Letter number 95 of July 2016
- QUESTIONS & COMMENTS
“The dividend is something sacred for Shell. I’ll do all in my power to protect it.” Ben Van Beurden, Shell CEO.
“The dividend is the highest priority for Conoco when it comes to using its treasury.” Ryan Lance, Conoco CEO.
“Total will not introduce a yoyo policy, not for jobs, not on an industrial level, not for the dividend.” Patrick Pouyané, Total CEO.
Which did not prevent one of these CEOs from dividing his group’s dividend by three a few months ago.
When looking at the subject of oil company dividends, one can only be surprised at how investors in this cyclical sector are extremely keen to receive dividends that are, at the worst, stable. Cyclical sectors and stable dividends, however, are concepts that would appear to be at odds with each other, especially if we look at the performance of oil prices since the early 1970s:
It is true that the operating cash flows of oil groups are less volatile than the price of oil: where the latter has dropped by around two-thirds, the former have only been reduced by half. Of course, the diversity of their activities, their capital structure (Exxon Mobil was one of the very last industrial groups that was still rated AAA until a few months ago) provide them with stability that is not enjoyed by many. Nevertheless, what a challenge it is to maintain a stable dividend in these conditions for investors seeking the recurrent returns that are needed to pay pensions!
And because the oil sector is the leading payer of dividends on the London Stock Exchange, with nearly 20% of sums paid out, pressure is high. The mischievous reader will be quick to note that it will not be the second (banks) or the fourth (mines) biggest dividend payers who will be in a position to make up for the low oil dividends right now. In short, pressure is very high and also very efficient as it is very well internalised, as illustrated by the quotations at the beginning of this article.
The description “large international oil group”, apart from a market capitalisation of at least €70bn, covers many different situations. Shell is in the process of acquiring BG for £36bn, BP still bears the scars of the 2010 industrial accident, ENI is the only one with a reference shareholder, (the Italian government) and with a recent major discovery (Egypt), Conoco has refocused on exploration –production by selling off its refining-distribution activities, etc. All of this has, of course, had an impact on their dividend policies.
But all of them have in common the fact that they no longer generate sufficient free cash flows to cover the payment of their dividends, without selling off assets or increasing debt. This has been the case for Total since 2009, ENI since 2006, BP since 2009 if we exclude 2014, Shell since 2009 and Exxon Mobil in 2015.
For groups of this size, there is nothing shocking about selling off assets since experience has shown that these majors are not the best placed for exploiting end-of-life oil fields and that much smaller groups are far more efficient at this. It is after all, the lions that chase, kill and eat the zebra, but the hyenas that feed on the carcass.
Similarly, since debt levels in 2008 weren’t very high (net debt/EBITDA of 0.1 for Shell 0.3 for Total, 0.6 for BP, 0.7 for ENI), there is nothing alarming about recourse to a bit more debt in a mature sector. And there is nothing unreasonable about the figures in late 2015 (1.0, 1.4, 1.3 and 1.2 in the same order), although they could not be very far off the maximum if 2016 EBITDA figures were to decline.
Until now, the biggest of the majors have preferred to maintain or increase (Exxon) their dividend per share, even if this means deteriorating their credit rating, rather than to decrease it. Given current interest rates, there is no serious drawback.
So what now?
Conoco cut its dividend in half in early 2016. It is true that it did not benefit from refining-distribution margins, which are now very high again, since it is no longer active in this business. ENI reduced its dividend by €1bn, but did not reduce its investments by any less than the three other European majors, which have trimmed theirs by around 40% since the highest level in the 2010s, without touching their dividends.
It is obvious that all will depend on what happens to the oil price. If it remains at around $40 for a long period, it is difficult to see how the oil majors will be able to maintain distribution rates that are higher than 100% which may be the case again in 2016 (except for Total).
The most important aspect of a dividend distribution policy is that it must be credible and sustainable over time.
