Letter number 63 of December 2011
- QUESTIONS & COMMENTS
On August 31, 2011, the Bouygues group announced its plans to offer to buy back 11.7% of its own shares for a total amount of €1,250bn. This plan, which was approved by the French regulator, materialised in October.
Each share bought back was purchased at a price of €30, representing a premium of 30% on the share price on the eve of the announcement, 29% on the average share price during August, 21% on the 6-month average share price, and a discount of 3% on the 1-year average share price.
If all of the shares targeted by the tender offer were brought to the offer, the impact on Bouygues’ 2011 EPS was estimated at +11%.
The main shareholder, the Bouygues family owner a 18% stake, let it be known that it would not bring its shares to the offer. The Chairman of the board of directors and CEO is a family member.
This financial transaction, financed entirely using the group’s cash, inspired us to think about the following seven points.
1. There’s nothing unhealthy about giving money back to shareholders
In fact, it becomes a duty when cash starts to mount up in the company’s accounts and there is no obvious immediate or even long-term use for it. If not, equity is transformed into debt (as the company’s cash is, for reasons of caution, placed in debt instruments and not in shares), which macro-economically, penalises those who need equity to finance their development. Once it has been returned to shareholders, this money can be invested in either debt or equity.
On December 31, 2010, the Bouygues group had consolidated cash assets worth €5.6bn and consolidated gross bank and financial debt of €8.1bn, which works out at consolidated net bank and financial debt of €2.5bn, representing 0.5 times 2010 EBITDA and 23% of book equity.
At the mother company level, gross debt stood at €10.2bn and net debt €5.7bn, after deduction of €4.5bn in cash.
Even though Bouygues’ financial situation is healthy, and it remains so after the share buyback, it cannot be shown that the Bouygues share buyback tender offer is justified by an excess of cash that needs to be returned to its owners, the shareholders.
We note in this regard that the motivation of this tender offer differs significantly from the one of the exceptional €1.7bn dividend paid by Bouygues in 2004. The aim of the exceptional dividend was to redistribute cash following the disposal of the Saur subsidiary. The exceptional dividend had no impact on the shareholding structure and was probably initiated in order to ensure that the family holding company had the cash it needed to pay back a loan contracted in 2000 for the purposes of participating in a capital increase.
2. Should shareholders tender their shares to the buyback offer or not?
From a financial point of view, and regardless of their opinion on the share price (whether it is undervalued or overvalued) shareholders would be well advised to tender their shares to the buyback offer provided the offer is proposing a price that is substantially higher than the share price. If all of the shareholders reason in the same way, bringing their shares to the offer will not make any of them any richer, even though they will have the possibility of selling a portion of their shares at a premium. What will happen is that, on completion of the tender offer, the share price will fall by an amount reflecting the premium paid.
It is only if some shareholders, for reasons that are not financial, decide not to bring their shares to the buyback offer, that those who do so will be able to realise a gain. This gain will be the counterpart of the loss born by those who do not bring their shares to the offer who, in any event, since there is a premium on the tender offer, will lose out.
Let’s look at this in greater detail.
Shareholders who believe that the share price reflects the best value of a share have every interest in tendering their shares to the buyback offer when a premium over the stock market price is offered. In this context, selling a part of their shares at €30, when a few days before the close of the offer, the share price was around €27 is not a bad deal. But they should not delude themselves!
If they believe that €27 is the right price, then from a purely rational point of view, the share price should fall after the offer to reflect the fact that the company has got poorer, having bought for €30, shares that are worth €27, which is an impoverishment of €3 x 41.7m shares bought = €125m to be divided among the remaining 315m shares, which works out at a theoretical loss in value of €0.40, which is difficult to see with the naked eye.
If all of the shareholders bring their shares to the tender offer, in proportion to which they are entitled, the amount that will be gained on one share out of eight (only 11.7% of the shares are targeted by the tender offer), i.e., €3, will be lost again after the drop in the price of the 7 other shares following the buyback (7 x €0.4 ~ €3 rounded off).
Here, since some of the shareholders will not be tendering their shares to the offer (the Bouygues family which has a stake of 18.6%, and may be employees through their savings plans (20.4%)), investors who do tender their shares to the offer will make a gain that is symmetrical to the financial loss that those who do not tender their shares to the offer will bear, since their shares will be devalued by €0.4 each.
