Let the church bells be muffled, flags be flown at half mast, and children's parties cancelled; for we are entering a time of financial mourning. The last day of October, and the subsequent two weeks, witnessed the commencement of an equity value destruction cycle to a degree not seen since the late 1990s.
Corporate executives in Britain and elsewhere have developed a collective masshysteria. After two and a half years of generally rising equity market indices, valuations apparently have never looked so cheap, if only to these Captains of Industry. Each will readily admit individually that they understand the facts; these are that in every land, three quarters of all takeovers and mergers destroy value yet each also clearly believes in his own corporate acumen; for many have now decided to bet their entire balance sheet on a single deal at odds of 41. Collectively they have embarked on such a spending spree that M&A' activity in the second half of 2005 will prove to be one of the best six months ever. So why do Chief Executives (and their experienced' directors) persist in their "buy high, sell low" strategy?
Mergers and acquisitions: heroic valuations
At the centre of this current phase of takeover fever is London (by number). Investment Bank and press reports in the last two months have hinted at or forecast that 38 of the FTSE 100 index's leading companies are either under offer or about to be taken over. In the 250 index, this rises to 42%. If the reality were that these investment banks are merely hyping up share prices their proper and worthy function then it would be business as usual. However, not only are many of the bids proving to be real, a surprising number are even taking place for hard cash. Such a use of real money is a sure sign that the bidding company really does believe it is buying a bargain, as many takeovers have a high paper content (which essentially means we're not sure that this is really a good idea').
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A few of the current crop do have logic. That by Dubai Ports for the Peninsular and Oriental Steam Navigation Company (better known as P&O, a sad remnant of Empire) reflects that various Middle Eastern Sheikdoms are enjoying an oil bonanza and need to recycle their money. However, drill down into most other bids and the only conclusions that can be drawn are:
1. Company boards are using heroically optimistic forecasts for economic growth.
2. They really believe they can grow the acquired company's sales faster.
3. Thus the return on capital will easily cover more than the cost.
In practice it would seem that many of these bids are wilfully structured to destroy shareholder value. The $1.2 billion move by Talisman of Canada for Britain's plucky little Paladin is not a major deal in the oil world, merely krill snacking on plankton. We estimate that the bid values proven and probable oil reserves at an amazing $12 per barrel. The previous recent record was about $7.50. If Talisman is right, then Exxon, Shell and BP are worth about 50% more. This is clearly bonkers, but this valuation now becomes a benchmark for wannabe oil majors, when trying to buy out assets through taking over junior explorers'.
The bid by Nippon Sheet Glass for Pilkington is surreal. NSG has been a 20% holder for well over a decade and is about 60% only of the size of its prey having recently been twice the size. Policy at its Japanese HQ appears to have been one of waiting until Pilkington's share price had nearly trebled from its 2003 level of 44p, then to bid £1.50 or more at the peak of the auto and building cycle Pilkington's main businesses because only now has it become good value. Telefonica of Spain too, has had a Damascenelike conversion. It has decided that the Division II mobile phone company O2 is also a must have', again at a price nearly three times higher than the 2002 low point. Moreover, the timing of Telefonica's move is delightfully quixotic, given the changes in the industry; for having restructured and reduced its crippling debt, as a result of overpaying for 3G licences, the whole sector is about to undergo another squeeze. It is now a very mature industry, with intense margin pressure, saturation in many countries and aggressive competition. The only real hope for mobile telephony's profits is pornography. Mobile companies must lobby to lift government restrictions banning telephonic filthy pictures, to have any hope of growing revenue. (Note that over one third of all internet revenue is sexindustry related, be it with consenting animate objects, or otherwise.)
Mergers and acquisitions: Guten Abend Herr McTavish
The German giant utility E.ON, with a market capitalisation of €50 billion and 150 million people within 200 miles of its HQ, has developed a craving to generate electricity for use in some areas in Scotland, at a price of around €15 billion; thus it is stalking Scottish Power. The land of the thistle has a total population of less than six million. European utilities are a particular Bedlam favourite, as their track record of paying too high a price provides a rare certainty in a world of shifting valuations. On the mooted price tag, we estimate the result will be an awesomely low return on capital of 6%, unless there is some mystic synergy in lighting up the streets of auld Dundee and mining brown coal in East Germany; so this is not a great use of shareholders' money. E.ON has only recently cleaned up its balance sheet from earlier mistakes (and, like previous examples, could have picked up Scottish Power at 350p per share in 2002 vs. 580p now). Ironically, other utilities have finally realised the error of their ways and are retrenching. E.ON's direct German competitor, RWE, is looking to unload Thames Water, London's water provider which it took over in 2000 at such a high price that the company was almost killed in the rush to accept by thousands of small investors; they recognised a really bad price when they saw one. Within four years, RWE quietly wrote down the value of Thames a sure recognition they had paid too much and is now trying to float it off again. There are other examples, such as St Gobain's current £3.7 billion bid for BPB at another full price, and at the start of a housing downturn; all are extremely dubious, unless one is superbullish on global growth.
