Will the merger between BT and EE generate shareholder value?

The basic motivation of a merger should be to add value to a company, thereby enhancing shareholder wealth. That said, this is not always the case. There is much debate regarding the success of mergers, with some claiming the majority destroy shareholder value. With this in mind, the recent announcement of BT’s takeover of EE provided an interesting read (Roland & Williams, 2015; Thomas, 2015; Williams, 2015; & Hargreaves Lansdown, 2015); would this takeover succumb to the factors that have previously rendered other mergers disasters? Or would, despite the odds stacked against the success of mergers, it realise the benefits it anticipates from the merger?

A merger is typically classed as a friendly, negotiated deal. So far, the BT-EE merger has been friendly, although approval is still required from shareholders. There are 3 different types of mergers; horizontal, vertical and conglomerate. The BT-EE merger takes the form of a horizontal merger as the two firms are involved in similar business activity. The horizontal nature of the merger means competition clearance is required from the UK Competition and Markets Authority. A vertical merger is a situation in which firms from different stages of the supply chain merge. Businesses in completely separate industries that unite is known as a conglomerate merger, although these are quite rare in the UK.

There are various different motives associated with mergers being undertaken.  The neoclassical theory proposes that managers will only engage in takeover activity if it leads to the creation of shareholder wealth. This is likely to be the case with the BT-EE merger, and most horizontal mergers, as there are various potential synergies from the deal which have the ability to maximise shareholder wealth. Economies of scale play a large role in this, as a larger sized firm may lead to lower costs through the utilisation of resources. BT forecast a large cost saving off the back of the merger, with an expected £360m saved on operating costs and capital expenditure every year by the fourth full year following the transaction. This has a net present value of around £3.5bn before integration costs, falling to £3bn after these costs are taken into account. Spreading costs over an increased range of products creates economies of scale. As BT is aiming for a full union of mobile and fixed telecoms, this is likely to result in new products and services to spread their costs and generate further revenue. Revenue synergies from the wider range of products are expected to amount to a net present value of £1.6bn.

Managerial synergy could also have played a role in the merger, as BT clearly believes they can run EE better than it is currently being run. Inefficient managers can be replaced and expert skills transferred between both companies. This can be seen in the takeover agreement between the two firms, which states Deutsche Telekom, joint owner of EE, have the right to appoint a director to the BT board. The two companies say this creates a platform for them to work together, sharing best practice in the process. These motives behind the BT-EE merger suggest it will generate value for shareholders. BT seems focused on creating synergies, including higher revenues and lower costs, as well as working with EE. At first glance, there does not appear to be any managerial motives, such as higher salaries and remuneration packages, behind the deal.

An alternative argument suggests managers own personal interests could be the motivations behind mergers. This stems from agency theory, which suggests a difference in goals between managers and shareholders may cause managers to prioritise their own needs as opposed to shareholder wealth maximisation. Factors including increased remuneration and power may encourage such behaviour. Evidence has found managers are rewarded off the back of mergers even if they turn out to be unsuccessful. Alternatively, the manager could suffer from 'hubris', leading them to overestimate their abilities to run the merger on completion. This stems from overconfidence. It may be the case that the managers at BT simply wanted to 'enhance their CV' by running a much larger, more dominant company. If this proves to be the case, it is unlikely to merger will be successful in generating shareholder value.

The financing of mergers is most frequently made up of either cash or shares. BT is paying £12.5bn for EE; however, the sellers, Deutsche Telekom and Orange, are receiving most of this in stock. Deutsche Telekom will have a 12% stake in BT, and Orange will have a 4% stake. A major advantage of this is that tax can be avoided for the time being. It also reduces the amount of cash BT must provide as part of the deal.  However, to achieve this BT raised £1bn from the sale of 2.2 million new shares at 455p. This will dilute the position of existing shareholders; not necessarily a popular decision. Despite this, BT will still have to make use of debt to fund the rest of the takeover, and take on EE’s existing debt of £2.1bn. This will affect BT's capital structure as gearing would be increased; the company should ensure this would not increase financial distress costs too dramatically as this may destroy shareholder wealth. Cash may be preferred by the target as it carries a certainty of worth, however, this may be subject to taxation. Despite the limitations associated with each financing method, it appears to me that BT has funded the merger in a way that best suits the company. This has allowed them to strengthen their abilities and improve their free cash flow.