As for investors who believe that the Bouygues share is worth more than the post-offer share price of €27, and more than the offer share price of €30, they would also be well-advised to tender their shares to the offer, since they could sell some of their shares for €30, and buy on the market at €27 - €0.4 = €26.6, a larger number of shares than those sold in the tender offer. All in all, they would become richer, as the increase in the number of shares that they hold would be higher than the drop in the value of the share. This theoretical enrichment is solely due to the fact that some of the shareholders will not be tendering their shares to the buyback offer (the Bouygues family).
As for shareholders who believe that the Bouygues share is overvalued, well, if they are rational beings, they will already have sold their shares and there is nothing further to be said on the matter!
In the end, the only shareholders who get poorer as a result of a share buyback tender offer are those who don't tender their shares to the offer. They do not get the benefit of the buyback of a portion of their shares at a price that is higher than the trading price (and we’ve just seen that even if they believed that this price undervalued the share, it was still in their best interests to tender their shares to the offer) and they bear the full weight on all of their shares of the impoverishment effect linked to the premium on the tender offer compared to the share price.
So, in terms of financial rationality, all shareholders should tender their shares to a share buyback tender offer, as long as the premium on the share price, during the last days of the offer when investors make their decision, is substantial (at least 5 to 10%).
If they don’t do so, it is because they are reasoning in terms of something other than finance. Accordingly, the Bouygues family, if all of the shares targeted by the tender offer are effectively bought back (and cancelled), will see the size of its stake increase from 18.6% to 21.1% of shares and from 27.5% of voting rights to 30%, i.e., the maximum possible given the 30% threshold for launching a mandatory takeover bid in France (1).
The Bouygues family could have decided to tender its shares to the offer and then buy back shares on the market. In practice, communication to the market would have been complicated (selling through a share buyback tender offer only to buy up shares on the market) and the implementation not free from risk, given the volumes involved.
This share buyback tender offer is a very opportunistic transaction for the Bouygues family, which enables it, without any new investment on its part, to raise its controlling stake in the group to the maximum allowed before having to make a public offer on all of the capital, thus securing its control.
This is achieved without any negative impact on the capital structure of the group, taking advantage of the lowest share price since mid 2004 thanks to a frenzied market, and for a cost, in the end, of 1.5% (2). This is the fine reward of those with nerves of steel during a period of crisis!
3. Is launching a share buyback tender offer better than buying up shares on the market?
From a financial point of view, shareholders who are not keen on selling their shares would prefer Bougues to do its buy-back on the market over time, since the premium paid compared to the market price is nil, which means a smaller reduction of Bouygues financial means, while at the same time achieving the same goal in terms of accretion for the family.
In this case, this issue encounters a liquidity problem. If the liquidity of the Bouygues share is good (the daily trading volume represents 0.7% of the freefloat), it will take one year to buy up 11.7% of the capital without impacting the share price (for example, by limiting purchases to 10% of the daily volume).
In other words, the plan to increase the value of the Bouygues family stake becomes less reliable in terms of both occurrence and cost (the share price has a much higher chance of rising sharply over one year than over the two months that a tender offer will last, but it could also fall).
In any event, there is one point on which a tender offer has a clear advantage over buying up shares on the market. It is the spectacular nature of the offer which forces investors to take another look at their Bouygues portfolio and say: “My goodness, if the family and the CEO are not tendering their shares to this buyback offer at €30, perhaps I’m being a bit hasty in pushing the share price down to €23!"
On the day of the announcement of the buyback offer, the Bouyges share, which had slid by 32% over 4 months (25% only for the market index), rose by 16% when the market index only rose by 3% on that day. This is a fine example of signalling theory (3).
4. Relevance of the change in EPS
We may as well be clear and to the point – the change in EPS has absolutely no relevance.
We remind the reader that you can only compare EPS before and after an transaction (acquisition, share issue, buyback tender offer, etc.) and apply the same P/E ratio in order to determine the value of the share, if and only if three conditions are met:
• the risk of capital employed is unchanged after the share buyback offer;
• growth in EBIT remains unchanged;
• and the capital structure remains unchanged.
Clearly, this third condition is not met in the present case. Admittedly, the capital structure of Bouygues is not completely overhauled after the tender offer, but it is no longer the same. Net debt rises from 30% to 54% of market capitalisation (at €23) or from 26% to 47% (at €27), which is not the same thing. In other words, since the risk of its capital structure has increased, the Bouygues share deserves a lower P/E ratio after the tender offer.
It is only if the P/E ratio is constant that we can compare EPS before and after an operation and that the enhancement of EPS will be synonymous with the creation of value.
Remember that this is automatic as soon as the after-tax interest rate of funds used to finance the share buy back is less than the inverse of the P/E ratio.