Bidding fever for assets in UK Inc is not confined to foreigners; many hoary old chestnuts are alleged to be back in play from domestic bidders, such as for British Gas, ITV or BOC. Even at the bottom of the food chain, in industries doomed by their cost structures to forever lose money, there is also bidfever; i.e. Aston Villa and Heart of Midlothian (who?) football clubs are being bid for by GentlemanPlayers from Russia and Lithuania respectively.
Away from Albion's fair shores, Germany's Heidelberg Cement has recently been acquired by Spohn, in Spain Endesa has been under siege from Gas Naturale and France Telecom has just taken over the mobile group Amena, thus breaching its new strategy announced only eight weeks earlier. This was only to make acquisitions if they enhanced free cash flow per share. Amena does not. Unicredito recently bought out the German Bank HVB. Now that the gold price has moved from $300 through $460 per oz., Barrick has decided to bid around $20 per share for Placer in a $9.2bn deal to buy shares it could have scooped up only three years ago at $9.
Why are chief executives acting so dumb?
Typically, the competence of senior management is significantly lower than they themselves believe. CEOs like to believe that they are the Masters of Corporate Destiny'. In reality, given that the average CEO now lasts less than four years, or half of a typical market cycle, they are journeymen whose success largely depends on the stage in the cycle when they were hired. Many come through the ranks of their company and by not bungling too often, have gradually floated to the top. Shell frequently used to win Best in Class' prizes for its corporate governance and management, even as the board either did not know, or did not fully investigate, one of the largest reserves misreporting scandals ever in the oil industry. For all that we subscribe to the Bumbledom theory of corporate management he who makes the least mistakes will win it would be naive to believe that collectively these senior people are so stupid or disingenuous that they do not understand the destructive impact of most takeovers. So why do they do it?
Essentially there are two factors which force them to forever buy high and sell low. At the bottom of the business cycle, companies suffer thin margins and stagnant sales, and have often accumulated too much debt (from previous expansion binges). They have no time to embark on glory bids, and lack the access to cheap funding. Moreover, when equity markets are low, shareholders flex their usually puny muscles to prevent expansion or the issuance of new paper. Thus companies are highly constrained and have to embark on costcutting and rationalisation programmes (such as the spin off of O2 by BT, at a very low price) to repair their balance sheets. This has been the case since 2001 across most of Europe, North America and Japan. Thus balance sheets now are generally very healthy. Moreover, even though interest rates bottomed in most countries in 2003, liquidity hence loans remains in ample supply. Shareholders, having seen share prices rise, also change tack and urge their companies to expand again. So companies can only bid for others when their own businesses and balance sheets are in good shape. In the last cycle this has occurred just as their competitors have also enjoyed a recovery. So the business cycle prevents them from being able to buy at low prices.
The second reason is of equal importance. From 2000 to 2002, world equity markets suffered a synchronised slump, largely because all had been suckered into the same technology boom. Unusually (with the notable exception of commodity companies which have wandered off on their own supercycle), most sectors have been recovering at the same time. For a number of reasons that need not concern us here, many businesses from insurance to auto manufacturers, food retailers to construction are finding it very tough to increase sales much more than the mild inflation rate. Further, energy prices, Asian competition and rising interest rates are slowly squeezing profit margins. Very few companies in the FTSE 100 or the Dow Jones indices can be expected to grow their sales organically by more than 10% in 2006. Given that their cost cutting and rationalisation are largely complete, the obvious action is to return capital to the owners (shareholders). This however, is usually contrary to the mindset of dynamic CEOs and the often supine boards who appointed them to be dynamic. Many have a minimal interest in actually increasing shareholder returns, and confuse good stewardship their actual role with activity. Money burns a hole in their pockets, so they look to buy the growth they cannot otherwise achieve, through takeovers.
The disproportionate amount of activity in Britain is at first glance particularly odd, given that the twin props of the grumpy Chancellor's "economic miracle", massive household debt funded by rising house prices, and a government which has been on the largest hiring/spending spree since just before the 1974 crash, are falling over. Revenue growth for UK Inc is certain to be weak in 2006, with thinner profit margins. For historic reasons, barriers to foreign bids are very low less than even in America, where the poison pill still rules. But why do so many foreigners feel this astonishing urge to buy up British businesses? There is one obvious reason, the cost of capital.
Irrespective of one's personal politics, all British Governments since the late 1960s have managed the economy badly. The objective test is the rate at which the Government can borrow money. This cost has nearly always been higher than in America, Germany, France or Japan. Earlier this year, UK Base Rates were 4.5%, those in America 3.25%, the EU 2% and Japan less than 0.25%. So the theoretical cost of capital to foreigners borrowing in their own countries, assuming constant exchange rates, is much lower. Thus the return required is also much less than for a domestic British company, where the cost of capital is normally higher. So NSG, Talisman, Dubai, St Gobain and Telefonica are not operating quite as idiotically as it first seems. Yet where they, and others will be proven to have been foolish again, is that high British interest rates mask two features: first, the economy is genteelly sliding into very low growth; second, sterling is an inherently weak currency (hence the slide in 55 years from a rate of £1.00 to 14 Deutschemarks to the current equivalent of approximately 1.4).
Bidding fever, corporate machismo and dysfunctional international takeovers never indicate a low point for equity markets. Be happy that Johnny Foreigner so loves the local climate. Take the money.
First published as Bedlam Asset Management's 'Pick of the Week'
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