Despite potential synergies and opportunity to maximise shareholder wealth, there has been widespread criticism of mergers. Grubb & Lamb (2000) claimed that only 20% of all mergers succeed; hardly enticing odds for shareholders facing the prospect of a merger. Evidence regarding whether bidding firms generate value through mergers is somewhat ambiguous. Jenson & Ruback (1983) showed share price increased by 4% on average following a successful bid, and dropped 1% following an unsuccessful bid. The BT-EE merger certainly follows this proposal, with BT experiencing a 4.5% increase in share price on the day the final terms of the merger were announced. Shares reached their highest point in 14 years, showing the positive reaction from the marketplace. However, it remains to be see whether this success will continue once the merger is undertaken. Alternative studies have found successful mergers reduce the wealth of bidding firms shareholders (Firth, 1980). This implies the motivations behind the takeover may play a role in determining whether the merger is successful; it will create shareholder wealth if shareholders interests were prioritised when creating the deal. Target firms seem to benefit from mergers more; Jenson & Ruback (1983) found shares increased by 30% upon successful bids, dropping 3% for any unsuccessful bids. This led some to claim the increase in wealth of target shareholders is at the expense of bidding shareholders

The forecasts provided by BT of the synergies expected from the deal seem well thought out. They recognise the cost of integration and time required to make the merger a success, stating benefits will be realised in the fourth full year from the transaction. The marketplace reacted well upon the announcement of the merger and I believe this signals that the deal has the potential to generate shareholder wealth. Having said that, the merger still requires approval from shareholders and clearance from UK authorities, showing it is still in its early days. On the basis of this, I am inclined to refrain from full judgement of the merger, at least for now. Therefore, it remains to be seen whether the BT-EE merger will relish in the predicted success, generating value for shareholders, or fall foul to the curse of mergers falling flat and destroying shareholder value.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Hargreaves Lansdown. (2015). BT Group plc. Retrieved 24 March 2015, from http://www.hl.co.uk/shares/shares-search-results/b/bt-group-plc-ordinary-5p/share-research

Jensen, M. & Ruback, R. (1983). The market for corporate control: The scientific evidence, Journal of Financial Economics, 11(1-4), 5-50. doi: 10.1016/0304-405X(83)90004-1

Firth, M. (1980). Takeovers, Shareholders Returns, and the Theory of the Firm, The Quarterly Journal of Economics, 94(2), 235-260. Retrieved from JSTOR http://www.jstor.org/

Roland, D. & Williams, C. (2015). BT unveils £1bn share placing to help fund EE takeover. Retrieved 23 March 2015, from http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/telecoms/11407624/BT-unveils-1bn-share-placing-to-help-fund-EE-takeover.html

Roll, R. (1986). The Hubris Hypothesis of Corporate Takeovers, The Journal of Business, 59(2), 197-216. Retrieved from JSTOR http://www.jstor.org/

Thomas, D. (2015). BT shares surge as £12.5bn takeover of EE is finalised. Retrieved 23 March 2015, from http://www.ft.com/cms/s/0/4a88704e-ae20-11e4-8188-00144feab7de.html#axzz3VEtETs3w

Thomas, D. & Massoudi, A. (2015). BT seals the £12.5bn deal to buy EE. Retrieved 23 March 2015, from http://www.ft.com/cms/s/0/9a74a0ec-ac6c-11e4-9aaa-00144feab7de.html#axzz3VEtETs3w

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Williams, C. (2015). BT begins 48-hour ‘£17bn’ spending binge with EE takeover. Retrieved 23 March 2015, from http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/telecoms/11394138/BT-begins-48-hour-17bn-spending-binge-with-EE-takeover.html

Has Centrica's change in dividend policy cost them market value?