Failing this, experience has shown, time after time, that investors sell their shares, fearing that value-creating investment opportunities may be abandoned or neglected in order to maintain the dividend. The rate of earnings per share will rise, which will delight the naïve, but which is only an indicator of the anticipation of a future dividend reduction, bringing it back to a normal level. Stubbornly seeking to maintain it despite all evidence that this is not sustainable is counter-productive and detracts from management’s credibility. The management team in place at Deutsche Telekom in the mid-2000s which, believing it was doing the right thing, followed this path can testify to this. They have never recovered.
In other words, there are only a few commentators who think that shareholders cannot see beyond the ends of their noses!
If the oil price now takes off again compared with its level at the start of the year, which is the current consensus, then it should be possible to maintain dividends. Because it is obviously impossible to predict what is going to happen to oil prices, even for the financial director of an oil group, we think that the solution arrived at by Total is rather elegant.
Since 2015, Total has offered its shareholders the choice of receiving their dividends in cash or in Total shares. Those who need cash opt for cash. The others, who would perhaps have invested the dividend in Total shares in order to maintain its weighting in their portfolios, opt for payment in shares.
Obviously, the company cannot be sure in advance of the percentage of its shareholders that will choose payment in shares, which also depends, for a large part, on the performance of the share price around the time of the choice. But since Total pays a quarterly dividend, the uncertainty is repeated four times a year and each time brings amounts that are divided by four.
So, Total has maintained its announced dividend while preserving its financial situation.
It is clear that those who are misled are only those who want to be misled. But on the other hand, receiving a dividend in shares and selling it on the stock market in order to get cash is not very different from not receiving a dividend at all and selling a portion of one’s shares to cover one’s cash needs. The dividend, notwithstanding its name, is in the end, only a partial monetisation of capital.
Disintermediation is a clear trend in modern finance in Europe. The graph below shows the expansion of debt private placement products in Europe since 2010. This product is available for SMEs contrary to public bonds. It allows therefore a much larger number of companies to take the disintermediation route.
In a world where banks will increasingly be constrained to lend because of regulatory reasons, this may prove a smart move.
With Simon Gueguen, lecturer-researcher at the University of Paris-Dauphine
The credit spread paid by a borrower, measured as the difference between the interest rate applied to its loan and the “risk-free” rate (in fact without a corporate risk, typically that of government bonds), depends on the nature of the borrower, i.e. its risk of default, amount of losses in the event of default, correlation of risk with the economic situation, etc. Logically, this means anticipations that depend on the firm’s situation at the time at which it contracts the loan. The past is only a factor in that it enables us to better anticipate the future. However, the article that we present this month reveals a surprising determinant of the spread: the spread paid at the time of the previous loan. Dougal et al show that, with equivalent features, and an apparently equivalent risk, a company whose previous loan was taken out during a period of low rates, pays a lower spread than a company which borrowed during a period when rates were high. They offer a behavioural explanation – the concept of anchoring.
The study covers over 15,000 loans (short- and long-term loans and renewable credit lines) contracted between 1987 and 2008 by US firms. The loan agreements are divided into three categories: those for which spreads were increased by more than 25% since the firm’s previous loan, those for which the spreads were reduced by more than 25%, and finally those for which the spreads remained more or less stable. The main result is as follows: when the previous spread was lower than 25%, the new loan was contracted at a spread that was 13% lower compared with peers. Conversely, when the spread was higher than 25%, the new spread was 15% higher than what it should have been. The total effect is significant – a 28% difference between the spreads of firms whose sole apparent difference is the level of the spread on previous loans. This represents around 50 to 80 base points on the cost of the loan. There are several possible explanations. Some of them are rational and based on the real risk of the loan, or the lender-borrower relationship. Dougal et al attribute this to a behavioural explanation called anchorage, which results in spreads that do not correctly reflect the level of risk.
