugh at this Bear’s expense as I have paid little attention to such risk arbitrage thinking.
No, that Cintra and Macquarie can get an internal rate of return that is double a reasonable discount rate by offering more than twice what Governor Daniels saw as his reservation price is hard to explain simply on the grounds of efficiency gains. If this is not a gigantic efficiency gain, what explains the substantial difference between the Crowe Chisek DCF model and what Cintra and Macquarie seem to be modeling?
There are four other possible explanations: (a) the Cintra and Macquarie discounted cash flow model is the kind of insane analysis that Andrew Fastow used to justify bad deals for Enron, which would mean Governor Daniels did snooker these firms; (b) the Crowe Chisek analysis was insane; (c) the toll increases contemplated by Cintra and Macquarie exceed the toll increases contemplated by Crowe Chisek; or (d) some of the costs of running the Indiana Toll Road will still be borne by the government.
I’m afraid that explanation (b) is a real possibility as the Crowe Chisek is a real mess. Its present value calculations don’t seem to follow from its (poorly explained) modeling assumptions. And its modeling assumptions strike me as grossly understating the cash flows. First of all, the write-up fails to tell us what the expected growth of revenues is, but it appears to be 4.3% per year. The write-up also tells us that they are assuming general operating costs are expected to rise by 5.1% per year, but their tables appear to assume general operating costs rise by 6.1% per year. I tried to replicate their model by assuming revenues in 2006 were $170 million with 4.3% growth through 2081, general operating costs in 2006 were $45 million with 6.1% growth through 2081, and repairs and maintenance costs in 2006 were $55 million with 2.5% growth through 2081. My attempt to replicate their model estimates the value to be $2.3 billion, which exceeds their $1.9 billion as Crowe Chisek tossed in an interest expense deduction with no explanation as to why one would both deduct interest expenses from cash flows and also discount cash flows. Notice something, however – general operating expenses start at 26.5% of revenues and rise to more than 90% of revenues by the end of the lease term. Crowe Chisek offers no explanation for what appears to be an incredibly biased assumption.
I re-ran their model a couple of ways. The first assumes both revenues and general operating expenses both increase by 5% per year. Under these assumptions, the rights are worth almost $5 billion. Now one might wonder why Crowe Chisek assumed repairs and maintenance costs would grow at a lower rate than revenues and other costs. Add to that the offsetting problem that Crowe Chisek assumed 2006 total costs were $100 million versus total costs in 2005 that were less than $70 million. So my alternative model starts with total costs being $70 million but letting all costs rise by 5% per year. This version has the estimated value being in excess of $5 billion.
So the Governor – aided by what appears to be a faulty Crowe Chizek analysis are selling assets that may be worth $5 billion to private investors for only $3.8 billion. One could argue that I’m being very hard on Crowe Chizek. But I would have hoped senior management would have spotted what appear to be flawed assumptions assuming they were asked to do a truly independent analysis. Maybe they can explain their conclusions, but one would have thought they would have written a better report. Then again – one might wonder of the Governor asked them to lowball the reservation price. In other words, is this some form of financial fraud imposed upon the taxpayers? Why would any responsible Governor be engaged in this kind of behavior? Oh but – we are talking about George W. Bush’s first OMB director.
As far as possible explanations (a), (c), and (d) – I have not seen the analysis that Cintra and Macquarie relied upon, so I would not be able to comment further. If Daniel Gross has and if he is reading this post – we’d love to hear your insights.
Update: Roland Patrick (aka Patrick R. Sullivan) attacks Max Sawicky (his name does not include mad except when referring to Patrick’s incessant nonsense) and then Patrick claims that Don Coffin argued I was wrong with this statement:
Cintra is paying $3.85 BILLION up front for this lease. And they expect a 12.5% internal rate of return. If I can still do arithmetic, that’s more than $400 MILLION per year in net income from the lease.. From a toll road currently generating only $96 MILLION in REVENUE (before any costs). And Cintra will be responsible for the operating costs, maintenance, and at least some expansion costs. The more I look at the numbers, the more I think it’s a better deal for the state of Indiana than I originally thought.
Notice the date of Don’s post – April 3, 2006. Max and I only recently made our posts and if you read enough of what Don has said, Don has been thinking in terms of what might explain why Cintra would pay so much for something whose past profits were so modest. The answer is obvious to anyone who understands finance – value depends on expected FUTURE cash flows. Then again – Patrick first claimed Crowe Chizek was examining past performance when it is clear their (possibly flawed) DCF model was offering some spin on expected future cash flows.
And it would seem Mr. Patrick claims to have discovered auction markets as he refuses to believe that a politician might game the system. And I thought he distrusted politicians – or is it that no GOP politician would game the system. I see.