Shutterfly: When a company is for sale but not yet sold

In a recent column, I laid out a case for why the current cult of Innovative Disruption is a distraction to the day-to-day job of finding high quality companies in which to invest. We never fall for that kind of so-easy-anyone-can-do-it analysis. In that column I highlighted some of our holdings that happened to be disruptive to their particular industries, but which we owned for more prosaic reasons like cash flow and market share gains. One example of this was long-time holding Shutterfly (SFLY).

But no sooner had I submitted that piece for publication than my early morning sleep was disrupted by the news on July 2 that Shutterfly had engaged an investment banker to shop the on-line printing firm to prospective buyers. Shutterfly stock closed up nearly 15% that day.

That’s categorically a nice thing. But what to do next?

Typically, when one of our holdings is the subject of an actual takeout offer we sell our position immediately. Our attitude is that we’re in the long-only equity investing business not the M&A risk arbitrage business. If there’s a credible offer on the table, we take it.

We don’t wait for higher offers because the firms we typically own don’t attract them. They’re mature, cash-generating companies that have been public for a long time. Anyone who wanted to kick the tires has had the opportunity to do so.

And buyers of companies like ours tend to pay cash, not stock, for the cash flow of the target company. It’s rare therefore that the potential buyer is using highly valued shares to buy its target in a stock-for-stock transaction, which in turn would invite another suitor offering even-higher-priced shares.

So we usually just take the first deal that’s on the table. And we sell right away. If the buyer is somebody with an impeccable pedigree like IBM or some no-fooling-around private equity firm with which we’re familiar, then we don’t even bother selling and just wait for the cash when the deal closes.

But what about the present situation? Where Shutterfly is being shopped around, but hasn’t yet found a buyer? I’ve been investing in tech stocks for a really long time. Here’s what I think is really happening.

Although the “news” that Shutterfly is being shopped around was presented by the media as a kind of ‘scoop,’ it isn’t. I’ve worked for investment banks and I know firsthand they have all manner of internal rules about client confidentiality. In other words, the fact that regular folks like us know about a possible deal is no accident: I believe it’s very likely somebody from Shutterfly or from its investment bank has deliberately leaked this information.

My experience is that one of two possible scenarios is at hand. The first scenario is that the investment bank has found a willing buyer, but there is a disagreement on the price to be paid or the currency to be used. This happens with companies that are seasoned, have straightforward business models and becoming part of a larger company is a natural next step.

So the bank discreetly leaks the news to the media, allowing the target’s stock price to rise and giving everyone involved a kind of ‘sneak peek’ at what the market thinks the target company is worth in a takeout. With this new information, everyone is more comfortable about negotiating a final price and terms.

The second scenario is that the investment bank has shopped the company around but found no takers, perhaps at any price. This happens with smaller, less-seasoned companies, whose early growth has decelerated sharply and whose better competitors have already been scooped up. So the ‘news’ of a pending deal is leaked as a kind of last-gasp, throw-up-your-hands effort by the bank to both roust out any possible suitors no one has thought of, and simultaneously giving cover to the investment bank which can now say, “hey, we’ve done all we can.”

Shutterfly clearly falls under the first scenario.

That’s why I’ve decided to not sell our Shutterfly position. It’s immensely tempting when a company’s stock price jumps to immediately sell. The news is good, the price is up and the future is uncertain. There’s a bird in the hand.

The key here is that Shutterfly not only has the high-quality attributes we noted earlier, but also is moving from strength to strength. The 2013 holiday season was very strong. On April 30 they reported a solid March quarter and raised EPS guidance for the full year. They haven’t pre-announced their second quarter financial results and are scheduled to report them on July 30. Doesn’t sound like a company under major stress.

Which is why I’ve decided to wait. There are no shortage of companies like Yahoo (YHOO) or Microsoft (MSFT) that could leverage Shutterfly’s strengths (and pay about two weeks of cash flow to own them).

One underappreciated aspect of decisions like this is that a portfolio manager can’t think of them as a mystery that can be ‘solved’ with one or more ‘magic’ piece(s) of information. Instead you think of them as one of a series of mysteries, where, say, seven out of 10 times you expect to be right. For those of you who can’t stand suspense, don’t worry: we’ll know the answer in a matter of weeks.

In the meantime, June continued May’s strength for the Crabtree Technology portfolio. The portfolio rose 3.6% in the month, compared with a 5.2% gain for our Russell 2000 (RUT) benchmark and a 1.9% gain for the S&P 500 (SPX). Our internal benchmark, the Merrill Lynch Technology 100 (MLO) also rose 3.7% in June.

The most widely held technology ETF, the State Street Global Advisors’ Technology Select SPDR (XLK) rose only 1.9% during the month, including the effect of a $0.176/share dividend.

DISCLAIMER: The investments discussed are held in client accounts as of June 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.