Anchorage means the tendency to retain the terms of a loan agreement over time (in this case, the credit spread) even though the situation has changed. There are several reasons why Dougal et al favour this interpretation of their observations:
- when they compare the new loan with the previous one, they observe that frequently, the new loan is contracted at exactly the same rate as the previous one, even when the economic situation has changed;
- the impact of the previous spread is stronger when this loan is more recent, when the lender is the same and when the firm’s debt is not rated. These are all conditions that could reinforce a behavioural bias;
- no concrete difference is observed between companies based on the time at which they took out their previous loan. Profitability, financial leverage, valuation ratios, historical performance, and even future performance are the same. A rational explanation of the size of the previous spread is thus unlikely;
- the effect is observed, even when the firm changes its principal lender so it is not linked to a relationship or a special agreement between the borrower and the lender.
Finally, Dougal et al check that the impact of previous spreads on new ones is not set off by changes in the opposite direction of the other terms of the loan. They find that there is no set-off and conclude that this behavioural bias leads to spreads that are over- or under-valued. They also show that anchoring is not as strong in the case of stiff competition.
A major consequence of these results is the importance of timing in loan-related decisions. When a firm borrows at the right time, the effects of this good timing can be felt beyond the loan in question. The low spread obtained will also lead to a lower spread for future loans! Rather good news for borrowers today given the current conditions of risk remuneration.
In an M&A transaction, a negotiating strategy aims at achieving a price objective but price is not everything. The seller might also want to limit the guarantees he grants, retain managerial control, ensure that his employees' future is safe, etc.
Depending on the number of potential acquirers, the necessary degree of confidentiality, the timing and the seller's demands, there is a wide range of possible negotiating strategies. The two extremes are private negotiations and auctions.
Academic researchers have established that none of these strategies is better than another. The context dictates the choice of a strategy.
1/ Private negotiation
The seller or his advisor contacts a small number of potential acquirers to gauge their interest. After signing a non-disclosure agreement the potential acquirers receive a pack of information (potentially in the form of an information memorandum, “info memo”) describing the company's industrial, financial and human resource elements. Discussions then begin. In principle, this technique requires extreme confidentiality.
To preserve confidentiality, the seller often prefers to hire an investment banker, to find potential acquirers and keep all discussions under wraps. Strictly speaking, there are no typical negotiating procedures for private negotiations. Every transaction is different. The only absolute rule about negotiating strategies is that the negotiator must have a strategy.
The advantage of private negotiation is a high level of confidentiality. In some cases, there may be no paper trail at all.
The discussion focuses on:
- how much control the seller will give up (and the status of any remaining minority shareholders);
- the price;
- the payment terms;
- any conditions precedent;
- representations and warranties; and
- any contractual relationship that might remain between the seller and the target company after the transaction.
Price usually remains the essential question in the negotiating process.
When a framework for the negotiations has been defined, a memorandum of understanding is often signed to open the way to a transaction. A memorandum of understanding is a moral, not a legal, commitment. Often, once the MOU is signed, the management of the acquiring company presents it to its board of directors to obtain permission to pursue the negotiations.
The memorandum of understanding is not useful when each party has made a firm commitment to negotiate. In this case, the negotiation of a memorandum of understanding slows down the process rather than accelerating it.
The next step might be an agreement in principle, spelling out the terms and conditions of the sale. The commitments of each party are irrevocable, unless there are conditions precedent such as approval of the regulatory authorities. The agreement in principle can take many forms.
In an auction, the company is offered for sale under a predetermined schedule to several potential buyers who are competing with each other. The objective is to choose the one offering the highest price. An auction is often private, but it can also be announced in the press or by a court decision.
A brief summary of the company is prepared (a “teaser”). It is sent to a large number of potentially interested companies and financial investors.
In the next stage (often called “Phase I”), once the potential buyers sign the NDA, they receive an info memo. Then they submit a non-binding offer indicating the price, its financing, any conditions precedent and eventually their intentions regarding the future strategy for the target company.