The proportion of profits a company pays to its shareholders is known as the dividend policy. In the UK, dividends are usually paid every 6 months in the form of an interim dividend for the first half years trading, followed by a final dividend at the year end. The dividend policy of a company should link with the overall objective of maximising shareholder wealth at every opportunity. It is argued by some that dividend policy should remain stable so shareholders know what to expect, making the flurry of news articles regarding the change in the dividend policy of Centrica an interesting read (Farrell, Kavanagh, Bloomberg, Financial Times & Patron. 2015). Centrica announced plans to cut their dividend for the first time since it was created in 1997. The large scale drop of 30% led to queries regarding what caused this sudden change in dividend policy and whether it maximised the wealth of shareholders.

Despite the argument that dividend policy is of importance to shareholders, this is not unanimous. Miller & Modigliani (1961) argued that if a few assumptions were made, including no transaction costs, no taxation and perfectly efficient markets, dividend policy is irrelevant to the value of shares. They claim share value is a result of corporate earnings, reflecting investment policy, rather than the amount of dividends paid. Consequently, investment policy is the only factor determining market value, implying value is independent of the dividend paid. Miller & Modigliani also claimed that rational investors are indifferent to whether they receive dividends or capital gains. The important factor is that a company maximises shareholder value through the adoption of an optimal investment policy, in which they invest in all projects with a positive NPV. Any remaining earnings can then be paid out as a dividend. If a shareholder wants a dividend and the company chooses not to pay one, they can create their own through the sale of shares.

According to this policy, Centrica’s market value would not be affected by the decision of the company to cut the dividend. This is not because they are 'not bothered' about receiving a dividend, but rather due to an indifference to the timing of the dividend. Shareholders would recognise appropriate investments had been made which would contribute to expected future dividends. However, this is not the case for the shareholders in Centrica, as share price fell by 8.3% following the announcement of the dividend cut. Critics of this theory would argue this is because in the real world taxation and transaction costs do exist; making dividend policy much more complex and disputable. 

Contrastingly, the traditional view argues dividend policies do influence share valuations (Lintner 1956, Gordon 1959). This approach believes shareholders prefer a certain dividend to be paid now rather than receiving the equivalent value through an investment with uncertain future value. Hence, dividends are considered more reliable than capital gains. This would explain the drop in Centrica’s share price following the dividend cut; shareholders perceive the cut as a return with much less guarantee.

Clientele effect goes some way to explain this, proposing that shareholders prefer a dividend pattern which matches their desired consumption pattern. Some clientele may not be interested in receiving dividends in the short term, and vice versa. This implies companies should aim to provide a stable and consistent dividend so investors know the investment will suit their preferences. This is apparent in the case of Centrica who, as a utility that has never lowered its dividend up until this point, has become popular with investors looking for a high dividend income. It therefore seems rational to suggest some shareholders in Centrica will have purchased the shares at least partly because the dividend policy suits them, putting pressure on Centrica to maintain a stable, consistently high dividend. The graph below demonstrates the extent of the change in dividend policy by Centrica. Total dividends per share have historically increased continuously, no doubt reinforcing the shock of the dividend cut. The cut threatened Centrica’s status as one of the FTSE 100’s highest yielding stocks, strengthening the argument shareholders in Centrica expect large dividends.

Made by blog author
Data obtained from Centrica (2014)

Another potential explanation for the drop in share price after Centrica announced its dividend cut is the belief that dividends convey information about the future of a company. An unexpected decline in the dividend, as is the case with Centrica, may signal a pessimistic view of the future. Shareholders may become uneasy and, due to a lack of other information, lose confidence in the company. Despite Centrica providing an explanation for the dividend cut, stating it is necessary for the continued success of the business, it would appear shareholders are not keeping this in mind. Investors often tend to have a short sighted view of the market; thus, are not taking the potentially positive future results from the dividend cut.