With risk free rate at the most 2%, the P/E ratio would have to be above 50 in order to dilute EPS (4). Bouygues’ P/E ratio is a little under 10.
In the interests of being constructive, we believe that it would be a good idea for stock market regulators to inform companies that putting emphasis in their press releases about increase in EPS following a deal is intellectually biased, and likely to mislead investors who are not well informed, and that they should be done away with.
5. What sort of market risk premium should be used for computing the cost of capital in the context of a very bearish stock market?
In a context where the stock market index fell by 25% in two months, we find it astounding that the spot market risk premium on September 15 of 9.6% is used in work to value the Bouygues share presented to the public. This rate is close to its historic high and it is unrealistic to assume that it will remain indefinitely at this very high level. This pre-supposes that the company will be able to generate in normal times, earnings that are only required in periods of crisis. This makes no sense. This naturally has the effect of increasing Bouygues’ cost of capital and reducing the values of its assets.
Of course, shareholders are not obliged to tender their shares to a share buyback offer, as they are for a squeeze-out (5). But this is not a reason for choosing a very high spot discount rate (6) like Bouygues’ advisory bank did, instead of taking an average over several months to smooth out a market situation that will not last, or, given that generally the calm comes after the storm, using premiums that decrease over time until they reach a normal level at around 4 to 6%.
Admittedly, sensitivity of + 0.5 % was tested in the prospectus but this figure is too low given the very skittish stock market in September 2011.
We’d like to refer the reader to the Vernimmen.com Newsletter of January 2009 to our article in which we question the sustainability of a risk premium of close to 10%. Recent history has shown that even in an economic environment that remains very difficult, the risk premium does not stay at these levels long term.
6. The role of the independent expert – mission impossible?
In France, the market regulator (the AMF) makes provision for the appointment of an independent expert in the case of a conflict of interest, whose role is to reach an opinion on the fairness of the offer. Here, the conflict of interest arises out of the fact that the offer is being proposed and approved by the main shareholder, which is not tendering its own shares to the offer.
Firstly, we note that generally speaking, the role of any expert is a thankless task. It is, by definition, impossible to observe the positive result of his work upstream of the announcement of the tender offer when it leads the offeror to raise the price of the offer, or to refrain from going ahead with it, at prices that the expert deems to be unfair.
In the case of the Bouygues share buyback offer, the independent expert’s report reveals that the latter is concerned about the timing of the tender offer, which is too perfect. Far from taking a spot risk premium of 9.6%, as the advisory bank does, the independent expert seeks out another source which yields a lower figure (7.95%), mentions a 3-month average (7.4%) and a 24-month average (5.7%) but which, in the end, she doesn’t use, which would have caused a very sharp rise in prices.
She remarks in passing in his conclusion that the Bouygues family will not be tendering their shares to the offer, without going into details, and concludes that this offer at €30 is fair. The price is between the market value (share price and comparable) at around €25 and the intrinsic value (discounted free cash flows), capped at €35 given the market risk premium chosen.
A few years ago, the AMF introduced a rule that the independent expert should be appointed by the target of a tender offer and not by the offeror, which is real progress in that it eliminated an obvious conflict of interest. In this sort of share buyback offer, where the offeror and the target are not separate, and where the operation is more complicated that it at first appears (see §2), we believe it would be logical for the expert to be appointed and paid by the market regulator, rather than by the target company which happens to be also the offeror.
The independent expert’s opinion would then be above suspicion, whether founded or not, of being too understanding or even of connivance. After all, more than 2,000 years ago, it was said that “Caesar’s wife must be above suspicion (7) ”. Some experts would then be able to exercise greater freedom of judgement.
We could even imagine extending the appointment and payment of the expert by the regulator in the case of squeeze-outs, because when the parent company holds 90 or 95% of the subsidiary, the independence of the subsidiary is often a mere formality.
Of course, it is highly unlikely that offerors will be in favour of this development, and the same goes for the regulator. At the very least, and in the case of share buyback offers and squeeze-outs, the regulator should systematically appoint a second expert, making the valuation a joint effort.
This would be the last step of a welcome and audacious reform, which saw the regulator impose the presence of an independent expert for tender offers.
In the four days following the close of the offer, the Bouygues share price fell by 13% from €28.2 to €24.65, showing clearly that, generally speaking, it is a good idea for shareholders to tender their shares to a buyback offer. Those who tendered a portion of their shares were able to sell them at a price of €30, and those shares were worth only around €25 subsequently.
