A most interesting article in the latest Barron’s by Michael Santoli (Leaving With the One Who Brought You, Barron’s Online, Monday 12 October) points to the opportunities and pitfalls provided by a highly receptive market for high grade corporate paper. Santoli observes:
Any CFO of a high-investment-grade large company who reaches for a phone to call his or her banker in the morning will have multiple hundred millions of cheap, no-strings debt financing offered up by bond-fund managers before happy hour. Or so it seems. Companies that really don’t need the money can – and are – selling bonds at will.
While the bond market is highly solicitous of new paper the share market can be very critical of the purposes to which this newly found balance sheet strength is being put.
To quote Santoli:
In the recent wavelet of M&A action, a particular sort of corporate transaction has been applauded. To specify: When large, self-financing, market-leading companies have deployed their balance sheets to opportunistically grab for unique and easily digested assets, investors have celebrated.
Moving from the warmth of the market’s hearth to its chilly woodshed, we can find the would-be acquirers swiftly punished by investors for the transgression of bidding generously for a business in an adjacent market and, in so doing, negating the reasons so many shareholders owned the shares in the first place.
Recent deals that have earned the strong disapproval of the market referred to were the moves made by Kraft Foods and Xerox, for Cadbury and Affiliated Computer Services respectively.
As Santoli opines: “In both cases, a shareholder base that owned the buyers’ stocks for their steady, cash-flow-generating attributes woke up in alarm as management opted to pay large premiums for companies that the shareholders could themselves have owned more cheaply the prior day, and whose integration might not be effortless.”
In other words shareholders have been rudely reminded that they do not control the free cash flow generated by the companies they invest in. These cash flows remain largely at the mercy of management who have their own interests to pursue that are not necessarily consistent with the interests of shareholders.
This reminds us of M&A activity on the JSE and in particular the attempt by MTN to buy a big chunk of Bharti, which was frustrated by regulatory issues. The deal falls decidedly into the category of free cash flows at risk. MTN is a company with a strong balance sheet and one presumably easily able to issue more debt. Its free cash flow from its current operations is growing rapidly and is expected to increase from an estimated R8.6bn at 2009 year end to over R16bn at year end 2011 (by Jonathan Kennedy Good of Investec Securities).
This improvement in free cash flow, absent of acquisitions, is estimated despite an ambitious accelerated programme of capital expenditure over the next few years designed to roll out its network in under serviced Nigeria and Iran. Capital expenditure would then be expected to taper off in the absence of acquisitions or, less likely, to till large new green fields for voice or data transmission.
It should be fully appreciated that MTN in its dealings with Bharti was decidedly on the trail of the utilisation of cash and borrowing facilities. While MTN planned to issue more equity to Bharti (issues of approximately R59bn of equity was proposed) MTN had additionally committed to pay cash of some US$2.9bn (approximately R22bn) for its stake in Bharti. Clearly additional MTN debt would have had to have been issued to this purpose and we understand negotiations had been entered into with banks to this purpose. Bharti, in its turn, proposed to exchange newly issued shares as well as cash with MTN shareholders for part of their stake in MTN.
Presumably shareholders in MTN are not surprised by MTN’s appetite for acquisitions, especially in the light of much improved credit market conditions. Shareholders in MTN would have even less reason than those of Kraft or Xerox for believing that the cash flows that emerge from maturing operations will increasingly flow their way.
The big issue for shareholders in MTN is not whether or not they will control the free cash flow emanating from MTN, but rather how much return on capital they should expect from management exercising their ambitions. Will the assets they buy prove “opportunistically cheap and easily integrated” or will MTN overpay “for businesses in adjacent markets that shareholders could access cheaply on their own”.
MTN’s great value added for its shareholders by rolling out operations in South Africa, Nigeria and Iran could be regarded as of the first kind of investment. But the scope to exploit virgin telecom territory is increasingly limited. The Investcon acquisition, an investment in adjacent markets, might well be regarded as value destroying, judging by the returns so far realised on the extra capital employed.
Shareholders in MTN should seek good answers to this question of prospective return on debt and equity capital when MTN management comes around again, as they are most likely to do, to seek approval for an acquisition that would commit a large proportion of the potential cash flows from operations. Strong balance sheets that comfort debt holders are always a powerful temptation for managers – they allow managers to raise and invest capital both internally and externally derived – with often unfortunate consequences for shareholders.
Growth in earning that comes with the expectation of improved returns on capital at risk is the magic that drives share prices higher. Growth in earnings that promises to reduce the return on shareholders capital below its opportunity cost clearly punishes the value of a company to its shareholders, though not necessarily its managers.
MTN has made great value adding investments that shareholders have applauded. MTN may well be embarking on a growth course through acquisition that will realise below cost of capital rewards. This fear is presumably holding back its share price.
The MTN’s share price does not appear to carry any optimistic forecasts of improved flows of cash to shareholders. What would happily surprise the market would be an indication that MTN would not be making major acquisitions, and or that it intends to be much more demanding of a high return on capital from any acquisition it might make – including that of Bharti shares.
Ideally for shareholders, MTN would announce it is no longer interested in acquiring other established telecom companies and that it intends to focus entirely on realising the organic growth or green field opportunities that still present themselves. Then shareholders could anticipate a very healthy flow of cash over the next few years that they could hope to deploy in cost of capital beating ways should MTN be unable to do so.