Ultimately, I believe it is clear clientele effect has played some role in reactions of Centrica’s shareholders; lending support to the traditional view of dividend policy. Having gained a reputation as one of the FTSE 100’s highest yielding stocks, it is apparent investors have come to expect this which is likely to have played some role in the decision to purchase shares in Centrica.  Upon the announcement of a dividend cut, share price dropped as the dividend policy was no longer stable. This exposed shareholders to potentially volatile dividends which were unlikely to meet their particular requirements. Consequently, the confidence shareholders have in Centrica is likely to have started declining.


References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Baker, H., Powell, G. & Veit, E. (2002). Revisiting the dividend puzzle: Do all of the pieces now fit?, Review of Financial Economics, 11(4), 241-261. doi: 10.1016/S1058-3300(02)00044-7

Bloomberg. (2015). Centrica slumps most since 2008 after cuts dividend on loss. Retrieved 9^th March 2015, from http://www.bloomberg.com/news/articles/2015-02-19/centrica-cuts-dividend-after-posting-1-6-billion-full-year-loss

Centrica, (2014). Annual Report. Retrieved 9th March 2015, from http://www.centrica.com/files/reports/2014ar/Centrica_AR2014_Annual_Report.pdf

Farrell, S. (2015). Centrica slashes dividend after annual profit falls. Retrieved 9^th March 2015, from http://www.theguardian.com/business/2015/feb/19/centrica-slashes-dividend-after-annual-profit-falls

Financial Times. (2015). Centrica: upstream without a paddle. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/3/d943a040-b840-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Gordon, M. (1962). The Savings Investment and Valuation of a Corporation, The Review of Economics and Statistics, 44(1), 37-51. doi: 10.2307/1926621

Kavanagh, M. (2015). Centrica slashes dividend as losses bite. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/83d6d11a-b80c-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Linter, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. The American Economic Review, 46(2), 97-113. Retrieved from JSTOR http://www.jstor.org/

Miller, M. & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares, The Journal of Business, 34(4), 411-433. Retrieved from JSTOR http://www.jstor.org/

Patron, E. (2015). Centrica: What the analysts say. Retrieved 9^th March 2015, from http://www.ft.com/cms/s/0/c603dfea-b822-11e4-86bb-00144feab7de.html#axzz3USwO1NUm

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.

Is there an optimal capital structure?

As mentioned in my previous blog, the recent fall in crude oil has impacted many large oil companies. On 4^th March, oil and gas producer Afren announced it was defaulting on a $15m interest payment (Kavanagh & Wallis 2015, Aglionby & Thomas 2015, & Casiraghi, 2015). This default casts doubt on their capital structure, leading me to assess the options available to firms when deciding upon their capital structure.

Companies must decide on the level of debt and equity used to finance their business. Debt finance is much cheaper than equity; however, it has to be repaid whereas equity does not. The traditional view suggests that because debt is cheaper due to tax advantages, increasing gearing would reduce the weighted average cost of capital (WACC). Hence, shareholder wealth is increased as cash flows are discounted at a lower level.  Despite this, the traditional view suggests as gearing rises, the associated risks to shareholders increase due to the large interest payments faced. Whilst debt repayments remain constant, demand may not. This is certainly applicable in the case of Afren who, having generated $1.2bn of debt, were faced with a 60% drop in the price of crude oil. As debt repayments must be maintained, the company was faced with serious cash flow difficulties leading to their default on interest payments. To avoid instances like this, the traditional view proposes there is an optimal capital structure; if gearing is too low shareholder value opportunities may be missed, alternatively if it is too high risks are heightened, seen in the case of Afren.