Simultaneously, the stock market index rose by 1% and Bouygues’ main competitors or subsidiaries saw their share prices fluctuate by between -5% and +2%.
Accordingly, saying that a share buyback tender offer is an offer in which shareholders are not obliged to tender their shares is factually correct from a legal point of view, but false from a financial point of view, since those who do not tender their shares to the offer, will bear the cost of the premium paid to those who do tender their shares.
Around 80% of the non-family member and non-employee shareholders understood this and tendered their shares to the offer, which was four times oversubscribed, notwithstanding the drop in the premium of the tender offer on the share price over the last days of the offer.
(1) For more information, see chapter 43 of the Vernimmen 2011.
(2) At the close of the offer, the premium of 30 – 27 = €3 times the number of shares targeted (41.7m) brought to the remaining shares after the tender offer (315m), is €0.4, or 1.5% of €27.
(3) For more information, see chapter 27 of the Vernimmen 2011.
(4) For more information, see chapter 27 of the Vernimmen 2011.
(5) For more information, see chapter 43 of the Vernimmen 2011.
(6) For more details see the Vernimmen.com Newsletter n° 38 dated January 2009.
(7) In the words of her husband, according to Plutarch.
The composition of corporate boards of directors varies from one European country to the next, clearly reflecting the cultural and economic differences between the countries that make up Europe. In the UK, there is a large proportion of independent directors (61%) and managers (29%), as more often than not, controlling shareholders no longer exist.
Conversely, controlling shareholders still play an important role in France (L’Oréal, LVMH, Carrefour, Hermès, etc.), in Spain (Inditex, Repsol, Endesa, etc.), and in Belgium (AB Inbev, GBL, Solvay, etc.), which explains their strong presence on boards of directors.
In Germany, Australia and Denmark, salaried directors hold 30 to 50% of the seats on corporate boards due to local regulations.
There are both advantages and drawbacks to listing a company on the stock market. One of the advantages is that listing provides access to investors who can easily sell their shares on the secondary market. Liquidity reduces the risk for investors, and accordingly, the firm’s cost of capital (1).
Among the drawbacks, the problem of increased agency issues between shareholders and managers is often raised. Before listing, managers often hold substantial stakes in the firm. After listing, their stakes – along with the stake of the majority shareholder – are reduced and so the distance between managers and shareholders is increased.
The article we present this month (2) seeks to assess the agency problems posed by listing, in particular concerning the firm’s investment policy. The authors present two contradictory effects brought about by these agency problems:
• An over-investment, linked to management’s desire to increase the size of the firm (empire-building), for reasons of prestige and/or compensation.
• An under-investment, linked to information asymmetry that exists between managers and shareholders. Shareholders, given their lack of information, place too much importance on immediate cash flows (short-termism). This in return incites managers to reduce the amount of their investments.
The results show the dominance of the second effect. The authors relied on a large data base of unlisted firms (created by Sageworks), which until now had not been exploited academically. A statistical treatment of this data base and of a Compustat data base of listed companies enabled them to create a sample of comparable companies, of “small” listed firms and of “large” unlisted firms, all American, all non-financial firms, over the 2002 to 2007 period.
According to the study, with equivalent characteristics, listed firms invest less than unlisted firms. Annual growth of net fixed assets is 2.2% for the “listed” sample and 9.4% for the “unlisted” sample (3). Additionally, they are less reactive to investment opportunities, since an increase in the growth of sales leads to a smaller increase in investments when the firm is listed. The authors conclude that listing is generally a bad thing from the point of view of investment policy. It results in the firm failing to seize investment opportunities that would create value.
These results are confirmed by additional tests carried out by the authors. For example, they looked at firms that had recently listed without issuing shares (so without immediately increasing their capacity to invest). They show that the investment policies of such firms become less reactive following their listing.
Finally, they show that this reluctance to react is even worse for listed firms whose stock prices are sensitive to immediate cash flows. Under-investment at such firms is clearly linked to the short-sightedness of shareholders.
(1) For more information, see chapter 41 of the Vernimmen 2011.
(2) J.ASKER, J.FARRE-MENS A, A.LJUNGQVIST (2010), Does the stock market harm investment incentives?, ECGI Finance working paper.
(3) Even the unadjusted samples show a difference (smaller) in favour of unlisted firms.
Some firms asked themselves this question in 2009, and others may soon be forced to do so, following the example of certain European banks at the moment.
We’d like to postulate that, confronted a liquidity or a solvency crisis (or both!) (1), nothing prevents firms from resorting to one or the other of these means in order to solve their problems.