At that point of time (“Phase II”) a “short list” of up to half a dozen candidates at most is drawn up. They receive still more information and possibly a schedule of visits to the company's industrial sites and meetings with management. Often a data room is set up, where all economic, financial and legal information concerning the target company is available for perusal. Access to the data room is very restricted. At the end of this stage, potential investors submit binding offers.
At any time, the seller can decide to enter into exclusive negotiations for a few days or a few weeks. For a given period of time, the potential buyer is the only candidate. At the end of the exclusive period, the buyer must submit a binding offer (in excess of a certain figure) or withdraw from the negotiations. Exclusivity is usually granted on the basis of a pre-emptive offer, i.e. a financially attractive proposal.
Together with the binding offers, the seller will ask the bidder(s) to propose a markup to the disposal agreement (the Share Purchase Agreement, SPA) previously proposed by the seller. The ultimate selection of the buyer depends, naturally, on the binding offer, but also on the buyer's comments on the share purchase.
For an attractive asset, an auction will lead to a high price because buyers are in competition with each other. It also makes it easier for the seller's representatives to prove that they did everything in their power to obtain the highest possible price for the company.
An auction is faster, because the seller, not the buyer, sets the pace. A well-processed auction can take three to five months between intention to sell and the closing. It is sometimes shorter when an investment fund sells on to another fund.
However, the auction creates confidentiality problems. Many people have access to the basic data, and denying rumours of a transaction becomes difficult, so the process must move quickly. Also, as the technique is based on price mainly, it is exposed to some risks, such as several potential buyers teaming up with the intention of splitting the assets among them. Lastly, should the process fail, the company's credibility will suffer. The company must have an uncontested strategic value and be in sound financial condition. The worst result is the one of an auction process which turns sour because financial results are not up to the estimations produced a few weeks before, leaving only one buyer who knows he is now the only buyer.
3/ The outcome of negotiations
In the end, whatever negotiating method was used, the seller is left with a single potential buyer who can then impose certain conditions. Should the negotiations fall apart at this stage, it could spell trouble for the seller because he would have to go back to the other potential buyers, hat in hand. So the seller is in a position of weakness when it comes to finalising the negotiations. The principal remaining element is the representations and warranties provisions that are part of the share purchase agreement.
The final step is the actual consummation of the deal. It often takes place at a later date, because certain conditions must be met first: accounting, legal or tax audit, restructuring, approval of domestic or foreign competition commissioners, etc.
Some 18 months ago, we launched with HEC Paris and First Finance the first online executive certificate dedicated to corporate finance, ICCF@HEC Paris; ICCF stands for International Certificate in Corporate Finance.
Today, several of our HEC colleagues in strategy have followed on and launched an online executive certificate devoted to strategy.
Why do some firms perform better than others within the same industry? What is the key to success? Strategy@HEC Paris is designed to enable participants to understand the reasons for the success and failure of certain companies and to learn how to build an effective strategy for their own organizations.
HEC Paris professors Pierre Dussauge and Bernard Ramananstoa amongst others provide participants with the tools and frameworks needed to effectively formulate and implement a winning strategy.
The online program is made up of 3 modules – Business Strategy, Corporate Strategy and Strategy Implementation- all taught online through video lectures, discussion forums and practical case studies. At the end of the 5-month program, participants sit an exam at a Pearson Vue exam centre, located in 150 countries worldwide. Upon successful completion participants are awarded a HEC Paris certificate.
There is no selection process for admission to the program, which is priced at €1,800. The course is delivered in English with subtitles in French and the first intake will start on 27 September 2016.
As you are well aware, and not only because you have read the epilogue of our book entilted “Finance and Strategy”, finance and strategy are closely linked, and one cannot be a good financier without mastering strategy. Isn’t it time for you to make up for any deficiency in the strategy field?
For more information about Strategy@HEC Paris or ICCF@HEC Paris visit:http://hecparis.ff.institute/en/strategy-hec-paris/