Contrastingly, Modigliani & Miller (1958) found that WACC remains constant regardless of gearing levels, implying shareholder wealth cannot be maximised through capital structure. However, this paper was highly criticised for its major assumptions that there is no tax, financial distress or bankruptcy costs. In response to this, Modigliani & Miller reviewed their paper in 1963 to include the effect of taxation. Through this modification they found the optimal capital structure is as much gearing as possible due to the tax advantage of debt finances which decreases the WACC, thus maximising shareholder wealth. It could be argued Afren took this approach as they have extremely high levels of debt. Whilst this initially maximised shareholder wealth, with share prices reaching an all-time high in October 2013 of 166p, it is now having the opposite effect. Share prices hit a yearlong low in January, and reduced almost 27% to 6.6p the day the interest default was announced. Standards & Poor rating agency also reduced the company to a double C status, defining them as highly vulnerable; a further concern for shareholders.

Afren’s difficulties can potentially be explained through the work of Miller (1977) who again revisited the initial paper, this time including bankruptcy costs. As gearing levels increase, so do interest payments and the risk of being declared bankrupt. Miller found tax advantages from increased debt were counterbalanced by the increased risk. This increases the rate of return demanded by shareholders, thus Miller concluded WACC remains relatively unaffected by capital structure; parallel to the initial study. However, this could also bring us back to the beginning of the blog, in which it was suggested there is an optimal capital structure involving appropriate gearing and equity levels. If gearing is increased to an optimal level, tax advantages can be gained and risk can be maintained at a moderate level. It would seem Afren increased gearing too much, not foreseeing the drop in crude oil prices. Afren are in a dangerous position, having defaulted on a $15m interest payment and with nearly $400m of debt due to mature next year. In a bid to help the situation the company are seeking a capital restructuring, potentially increasing equity holdings. Afren need to raise in excess of $200m to achieve this, a figure higher than its market value. If this is achieved, Afren have warned this new equity will ‘substantially dilute the interests of the company’s current shareholders’.

In my opinion, by maximising gearing Afren have ultimately ended up damaging shareholder wealth despite having maximised it for a short period of time, suggesting this capital structure is not sustainable in the long term. Uncertainty in the economy, still prevailing since the financial crisis, further enhances the risk of high gearing levels. Therefore, I believe there is an optimal capital structure that involves the balance of making the most of low cost debt and its associated tax relief, whilst avoiding financial distress and bankruptcy costs. Having said this, I don’t believe there is a ‘right’ answer; each company will face its own risks and should therefore determine what the best capital structure for their particular needs is.

References

Aglionby, J. & Thomas, N. (2015), Afren defaults on $15m interest payment. Retrieved on 4^th March 2015, from http://www.ft.com/cms/s/0/e7d380c2-c23f-11e4-bd9f-00144feab7de.html#axzz3Ti5FZYjU

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Casiraghi, L. (2015). Afren defaults on bond as it holds out for restructure deal. Retrieved 4^th March 2015, from http://www.bloomberg.com/news/articles/2015-03-04/afren-defaults-on-bond-as-it-holds-out-for-restructuring-deal

Kavanagh, M. (2015). Afren shares plunge more than 65% on funding crisis. Retrieved 2^nd March 2015, from http://www.ft.com/cms/s/0/781cc12e-a612-11e4-abe9-00144feab7de.html#axzz3Ti5FZYjU

Kavanagh, M. & Wallis, W. (2015). Seplat granted extension for Afren offer. Retrieved 1^st March 2015, from http://www.ft.com/cms/s/0/9b7d2688-a89f-11e4-97b7-00144feab7de.html#axzz3Ti5FZYjU

Modigliani, F. & Miller, M. (1958). The cost of capital, corporation finance and the theory of investment, The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org/

Modigliani, F. & Miller, M. (1963). Corporate Income Taxes and the Cost of Capital: A Correction, The American Economic Review, 53(3), 433-443. Retrieved from JSTOR http://www.jstor.org/

Miller, M. (1977). Debt and Taxes, The Journal of Finance, 32(2), 261-275. doi: 10.1111/j.1540-6261.1977.tb03267.x

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.