The reader will not be surprised to see us recalling the fact that in finance, the determining factor is value. In other words, selling an asset at its value does not make the shareholder richer or poorer. Carrying out a capital increase by issuing new shares at their value does not make the shareholder richer or poorer. While obvious, this principle is frequently forgotten.
But what is value in periods of crisis, of panic, of liquidity restriction? What is an asset worth with the stock market index falls 25% in two months, like the some stock indexes did this summer? What is an asset worth when a listed share opens the trading session at 9:00am up 5%, falling by 7% at midday, gaining 4% by 3:00pm and closing down by 6% at 5:30pm?
Faced with the underlying nihilism of the obviousness of the above statement (since everything is worth its value regardless of the choice made), in times of crisis, the financial director retrieves his freedom of choice.
Let’s take the example of Saint-Gobain which had embarked on discussions in 2008 to sell its packaging division, valued at around €5bn. Following the crisis in Autumn 2008, the group could have at best managed to get half, which would have meant a (permanent) loss in value of €2 to 3bn. Accordingly, Saint-Gobain decided to issue shares while its share price had just fallen by 70% compared to its all-time-high of 18 months previously.
Crazy? No. A healthy decision as the share issue included the maintenance of existing shareholders’ preferential subscription rights. Those who wanted to or could afford to subscribed the new shares and those who didn't want to or couldn't afford to were able to sell their subscription rights.
So what Saint-Gobain was doing was asking its shareholders, i.e., its owners, to give it the means to continue to hang onto an asset that had become non-strategic, rather than to sell it at a knock-down price, so that it could sell it later at a decent price when market conditions were back to normal.
In such situations, it is, in our view, important to allow existing shareholders to subscribe to the capital increase if they so wish. Without having to resort to agency theory (2), it would seem to us to be a good idea, in a climate of confidence between shareholders and managers, for managers to refrain from reserving the subscription to the capital increase to a third party at the very moment when they’re saying that the share is under-valued.
If the share is effectively undervalued, it is important for shareholders to be able to take advantage of this opportunity, and that they don’t lose out to a third party, at a time when a decision has been taken not to sell an asset at a knock-down price in order to avoid making them poorer. It’s important to be consistent. One could, of course, say that existing shareholders could just buy on the market the same number of shares to which they were entitled in the capital increase. If the company is listed, that is. One could also say that the formalities involved in a capital increase with a preferential right are onerous and lengthy and that in periods of crisis, it’s important to act quickly. But that would be saying that there is no loyalty in shareholder-manager relationships, which in our view, is not healthy.
Sometimes we hear managers saying that they don’t intend to issue new shares as that would dilute EPS. This line of reasoning is false. After a share issue aimed at reducing debt, the firm and its EPS will be less risky, which will mean that it deserves a higher P/E ratio which will set off the dilution of EPS. The dilution of EPS will happen automatically, as soon as the inverse of the after tax interest rate on the reimbursed debt is higher than the firm's P/E ratio. With debt costing 4% after tax, the P/E ratio of the firm must be more than 25 in order to avoid dilution of EPS following the share issue (3). The assets sold must also be valued on a P/E ratio of 25 in order to avoid diluting EPS following the sale intended to reimburse the debt costing 4% after tax. But it is less frequent to work out the dilution of EPS after the sale of an asset.
Of course, from a psychological point of view, a manager will probably feel rather uncomfortable having to go and see his shareholders in order to ask them to reinvest in the firm in order to pay off debts instead of investing in new projects. But life is all about moving out of our comfort zones!
Whether the company is not very profitable, i.e., whether its ROCE is lower than its cost of capital, makes no difference at all. The new shares will be issued at a price (including the subscription right) that is lower than the book equity on the balance sheet and on this basis, investors will normally get their required rate of return, even though the firm will not get it on its book equity ; simply because investors will buy their shares at a discount on the book equity. And because the funds from the share issue will be invested in repaying a part of the debt and not in projects that are not earning the cost of capital, the firm will not, accordingly, be destroying value.
We also need to hope that the manager has not shouted from the rooftops that he does not intend to issue new shares on the basis of the current low share prices, when his firm is facing a real problem of solvency and liquidity. If the alternative is to dispose of assets at knock-down prices given the economic context, would it not be preferable to issue new shares? It’s all a question of choosing between two evils.
(1) For more on the difference between these two concepts, see chapters 12 and 14 of the Vernimmen 2011.
(2) For more on agency theory, see chapter 27 of the Vernimmen 2011.
(3) For more information, see chapter 39 of the Vernimmen 2011.